A note on selling distressed loans with bank bailouts: modelling of bank interest margins with default probabilities

Abstract

This article extends the framework of Merton (1974) with Vassalou and Xing (2004) to value a troubled but solvent bank's equity by explicitly incorporating distressed assets purchased by the government in an imperfectly competitive loan market. We show that the bank may be willing to take this bailout when the purchased amount is relatively small and the margin is relatively low. However, the bank may be harder to entice even when the unit price of the bailed-out assets subsidized by the government is relatively high. As a consequence, most of the first half of the Troubled Asset Relief Program's money is not used to buy troubled assets (Wilson, 2010).

Keywords:

• bank bailout
• interest margin
• default probability
• distressed loan

JEL Classification:

• G28
• G13

Notes

Alternatively, Jawadi (2010) explains bank losses through audit weakness, risk management and management errors in the financial crises. Jawadi and Arouri (2011) indicated that the present crisis had two consequences: less liquidity and credit that was more difficult to get and more expensive. These two studies implicitly allow the inclusion of more realistic market conditions along with the more appropriate behavioural mode of bank operations.

We note that our contribution differs from Petersen et al. (2010) in that it investigates the dynamics of bank equity value under loan securitization.