David Cameron's cunning plan to sort out insolvent banks

From today's interview with Andrew Marr*

Well what matters most of all is safeguarding the depositors in a bank like Bradford & Bingley. That is the absolute key. And I think what obviously is preferable is a private sale, so the business is a going concern. But I think what we've got to do in this country is get away from a situation where the only choice if you can't have a private sale is to throw the whole thing onto the taxpayer, nationalise it and have the taxpayer bearing all of that burden and bearing all of that risk...

And that is why we've been saying for a year now, because remember Northern Rock went over... went under a year ago, that we should have a situation in Britain where we have the ability for the Bank of England to take over a failing bank and to reconstruct - safeguarding the depositors and then making sure that those bits of the business that can be sold are sold. And in the end, then the bill effectively is picked up not by the taxpayer [but by the creditors]**...

So instead of nationalising [an insolvent bank], instead of the taxpayer taking all the risk, the Bank of England holds it, the Bank of England safeguards those deposits and then it works out with the business ... what bits can be sold as a going concern and what you're left with. But the key, the key at the end...the absolute key is that if at the end of that process there is a bill to be paid, the bill's paid by the creditors*** - by the banks and others that lent money to that business - and not by the taxpayer"

This method is more or less what I suggested, er, a year ago.

* Please note "The Andrew Marr Show" must be credited if any part of this transcript is used.

** Actually he said 'debtors' rather than 'creditors' at this stage, but AM kept interrupting him so we'll give him the benefit of the doubt.

*** It must be blindingly obvious that when any business goes bankrupt, shareholders get wiped out and other creditors get a pro rata share of the loss. It is vitally important at this stage to realise that there are different types of creditors. The order of priority in a liquidation is set by law, and the rules are broadly sensible. There is nothing wrong with having special rules for banks that say depositors, employees and trade creditors get priority, and that losses are borne by long-term bondholders****.

A failing bank can be sorted out even more simply and smoothly by being forced (at gunpoint if necessary) to write its mortgage receivables down to the truly recoverable amount (bearing in mind loan-to-value ratio, loan-to-income multiples, when the mortgage was originally granted and whether the borrower has ever missed a payment) and then simply replacing every £1 of long term nominal debt (that might have a market value of only 50p anyway) with a replacement debt with a face value of 50p, and compensate those bond holders by issuing them with more shares.

Hey presto, bank recapitalised - don't forget that a bank's capital is merely a balancing figure of assets (outstanding mortgages plus actual value of the business as a going concern) minus nominal debts. If you write down the book value of mortgage assets by 10% and reduce the nominal value of the debts by 50% (or whatever lesser figure might be required), all of a sudden, the bank is soundly capitalised again. We are beyond the stage of fixing this with rights issues, I don't think people will fall for that any more.

If the write-down was overcooked, then the shares that the bond holders are given will rise in value and they will recoup some of their losses.

**** There are all sorts of clever names for 'long term bonds', like 'deferred shares', 'preference shares', 'covered warrants', 'collateralised debt obligations', 'permanent interest bearing shares' and so on ad infinitum. Do not let this confuse you.