How would it have worked? Regulators would be given the legal authority to dictate the terms of a recapitalisation, subject to an agreed framework. The details will vary from case to case, but for Lehman, officials could have proceeded as follows. First, the concerns over valuation could have been addressed by writing assets down by $25 billion, roughly wiping out existing shareholders. Second, to recapitalise the bank, preferred-stock and subordinated-debt investors would have converted their approximately $25 billion of existing holdings in return for 50% of the equity in the new Lehman. Holders of Lehman’s $120 billion of senior unsecured debt would have converted 15% of their positions, and received the other 50% of the new equity.
The remaining 85% of senior unsecured debt would have been unaffected, as would the bank’s secured creditors and its customers and counterparties. The bank’s previous shareholders would have received warrants that would have value only if the new company rebounded. Existing management would have been replaced after a brief transition period.
The equity of this reinforced Lehman would have been $43 billion, roughly double the size of its old capital base. To shore up liquidity and confidence further, a consortium of big banks would have been asked to provide a voluntary, multi-billion-dollar funding facility for Lehman, ranking ahead of existing senior debt. The capital and liquidity ratios of the new Lehman would have been rock-solid. A bail-in like this would have allowed Lehman to open for business on Monday.
Many investors would no doubt complain about the rough justice of a regulator-imposed reorganisation. To preserve value, officials would have to move very, very quickly, leaving little time to fine-tune various claims or observe normal procedures. The new structure would be based on bankruptcy reorganisation principles, allocating value in accordance with investors’ seniority and ensuring that each class of investors would be better off than in liquidation. The process would not be pretty but overall, investors should be relieved by the result. In this example the bail-in would have saved them over $100 billion in aggregate, and everybody—other than short-sellers in Lehman—would have been better off than today.
Where and how did investors fail? Where and how did politicians fail? Who will unscramble the eggs?
In "Why Didn't Canada's Housing Market Go Bust?" James McGee finds that "Housing markets in the U.S. and Canada are similar in many respects, but each fared quite differently since the onset of the financial crisis. A comparison of the two markets suggests that relaxed lending standards likely played a critical role in the U.S. housing bust." It seems that the Canadians never got around to creating a Fan and a Fred. What were they thinking?
In "Alt-A: The Forgotten Segment of the Mortgage Market," Rajdeep Sengupta describes "aggressive underwriting" by various banks. What were they thinking?
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