Plan B

Luigi Zingales offers an interesting alternative bailout plan. His plan focuses on ways to recapitalize the banking sector and to deal with the mortgage crisis. His Plan B idea is to stop the piecemeal reaction to developments in the financial crisis and implement a comprehensive plan.

Here is the core idea regarding the bank part of the bailout:

The core idea is to have Congress pass a law that sets up a new form of prepackaged bankruptcy that would allow banks to restructure their debt and restart lending. Prepackaged means that all the terms are pre-specified and banks could come out of it overnight. All that would be required is a signature from a federal judge. In the private sector the terms are generally agreed among the parties involved, the innovation here would be to have all the terms pre-set by the government, thereby speeding up the process. Firms who enter into this special bankruptcy would have their old equityhodlers wiped out and their existing debt (commercial paper and bonds) transformed into equity. This would immediately make banks solid, by providing a large equity buffer. As it stands now, banks have lost so much in junk mortgages that the value of their equity has tumbled nearly to zero. In other words, they are close to being insolvent. By transforming all banks’ debt into equity this special Chapter 11 would make banks solvent and ready to lend again to their customers.

I wonder if policymakers in the US are ready for such a comprehensive solution. Certainly Congress did not display the attention nor energy with regard to Plan A. Perhaps the deepening of the crisis would help, but prior to the election I think we are going to have to rely on the discretionary power of Bernanke and Paulson.

We had better hope right now that some effort towards bank capitalization appears early this week.