The ''new'' Geithner plan

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The problem with the Bulow-Klemperer suggestion for bankrupcy procedure is that one has to figure out which debt-holders hold claims against the good stuff and which against the bad stuff. Right now they hold claim (in order of seniority) against a mixture of the two. If you do the splitting, what do you put in the balance sheet of the good bank, under liabilities? All the liabilities? Well, no otherwise the good bank is already broke. The most senior ones? That's not what seniority entitles you to, according to most bond covenants and exisiting regulations ... and so on.

In other words, the problem is always the same: who get's screwed? Who picks winners and loosers in this game? Until now, clearly, the government has been deciding who takes home the money and who pays for it, not the market or not even the law. Just the discretion of two different administrations. Not good.

No, I don't think this is a big problem. The liabilities are essentially of two types, deposits and non-deposits. Only deposits go into the good bank and they are therefore safe. But they are safe anyway since (mostly) they are already insured. The good bank also receives the good assets.

Currently, the other liability holders have claims against a mixture of bad assets and good assets but their claims are junior to deposits. Thus, effectively,  they have claims against bad assets and good assets minus deposits, assuming the difference is positive (which is the only case in which the BK operation makes sense). After the BK operation, they have claims against the bad bank, which means a mixture of bad assets and the equity of the good bank, which is owned by the bad bank. Since the value of the good bank is equal to the value of the good assets minus the deposits, they lose nothing. It only becomes clearer that they cannot hope for total reimbursement of their credit if the value of the bad assets is low.

Of course they lose with respect to a situation a la Paulson-Geithner plan, in which the bad assets are overpaid courtesy of taxpayers and the money is used to reimburse creditors. To make the point once again, this is exactly what I like of the BK plan. It separates the issue of how we treat creditors from the issue of keeping the banks running.