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Step 5: Decide how to allocate the losses between taxpayers, shareholders, and creditors The taxpayer is not the only potential source of value to fill the hole. There are common shareholders, preferred shareholders, bondholders, and other creditors who potentially could be forced to share in the cost by having their investments seized, diluted, or written down.

The most obvious candidate is to eliminate the value of the common shares, although the ability to force this action would be dependent on the legal issues discussed earlier. Beyond that, there may not be a lot of value left in the stock compared to the gap to be filled. It would be close to an absolute legal requirement that the accounting value of the common stock be reduced to near zero before the regulators could seize the bank or, under potential future regulation, the bank holding company.

The next candidates for losssharing are the holders of preferred shares. These represent equity investments and the holders should theoretically have been the second most prepared to lose their investments if the bank went off the rails, since their bankruptcy priority lies just above that of the common shareholders and below everyone else. Eliminating or reducing the value of these shares would face the same legal issues as with common shares. The amount of preferred shares outstanding is significant, but still not large enough, in all likelihood, to completely fill the value gap. Finally, eliminating the value of the preferred shares would raise a milder form of some of the same issues that will be discussed next in reference to giving a “haircut” to the value of outstanding debt.

The real jackpot would be writing down the value of the debt. The volume of bonds outstanding at the major banks is generally larger than the size of the potential financial rescue, meaning that a bank could be restructured financially without a penny of taxpayer money. However, debt investors developed a strong belief over a period of many years that bank bonds were safe and that there was an implicit government guarantee of the debt of the largest banks, those that were considered “Too Big to Fail.” This is a slightly weaker version of the belief among investors that Fannie Mae and Freddie Mac had implicit government guarantees – a belief that proved in the end to be justified.

There are number of implications of the existence of this market belief that have caused a large majority of policymakers and analysts to advise against forcing “haircuts” of the value of the bonds. Even Gary Stern, the President of the Minneapolis Federal Reserve Bank, and a prominent and passionate advocate of eliminating the Too Big to Fail doctrine, believes that it would do more harm than good to haircut the value of bank debt in the midst of the current crisis. He believes that reforms must be made that will eliminate the issue going forward, but with time for the markets to adjust to the changes. On the other hand, there is a vocal minority of analysts that call for haircuts to be applied in future bank rescues. This is a complex question that needs to be dealt with in a separate paper, as the author hopes to do shortly. However, the principal pros and cons can be summarized briefly as follows:

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