The Devil Is in the Bad Bank's Details

Bank stocks rallied sharply yesterday morning on the news that the administration and Treasury are developing a "good bank/bad bank" concept. However, whether this rally is justified is all in the details of the plan, which no one knows yet. For many banks, the concept of a good bank/bad bank scenario involves a binary outcome. Either the shareholders get screwed or the tax payers get screwed.

For instance, if the government just buys the assets from the banks and leaves existing management in place, then the shareholders win. The government will essentially be buying toxic assets at an above market value and putting the burden on working out the problems and taking the losses on the government.

However, if the government takes over Citigroup (C) because the company management teams have been incompetent, then the shareholders get nothing. It would be a repeat of Fannie Mae (FNM) and Freddie Mac (FRE). The banks get put into conservatorship until all the assets get worked out. Bill Siedman, CNBC commentator who ran the original Resolution Trust Company, explained the concept in a recent interview on Fast Money.

Seidman said he basically nationalized many banks. He even states that the RTC would have nationalized Citigroup if the company hadn't gotten "saved" by Prince Al-Waleed. Siedman nationalized insolvent banks, fired and replaced management, sold off the bad assets and returned a "good" bank to the market. The problem with this method is that it takes guts, resolve and toughness. The government is basically taking the bank away from the shareholders and current management. Those parties will scream bloody murder.

In one scenario many bank stocks go to zero. In the other scenario, many bank stocks double. However, in either scenario, the overall tone of the market should improve as a huge overhand gets dealt with one way or the other.

I would guess that with the current administration, the tax payers won't be the ones that will bear the brunt of the cost. President Obama doesn't seem to have the shareholders' or management's interest at heart. However, many Taft Hartley (union) and state pension plans have big exposure large cap bank stocks. Those plans would be badly hurt if shareholders were wiped out. In addition, buying the toxic assets gives the Administration a way to help homeowners and banks, but not look as much like they are coddling Wall Street. At this point, I think it is still a toss up which way the Administration will eventually lean.

Comments

[Tom Wright:]

So if incompetent (corrupt?) management, which has already put the screws to the shareholders gets removed and shareholders lose a bit more, that is bad but as long as shareholders get their dividends on their preferred or common shares (regardless of the reduced price of those shares) it is perfectly fine to keep incompetence in place at the top. No wonder our system has become so messed up.

Jan 29 08:38 AM

[kelm:]

The recent talk about the government directly purchasing common shares of banks is alarming and should be to anyone with money in the markets. The taxpayer takes on the debt burdens of the toxic assets, becomes a shareholder in the companies still run by the same management that created the problem, that same management sees their stock price rise and so is rewarded, the markets are distorted by government intervention due to being artificially propped up, and the government takes no board seats at those companies. This is worse than the Greenspan put and simply perpetuates the failed policies and regulation that got us here. No one is being held accountable.

Jan 29 08:53 AM

[jack kreg:]

"The government will essentially be buying toxic assets at an above market value and putting the burden on working out the problems and taking the losses on the government."
How is it that you are so certain that gov will be buying these assets at too high prices?
Many of these assets are way undervalued by cash flow basis.
Your comment and certainty are not substantiated!
That discredits your message.

Jan 29 11:00 AM

[OldLimey:]

"President Obama doesn't seem to have the shareholders' or management's interest at heart."

From my non-partisan perch across the Atlantic, it seems to me as though pretty much the same band of pin-striped brigands is pulling the strings on the whole bail-out scene as was running things up to 20 January. Some of the faces presented to the public change for the sake of appearances, but the same financial establishment is bankrolling politicians of both parties. I sincerely hope I'm proven wrong on this one, but for now I'm unconvinced that change - at least in the financial arena - will be any more than superficial.

Jan 29 01:45 PM

[Old Time Ba...:]

The need is an external model for unbiased evaluation. It could provide a basis of the true loss (“bad bank”/Taxpayer and/or the current holder of the toxic asset). The “bad bank” will have a basis to offer a reasonable acquisition price for the lender/holders of toxic assets and define a measurable loss. This will force the recognition of the true loss based on the realistic value of the underlying asset. It has to go back to proper valuation and protection to the taxpayer. Risk management and the ability to liquidate the asset comes in question also. If someone comes up with that model, we should give them the Nobel Prize!

Jan 30 07:28 AM