Jeremy Siegel, Ph.D. The Future for Investors

As the crisis in the U.S. banking system deepens, an idea has popped up among policymakers. The concept is an "aggregator bank," a bank run by the government that will buy the "bad" loans and impaired mortgage-backed securities from ailing financial institutions, leaving the remaining bank with the "good" performing assets. The motivation for the plan is that, if banks were rid of their bad assets, they would begin lending again, kick-starting our sinking economy.

The aggregator bank is a government version of the good bank/bad bank concept that has been proposed before for troubled banks. Lehman mulled the idea of spinning off its bad debt into a separate unit before it collapsed last September. Last month Citigroup announced it was splitting its bank along operational lines, but it never addressed how the good bank's capital could be isolated from the bad bank's assets.

As attractive as the plan sounds, the aggregator bank is no easy solution. In fact, it shares many of the same problems that plagued the TARP (Troubled Asset Relief Program) proposed by Treasury Secretary Hank Paulson last September. In that plan the government also proposed to buy the banks' toxic assets, asserting that removing these non-performing assets from the balance sheets would encourage banks to lend again.

An Abandoned Plan

The plan was quickly abandoned when the government realized there was no mechanism to determine the price at which they should buy these toxic assets. Instead, the Treasury pursued on alternative policy and "invested" TARP money in banks by giving them additional capital, acquiring preferred stock and warrants (options on common stock) in exchange for the money lent. But these capital injections have also failed to spur lending as the economy has soured and the number of troubled assets mushroomed.

Yet another plan involved the Federal Reserve putting a "fence" around troubled assets (about $300 billion for Citigroup and $100 billion for Bank of America) and agreeing, after a certain deductible, to take 90 percent of any further losses. But this measure also proved inadequate as the worsening economy increased the size of questionable assets.

The aggregator bank plan is really just a larger version of the original TARP plan, and it inspires the following question: At what price does the government buy these assets? If the government buys the assets at today's market price, ailing banks are no better off and may be insolvent. If instead the government buys the assets at a higher price, then the taxpayer is bailing out the bank's bondholders -- and there is still the question of what to do with management and stockholders.

Citigroup's Plight

To help us understand how an aggregator bank works, let us look at Citigroup (which on February 3 announced a plan to use funds from the TARP to put $36.5 billion toward boosting lending). As of year-end 2008, Citigroup had an almost $2 trillion book value of assets and about $150 billion in book value shareholder equity. But the market believes that many of Citigroup's loans and securities are badly impaired, and the true "market" value of these assets could be 10 percent or more below their face value, even after counting Citi's loan loss reserves.

If that is the case, then Citi is "underwater," and the $150 billion of shareholder's equity has actually been wiped out. If the firm is liquidated, the bondholders would have to accept less than 100 cents on the dollar. Clearly, if the government bought Citi's bad assets at today's market price, this would not be a good outcome for either Citi shareholders or bondholders.

There are many who advocate this extreme action, saying the government should liquidate Citigroup and any other bank that the market says is underwater. They rightly claim that the management took foolish risks and those who provided risk capital -- stockholders and bondholders -- should pay the price.

Huge Risks

But there are huge risks associated with putting Citi down in this way. First, any bankruptcy is liable to panic the capital markets. The impact of the Lehman bankruptcy last September was far wider than anyone expected. Imagine the impact of a Citigroup or Bank of America bankruptcy, both of which are many times the size of Lehman.

Second, although I have little sympathy for the management of these financial institutions that, in pursuit of short-term profit, overleveraged and put their firms at risk, I wonder who will run the firm after the bankruptcy? Will Congress or the president decide? Do we want these banks run by government bureaucrats or Congressional appointees?

Suppose the government takes over Citigroup and liquidates its assets, selling the deposits, properties, and other valuable pieces to the highest bidder. If, say, JPMorgan or Wells Fargo buys Citi's assets, these banks, already large, will become gigantic. In a world where "too big to fail" has been the cause of many of our problems, the liquidation of Citi could make the big banks even bigger.

A Second Solution

A second solution is for the government to avoid Citi's bankruptcy by buying its troubled assets at a price high enough to cover all the bondholders. But this policy could cost taxpayers hundreds of billions of dollars, and it might be too generous. All debt is not created equal. Some debt has senior claims on the firm's assets and other debt is "subordinated" to the senior debt.

There was considerable criticism after the government bailed out Fannie Mae, giving full value to those holding subordinated debentures -- the lowest rung of creditors who had been paid a hefty interest premium to provide credit to the faltering mortgage insurer.

A third solution is to just let the banks "muddle through." It is certainly true that the market price of some of the troubled assets is probably selling at too low an amount, and allowing the bank to hold the loan to maturity would allow it to recover more than the market is now paying. Furthermore, the profits from some of Citi's core businesses -- such as credit cards, deposits, and others -- might over time create enough capital to offset the shortfalls from over-extended loans and the risky securities Citigroup purchased. After a long period, Citi may be able to build itself back to profitability and cover the bondholders' stake.

Tough Decisions

But can we wait that long? One of the great criticisms of the way Japan handled its real estate bubble two decades ago was that the Bank of Japan didn't move fast enough to revive the banking industry. Many praise the Resolution Trust Corporation, which was created in the 1980s to recapitalize the failing savings and loan industry. But those firms were tiny compared to the megabanks that are now in trouble, and most of their liabilities were deposits which the government had an obligation to pay off.

There is no easy solution to the current banking crisis. The Obama administration will have to make a hard choice among these alternatives. I believe the Fed should put more pressure on banks that took TARP funds to keep the lines of credit of non-delinquent, credit-worthy borrowers open. The capital markets are clamoring for a solution and would probably welcome any that the administration comes up with, short of nationalization.

We have successfully stabilized many of the lending markets; if we can come up with a creative plan to stabilize the banks, the end of this long and painful recession will be closer.