Brad DeLong recommends this plan from Susan Woodward, Robert Hall, and Jeremy Bulow as “the cleverest plan I have yet seen.”
And, indeed, it is clever. Here’s the plan in chart form:
The other two columns show the balance sheets of the new good bank and bad bank. The good bank will continue to operate under the Citi brands as a well-capitalized operating entity. The bad bank will be a financial fund with no operating functions. The good bank gets the short-terms assets and the “other” assets because many of these are related to its operating activities. It gets the better half of the long-term assets, taken to have book value, while the bad bank gets the poor half, where the impairment has already occurred and suspicions of further price declines persist. The bad bank holds the valuable equity in the good bank to the tune of $427 billion.
The deposits remain as liabilities of the good bank. Because the good bank is heavily capitalized, the deposits are safe. Most are uninsured, so the creation of the good bank eliminates the danger of a run on the bank by those depositors. All of the debt goes to the bad bank. The holders of the debt were never promised a government guarantee. The shareholders in Citicorp become the shareholders in the bad bank. They are indirectly shareholders in the good bank as well, because the bad bank owns the good bank.
The bad bank is thinly capitalized. In fact, it has exactly the same amount of capital that Citi had in the first place. With further declines in the values of the troubled assets, the bad bank may become insolvent. In that case, the bondholders will need to negotiate diminished values or the bad bank will need to be reorganized. In either case, the shareholders will lose all their value, just as they would have lost that value had Citi not been divided and there had been no further bailout from the government. The bondholders will lose part of their value, because there is no reason or justification for bailing them out.
This seems suspiciously like magic, so I’d like to know what others with some expertise have to say.