Simple but makes sense

There has been tons of articles about good banks and bad banks written in the past few months; most of these articles are fairly arcane. This article by Susan Woodward and Robert Hall is not arcane and makes a lot of sense.

The key point of the article is that the bad bank owns the good bank. Further, that's about all the bad bank does; in the banking sense it has no operations except trying to get some money for the 'toxic' assets it now owns. Citibank is the example used to illustrate the concept.

The example does something most banks are loathe to do: mark the assets to market. It also values the equity at the current market of $11 billion. (As an aside, the $11 billion market cap for Citigroup today includes the $50 billion we gave it plus the guarantees we supplied. Does that say anything about Citi's future?)

After dividing the assets into good and bad and parceling them out to the respective entities, the current capital ratio of 1% becomes 32% for the good bank and remains at 1% for the bad bank. The current stockholders and bondholders own the bad bank, which, you'll remember, owns the good bank. So, these investors are no worse off then they are now. But we have one healthy bank that can actually be run as a bank and one unhealthy bank that, if the toxic assets cannot be resuscitated, does not need more of our money and could simply go into Chapter 11, where the stockholders and bondholders can fight over the carcass.

If Citi stays as a single entity and the market gets worse, what panic will be there if it becomes insolvent? Whereas, with this approach, it is extremely unlikely that the good bank will go belly up and, if the bad bank goes bankrupt, the taxpayers are not on the hook any further than currently.