Good Bank, Bad Bank: Is There Any Other Way Out of the Crisis?

The proposal to take the toxic/lousy assets of the US banking system into a ‘bad bank’ and leaving the performing/good assets with the existing banks had initially received a positive response from the street. But investors have been wondering how to value these assets.

As one expert explains:

Say a bank has a security it wants to sell to the bad bank. The face value is $100. The bank holds it at a value of $85. The market thinks it’s worth $65.

Banks will want the government to purchase assets for as high a price as possible, or at least to find some middle ground above depressed market values.

Buying the security at, or close to, $100 means the government would recapitalize the bank while transferring losses from shareholders to taxpayers.

Well, future taxpayers. They will be the ones who pay down the debt the government hopes to sell to fund this transfer, and make good on any losses. That debt, meanwhile, could prove stifling to the economy, and the losses pushed onto taxpayers could further undermine government finances.

‘Postpone the Pain’

Creative pricing of toxic assets will only postpone the pain, extend the duration of the crisis, and present a bigger bill...

If the government purchases the security at $85, the future losses and bill to the public purse would be less. The problem is that this price could cause banks to recognize as permanent their losses on other securities. Right now, they claim those losses are temporary.

Such a move would cripple banks’ regulatory capital ratios. Plenty of banks could still fail. In that case, banks and taxpayers both get hit.

Buying the security at the market price of $65 means banks and the financial system immediately face a day of reckoning. While bank balance sheets would get unclogged, many wouldn’t be able to, or willing to, face the losses.

Nationalizing Banks

If the government elects to pay fair market value, the bank will likely not elect to participate as capital hits would be too dear …

That could force the government to nationalize banks or seize them as part of the process of buying up assets. Either way, shareholders would get wiped out.

So what we have is a 'damned if you do, damned if you don't’ situation.

According to various reports:

• It is estimated that the falling US and British financial institutions have received $1trillion from the government (taxpayers), sovereign wealth funds and other investors.
• Bank losses from the write-offs of bad loans and busted derivatives tally up to $1.5 trillion so far. In addition, $5 trillion to $10 trillion worth of off-balance-sheet businesses such as structured investment vehicles -- leveraged lending vehicles used by big banks to fatten their profits in boom times -- are being forced back to banks' balance sheets by regulators. Rules require banks to keep a base of real shareholder capital amounting to 10% of those funds. So banks need to find up to $1 trillion within the next year to meet that objective.
• Add the $1.5 trillion in losses to $1 trillion in needed new reserves, and you can see that banks need as much as $2.5 trillion in new capital to remain solvent under current rules. Consider that the entire world banking system had only $2 trillion in shareholder capital in 2007, before everything blew up.
• When you add the $500 billion from sovereign wealth funds to the $500 billion from the first tranche of the Troubled Assets Relief Program, it's only $1 trillion. That's already been provided. So that leaves a gap of $500 billion to $1.5 trillion.

And the feeling one gets is that nobody has an idea of the depth of toxic assets in the system as a whole, while individual institutions may have an idea about their positions but may not want to disclose them fully.

The complication that has been brought in to the bailout approach is truly mind-boggling and it is becoming very clear that everyone is clueless.

Is there a simpler approach?

Now that it is very apparent that the taxpayers and public (present and future) at large are the suckers in this game and are going to foot the bill (which anyway is going to run into a few trillions of dollars), why not take a simpler approach.

The primary cause has been mortgages – and at the root are the subprime mortgages. If the bad loans have been identified as they should have been by now, the government can take over these loans into its books and tell the banks that it will pay the monthly installments as per the original agreement with the borrower. If the average tenure/maturity is about 15 years, say the government gets reasonable time to raise these trillions over a much longer period. As regards the banks, these become performing assets and the government, instead of doling out only to the banks, can also dole out to the mortgagees by giving them the actual ownership of their homes. While this would be akin to a grant and some may raise moral hazard issues, what morality is left in the present plans? Furthermore, taxpayers and citizens will feel better knowing that they have helped fellow citizens rather than the unscrupulous financial institutions. Politically too it might find favor as relevant constituencies are addressed.

Given that the mortgage repayments are now to come from the government, the derivatives based on the mortgages will also stabilize and the banks can reckon these mortgages in their books at face value, thereby avoiding any major need for recapitalization because of loan loss provisions. The derivative products, given the government backing may turn liquid and find its value too.

Am I missing something? I look forward to your comments and response.

Disclosure: No Positions.

Comments

[steve graves:]

Yeah you're missing something - something quite incredibly obvious and fundamental. The root of the problem may have been sub-prime mortgages, it's true, but the idea that can now somehow gobble up this sub-prime debt and magically mend the global financial crisis is almost ridiculously naive. Sub-prime may have been the catalyst, but the contagion has spread throughout our over-leveraged financial system and into the economy as a whole. Commercial real estate is collapsing, jobs are being shed at record pace, derivative markets are coming unravelled, the so-called 'shadow banking system' has been completely obliterated, etc. It's like lighting a match to burn down a house; once the house is on fire the match becomes irrelevant. And blowing it out won't do a damn thing to save the house.

Feb 01 01:52 PM

[Tom Armistead:]

If the banks have adhered to mark to market accounting, the assets are already on the books for market value. There is a third option for pricing the assets: most banks, insurance companies and bond underwriters have software and databases to price MBS based on discounted cash flows as proljected from current payment histories on the underlying mortgages. The government can publish the models to be used, require due diligence on the data concerning the underlying mortgages, and price the MBS at a discount to what Paulson called the "hold to maturity value."

That will create a stable market value and the government will be able to make money on what they buy.

Current risk based capital regulations and mark to market accounting rules are creating extreme stress on bank capital. The effect is what Ben Bernanke called "procyclicality," the tendancy of regulatory mechanisms to exacerbate the difficulties of the credit cycle rather than diminish them.

Fix that, outlaw naked CDS, and the problems will improve rapidly.

Feb 01 02:36 PM

[apppro:]

Of course there are other ways of fixing this mess that we have convinced ourselves into. I have posted them time and time again on my website, but in brief we must just correct the 3 main reasons we have this disaster:
1. Fix the accounting and regulatory regulations that plunged us into despair,
2. Fix the people that used those mistaken regulations at lengths unseen since the 1920’s.
3. Get the money out there needed to fix the damage and with little taxpayer costs.

Firstly get rid of ‘mark to market’. Fine you don’t want to do that - then just freeze the damage at this point. Give all institutions a set 10% write down over 10 years. Gives everyone breathing room. Also no write-ups unless there are statistically significant sales. Come on people – there was no reason that all those CDO’s destroyed by a handful of short sellers needed to be declared worthless in 3 months!! So they’re worth less, just give everyone some time to digest it.

Now fix the shorts that used every trick and rumor in the book to destroy companies that have existed for decades. Institute a 65% Windfall Capital gains tax on all short sales retroactive to 01/01/08.

Get money out there. Fix the monolines so local municipalities can issue bonds and build.. build.. build! Our current mess started with the monoline destruction by way of their CDO exposure, SO NOW FIX IT! Give the States and Cities DOLLAR 4 DOLLAR STIMULUS for every bond written used for infrastructure. BIGGEST BANG FOR THE BUCK!

Feb 01 05:23 PM

[Tradesense:]

Steve

To my mind what you have mentioned is the effect of not addressing the cause in a simpler and straight forward manner. The idea is to stabilize one key part of the crisis - so that it has calming effect on the others and provides confidence in the leadership. The idea is to use simpler approaches with less collateral damages (known and unknown) and that is politically expedient too...otherwise it may be too late...hopefully we are not yet beyond repair. The focus is also to try and find value of derivatives which have mortgages as the underlying. You may then create regulations that could address the do's and don’ts.


Feb 01 01:52 PM steve graves wrote:

> Yeah you're missing something - something quite incredibly obvious
> and fundamental. The root of the problem may have been sub-prime
> mortgages, it's true, but the idea that can now somehow gobble up
> this sub-prime debt and magically mend the global financial crisis
> is almost ridiculously naive. Sub-prime may have been the catalyst,
> but the contagion has spread throughout our over-leveraged financial
> system and into the economy as a whole. Commercial real estate is
> collapsing, jobs are being shed at record pace, derivative markets
> are coming unravelled, the so-called 'shadow banking system' has
> been completely obliterated, etc. It's like lighting a match to burn
> down a house; once the house is on fire the match becomes irrelevant.
> And blowing it out won't do a damn thing to save the house.

Feb 01 09:56 PM