To Fix Bank of America: Rules not Discretion

Despite Warren Buffet's interventions, The troubles at Bank of America seem large. Over concerns of rising credit losses and lawsuit risk, the company’s stock has plummeted, while the price of credit default swaps to protect against default have risen.

Henry Blodget, at Business Insider, offers a plan to fix Bank of America:

First, Treasury Secretary Tim Geithner needs to set a "trigger price" for Bank of America stock. If Bank of America stock falls through this trigger price, he will then automatically put this plan into action…

·  Write down the value of Bank of America's assets by whatever it takes to make the balance sheet bombproof—focusing on second mortgages, commercial real-estate, European obligations, goodwill, and other "assets" that the market is skeptical about.

·  "Haircut" the unsecured creditors by whatever amount is necessary to close the gap between the asset writedown and the equity (BOFA currently has $222 billion of equity, so there's a lot to work with).

·  Inject $300 billion (or some multiple of the asset write-off) of fresh capital into the bank in the form of preferred and common stock—enough to make the bank extremely well-capitalized.

His prescription has much in common with several bank resolution strategies like  speed bankruptcy and a new bankruptcy chapter code. The common thread through these solutions is a reliance on a rules-based system for handling bank liabilities that would place the bulk of the burden on the holders of junior liabilities like equity and junior debt. These would be written off or written down in order to facilitate an orderly recapitalization under new management.

Of course, it remains to be seen what sort of credit losses Bank of America will ultimately bear. It may well the case that the company will manage without any writedowns. However, given the importance that Bank of America has on the larger economy, it’s essential to have in place a viable back up option.

Unfortunately, it seems unlikely, however, that Geithner and colleagues will actually follow the rules-based back up outlined above. Instead, if Bank of America requires a bailout, it will happen in a similar manner to the bailouts during the financial crisis — which were ad hoc and driven by regulatory discretion.

New revelations from the Fed reveal the extensive nature of those bailouts. In response to inquiries from Bloomberg news, the Fed has revealed the existence of loans offered to major financial institutions. These loans may be defended on the grounds that such lending fits with the Fed’s mandate as a central bank, and were essential to allowing  the financial system to weather the panic. However, the lack of transparency that surrounded their disbursement and the quality of the assets used as collateral is certainly troubling.

This new discovery helps make sense of a research finding by Daron Acemoglu, Simon Johnson, and colleagues. In a paper, this group found that Geithner’s appointment was associated with stock gains among companies with close ties to Geithner. These gains were not present among financial firms generally — suggesting that connections, rather than Geithner’s performance as Treasury Secretary, drove these firms profits. Interestingly, this same group of companies suffered as Geithner’s tax problems led to lengthy confirmation battle.

The overall pattern in the last several years has brought new waves of crony capitalism to the foreground. Firms have received loans and bailouts in line with personal connections, and have seen their share values fluctuate in proportion with the career prospects of individual bureaucrats. Dodd-Frank enshrines this discretion-based approach into law, and does not auger well for the creation of a functioning financial system. Instead, we need a financial system based on rules. Bank of America could be a good place to start depending how the market value of its liabilities and equity hold up over the coming weeks.