Fleshing it out

The Treasury Department's Financial Stability Plan launched by Secretary Geithner was criticized for lack of detail. Here are four quick suggestions to put meat on its bones.

First, commit to the creation of a federally funded "bad" bank. It's a bold move but a sound concept. Such an aggregator bank would purchase the bad assets from the balance sheets of U.S. banks and resell them to buyers who believe profits can be made. In the process, the banks would emerge as healthy, creditworthy and capable of issuing new loans to jump-start our foundering economy.

Second, get valuation right. So far, the market has not been operating with respect to the bad assets. Federal regulators are conducting their own review of banks' balance sheets. They should use consistent principles to price the bad assets at no higher than the midpoint of the range of potential values, and the aggregator bank should be mandated to buy them at that level. That will provide uniform pricing principles to address the fear that the asset carrying values are overstated while giving the federal government an opportunity to recover a portion of the purchase price.

Third, guarantee deposits. The valuation and sale process will require a write-down of the bad assets. That will cleanse balance sheets at a realistic value but cost the banks' net worth. To offset that, the plan should offer banks extended deposit insurance, guaranteeing all deposit accounts for up to 10 years, with no limit on amount or type and a flexible standard of limiting interest payable to rates determined by a Treasury-approved formula. This will give depositors confidence to put their money in the banks.

Finally, provide a "capital cushion." The federal government should offer to make loans to or purchase preferred (or convertible preferred) equity in the banks. The capital should be sufficient to assure creditors that the banks will be viable and able to regain the confidence of their peers and customers. Such an assurance should permit the banks to re-enter the capital markets to raise funds. The capital cushion for each bank should be sized to cover short-term debt obligations and permit a capital injection equal to the bank's bad asset write-down. There ought to be sufficient flexibility so that banks that wrote down their assets more aggressively than their peers are not penalized. This will incentivize even the better-capitalized banks to participate.

There will be complications, of course. Some banks may decide not to sell their assets to the aggregator. Those that don't will not benefit from the extended federal deposit insurance nor receive the capital cushion. They will have to chart their own course to financial stability. How they participate in the cost of the extended depository insurance program would have to be determined, as would the coverage of the plan itself and the definition of qualifying bad assets. For some banks, federal regulators may conclude that no amount of assistance will be sufficient. Those institutions should be closed and their deposits transferred to another bank.

Some may object that this plan is too costly. Indeed, it is expensive in absolute terms, but precedents indicate it works. Sweden successfully bailed out its banking system in the 1990s, providing liquidity and guaranteeing repayment of bank creditors in return for equity, and requiring all banks to write down their impaired assets to a realistic value determined by banking regulators using consistent valuation procedures.

Indeed, a plan based on these four pillars could actually prove less expensive than other alternatives, as the assets acquired by the aggregator bank may be sold in the future (some at higher prices, recouping the cost, at least in part, of their purchase). The banking industry will stabilize and again begin to function, making the extended federal deposit insurance a confidence builder without substantial long-term cost, and the federal government will be repaid for the capital cushion it provides. Most importantly, banks will have cleansed their balance sheets in a transparent, consistent manner that restores confidence in their ability to function without further and continuing write-downs and thus once again become capable of raising capital.

Paul N. Roth is a founding partner of Schulte Roth & Zabel LLP. He is a member of the firm's executive committee and head of its investment management practice.