Current policy in our view has thrown all of the nation’s big banks into the same pig-pen,
with investors unable to distinguish which ones are in fact sunk in the mud and which
will clean up nicely. This is because policy-makers seem able only to prop up bank after
bank without differentiating the many that are survivors and the few that fall into the
zombie category. This policy is based on assertions that current law allows no other
course. There is, though, a good way now to handle any bank holding company and all
its affiliates – no matter how big or how many. In fact, there’s a way to resolve even
firms like AIG without bailing out all their shareholders and counterparties: split the

The reason so many observers are calling for nationalization – whatever each may mean
it to be – is that the FRB and Treasury continue to say they have no options under current
law to deal with the big, the bad and the ugly. Chairman Bernanke and Secretary
Geithner this week repeatedly told Congress they can only continue to throw out billions
of TARP dollars because there’s no way they know to handle the complex holding-
company structures that surround the biggest banks. Maybe so, but the Fed has used its
“exigent” authority to the extent of current law and, in fact, probably beyond it; the FDIC
has done the same with creative interpretations of its systemic-risk powers.

Based on their own readings of current law, the FRB and FDIC do in fact have another
way to handle a huge failing bank with systemic-risk implications. First, separate the
U.S. insured depositories into one or more bridge banks. What’s a bridge bank? It’s a
structure Congress devised in 1991 precisely to handle very large failing banks and the
regulators should make use of it ASAP. In a bridge bank, shareholders are toast, but the
institution – and its depositors and counterparties – continue in business as they were
before the intervention. Same bank, new owners: the taxpayer.

The reason the FRB and FDIC aren’t setting up these bridge banks is that this leaves
behind the holding company and a raft of often high-risk holding-company subs at home
and abroad. We have a solution for this: Newco. One hopes regulators know enough
about their charges to be able upon a moment’s notice to strip a big bank into its two
critical components: the insured depositories that go into the bridge bank and everything
else that goes into a new entity, “Newco.” The Fed and Treasury have proved they can
support non-bank holding companies — AIG, GM, etc. — with TARP money, loans, SPVs
and all sorts of financial engineering. They can and should do the same for the Newco,
buttressing the holding company’s counterparties and – most important – retail
customers. The bridge bank handles depositors, but we currently have no resolution
mechanism for insurance annuity holders, mutual-fund investors or other retail
customers. Until we create these safety nets – a critical priority for Congress – Newco
can and should hold them harmless.

This isn’t to say, though, that Newco makes everyone whole. At the outset, the old firm’s
shareholders take a dive and, thereafter so does most of its management and at least some
of its other insiders, counterparties and investors. What Newco does is give the
regulators time for an orderly liquidation of the holding company, propping it up with
loans, SPVs or other structures as needed. What’s different about Newco is that it
initially and cleanly separates parties of interest that can be addressed in an orderly
fashion. It’s not all that different from the final AIG structure except that shareholders
are wholly gone, the company is completely under federal control and the exit strategy is
in place at the start.

This is of course a very brief outline of an option readily at hand for the Treasury and
FRB. We don’t know why it hasn’t been used to date except that every decision so far is
made in dark of night under threat of panic. The new stress tests give the regulators
another chance for a resolution strategy that begins to separate the living from the dead
and deals with the zombies in a way that doesn’t hurt passers-by. We hope quickly they
use it because the longer all banks are lumped together, the harder it will be for survivors
to emerge.