About Creating "Bad" Banks

There is much ado this week about a putative 'bad bank' asset disposition plan from Treasury.

Well, sort of. Despite having months to conceive his plans for the financial sector and the economy at large, Treasury Secretary Tim Geithner apparently still needs a few more months to figure all that out. Heavens knows what he was doing since November.

Regardless, let's take a step back and consider just what it means to create a 'bad bank.'

First, it's basically Bill Seidman's RTC redux. Back in the late 1980s, in the aftermath of the S&L crisis in which those institutions borrowed short, lent long and low, and largely went insolvent. The thrifts were closed, loans collected into the Resolution Trust Corporation, and sold off to investors at deep discounts, providing many of the latter healthy returns. The 1980s S&L/RTC crisis was more about stupid funding strategies than bad loans.

Now, however, the nature of the 'bad bank' is different. This time, our largest commercial banks, as well as smaller ones and specialized lenders, e.g., Golden West and Countrywide, with Federal and state regulatory tacit approval, lent mortgages on only 5%, or less, down.

Consider two banks with different approaches to loan or securities value loss recognition.

Bank A, like Merrill Lynch, promptly begins to clean up its books by writing down questionable asset values. It rapidly erodes its capital, becoming nearly insolvent. It is taken over and merged with another institution, its shareholders losing everything. There may, or may not, be Federal loss-limiting guarantees on some of the loan portfolio.

If there are such guarantees, then not only investors, but all taxpayers, have just shared the losses of the badly-managed bank.

Bank B, however, holds out and avoids writing down its losses for months. Eventually, Treasury creates a 'bad bank' to buy bad loans from commercial banks. The theory is that, once freed of the bad loans they chose to make, these ailing commercial banks are now healthy and able to make new loans.

But before we know that, we need to know at what general price level the assets were transferred to the Treasury's 'bad bank.' I wrote about this dilemma back in late September of last year, in this post, when Bernanke and Paulson first unveiled their TARP plans. Specifically,

"Further, if Treasury bids such high, close-to-maximum-economic value prices for these securities, then there is virtually no chance of the US taxpayer realizing any gain on subsequent sales. At best, they may breakeven.

At the other extreme, though, also described by Bernanke, if Treasury's bid is a little above the fire sale price, but well short of the economic, or 'hold to maturity' value, then the selling bank receives little extra capital, and not much more in the form of marking similarly-held securities up to the bid, either.

What is it that I am missing? This isn't going to work!"

In fact, it didn't work that way, and was never actually implemented as stated. Now, Geithner's Treasury faces the same dilemma in creating a 'bad bank.'

If Treasury pays face value for the loans, fully recapitalizing the banks, then Bank B's management was smart in playing for time. In effect, by gaming the regulatory system, Bank B lives to make more bad loans, while Bank A was closed for the same offenses.

If, however, Treasury buys the bad loans at economic, or lower, value, which might be as low as the 37%-or-so value Merrill accepted in its funding deal last year, then the banks aren't sufficiently recapitalized to survive. Bank B is determined to be insolvent and, like Bank A, closed and/or merged with another institution.

In the latter case, taxpayers end up owning the bad loans at distress prices, so they don't share in the losses of the inept lending institutions.

From this little mind experiment, we've learned something valuable.

If Treasury pays at or near face values for the bad loans that will fill the 'bad bank,' then taxpayers, who individually may have chosen not to own equity in the ailing lending institutions, effectively find our government buying the losses from those banks anyway. And society is penalized for the sins of a few inept lenders, while the lenders get to remain in business and, in fact, are encouraged to lend again.

If Treasury pays economic, or lower, values for the bad loans to fill the 'bad bank,' then incompetent lenders and their institutions pay a price for their mistakes, and taxpayers don't subsidize them.

Either way, however, there is a net loss of recognized value to society, in the sense that the merry-go-round of overvalued assets stops and those values are forcibly reduced.

In the case of the RTC, the private, publicly-owned financial sector was not recapitalized by the government. Instead, weak and failing thrifts were eliminated, capacity removed, and a healthier, if temporarily smaller financial sector remained.

If Treasury creates the 'bad bank' by compensating existing publicly-held, private financial institutions at or near face value for recognized 'bad loans,' this will not be at all like the 1980s RTC solution.

Instead, Treasury will, in effect, be recapitalizing shareholder-owned institutions with public money, making taxpayers effectively own the mistakes, while rewarding the incompetent management that managed to hold on long enough to get this ultra-sweet deal.

Talk about moral hazard!

This would be among the worst things to happen to capitalism that ever occurred in the US.

Private financial companies are relieved of their mistakes and given money to err again. Taxpayers are socked for the losses, despite their perhaps not having chosen to ever buy equity in the incompetent financial institutions.

And to pay for all of this, Treasury prints or borrows money, thus either devaluing the dollar or saddling the entire society with the interest and principle costs associated with the stupid lending decisions of some publicly-held, privately-owned banks.

That scenario makes no sense. The only defensible course of action is the creation of a 'bad bank' through loan purchases at lower, economic prices, resulting in bank closures, a reduction in lending capacity, and stronger resulting institutions. Which is what Anna Schwartz advocated last fall.