With Geithner set to announce his plan for fixing the banks on Monday Tuesday it’s time to look at one of the biggest issues in the financial crisis: the fact that no one knows how bad the damage is.

Not only is the financial situation  getting worse, but a lot of securities either really have no market (they’re hardly ever sold) or the market price is actually below their probable long term value.  If the government is going to take over banks, or insure the securities, or set up a bad bank, they need to know whether they’re solvent and how risky the securities they hold are—how likely they are to go bad in the future.  Once they know that, they know how much to pay, which banks to take over and which banks can be saved.

How to value securities to allow proper bank triage and surgery

  1. If the security has an income stream value it based on the income stream and then devalued based on the risk that is average for paper with that return.  Take that value from securities which do trade on markets, even if this one does.   (i.e. 20% return is junk bond status, sorry).
  2. If the security has no revenue stream but does have a maturity value, value it at maturity discounted for risk based on return.  Again take the discount value from publicly traded securities with similar returns.
  3. If the security has speculative value but no guaranteed income or maturity value then you simply have to get some bids from the market and value it at those bids.  In many cases this is going to be, literally, cents on the dollar.  There’s no way around it.

The government takes these figures and calculates two numbers from it:

Assets – Liabilities:  After revaluing all the crap, does the bank have more assets than liabilities.  Is it bankrupt or not?

Cash flow:  Is the bank cash-flow positive.  Note that a bank could be bankrupt and have positive cash flow.

They then divide banks and other financial firms into four groups:

Cash Flow Positive and More Assets than Liabilities
This is a healthy bank.  The government gives them no money, and puts no specific restrictions on them other than whatever general regulatory reform everyone is subject to.  Tell them to go on their way and do what they want.

Cash Flow Positive But Less Assets Than Liabilities
You either nationalize this firm, hive the bad assets into a bad bank and then after some years sell the bank back to the private sector at a profit or you combine this bank with one or more of the next class of banks – those that are:

Cash Flow Negative But More Assets Than Liabilities
This bank can’t keep operating on its own, but combined with a bank with positive cash flow it could work out.  Combine it with a bank with cash flow.  If the government can’t find one, they shut the bank down in classic FDIC fashion, and sell off the assets to pay off the liabilities.  Done right shutting down the bank should cause no adverse ripple effect since assets are greater than liabilities (but if the government wait for that to change, it could cause a ripple effect, so they shouldn’t hesitate, get it done!)

Cash Flow Negative and More Liabilities than Assets
FDIC takes these banks over.  Don’t even bad bank them, just wind them down.  They’re dead, they just don’t know it yet.

Now the next step after the government has done done all this—found out which banks are alive, which are wounded, and which are dead is that they offer to insure the securities.  But instead of just blanket guarantees they offer properly done insurance which costs what it’s worth. You base default rates off the market, charge the right premiums and insure.  Since you’re charging enough money to cover the losses, the taxpayer won’t take a bath on this, and it will also reassure investors.  Some banks which are only slightly cash flow positive may go cash flow negative if they have to take out insurance, in that case they really belong to category four (they may not be dead yet, but the math says they will be soon) and you shut them down.

This process probably isn’t much like what Geithner’s going to propose Monday, but it should be. It’s based on three principles.

  1. Find out How Deep the Hole Is
  2. Perform Triage: Bury the dead, help the injured, let those only mildly wounded fend for themselves
  3. Make sure the damage to the financial sector doesn’t spread any further beyond the financial sector

We can only hope Geithner’s plan will do all three of these things. 

Endnotes

i. For restarting lending, you do it in two ways – the banks the Fed takes over which aren’t dead you use to lend to consumers under FDIC direction, and the Fed just lends directly.

ii. If you’re setting up a bad bank, you must nationalize the firms you are taking bad assets off of, otherwise private investors get all the upside, and taxpayers get the downside