Setting up a so-called “bad” or aggregator bank to purchase the banks’ toxic assets is all the rage now among some of the leading economists, politicians and government officials, but the idea is an unworkable disaster which needs to be immediately abandoned. Instead, what really needs to be set up by the government is a new “good” bank to make good, new mortgages for the many well-qualified buyers which now exist, especially because prices have made such a steep decline. Those buyers will include families who wish to live in them as well as investors seeking a return on capital.
The reason why the idea of a “bad” bank is unworkable now is the same as it was back in the Fall when the TARP was passed and the idea of purchasing all those toxic assets was abandoned; there is no way the process can go forward without further damage being done to either of the parties involved. If the assets were sold at their present low value, it would force the banks to take additional write downs and therefore do further damage to their balance sheets. If the assets were priced higher than what they are worth, the banks, their creditors and shareholders would receive a gift from the taxpayers who then become the ones left holding the bag. There’s no “win-win” solution here.
In and of itself, the only thing the bad bank solution does is to transfer the risk from the private to the public sector. It does nothing to stabilize home prices and therefore cannot stimulate demand, which can only be accomplished once buyers come to the realization that prices can stabilize and begin to rise within a reasonable amount of time. Another assumption of the bad bank solution is that the removal of toxic assets from the banks' balance sheets will then allow them to begin lending again. While this has happened in the past after the Resolution Trust Corporation took over certain assets from failed institutions, those instances involved more isolated markets. In this instance, the problem is far more systemic.
You can rest assured that once the government gets its hands on those assets, the underlying mortgages will be modified with a combination of lower interest rates, term extensions and principle reductions. The Fed is already doing this with the assets held by Maiden Lane LLC, the entity which now owns Bear Sterns’ book of rotten mortgages. The problem here is that thousands upon thousands of unqualified homeowners, including the many who lied on their applications for no-documentation Alt-A mortgages, are going to receive a gift at everyone else’s expense and be rewarded for committing perjury.
In this case, the entire bad bank process will amount to nothing more than an impediment to the normal workings of the market because it will interfere with the reallocation of capital into the hands of those better suited to use it, thereby making it less efficient. Not allowing the market to “clear” prevents recovery because as properties are foreclosed, they move out of the hands of those who can’t afford them and into the hands of those who can.
Setting up a new “good” bank designed to make high-quality loans is the long term solution to the housing problem for one simple reason; it will jumpstart demand at a time when a huge “buy low” opportunity exists because it will create the sense that prices can stabilize and then begin to increase. By one measure, housing affordability is at an all-time high; a family earning the median income has 158.8 percent of the income needed to qualify for a mortgage on a median-priced home.
If you don’t believe that a new “good” bank can jumpstart demand, ask yourself this question: If you were an able buyer, would you purchase now at these greatly discounted prices if you had a reasonable assumption that prices were going to stabilize and begin to go up within a reasonable amount of time?
A new “good” bank should be set up as a public company designed to get the government out of the mortgage origination business as soon as possible, but not before the banks begin originating far more new mortgages than they are doing now. The government can capitalize it with $100 billion and then leverage it up 10 times by issuing bonds backed by full faith and credit, thereby making about $1 trillion available for new borrowing. Its bonds can be initially priced to yield 25 to 50 basis points higher than 10 year Treasuries, and it should then originate mortgages 100 basis points above there.
Set up this way, the new “good’ bank will not crowd out the present banks because they too can issue bonds into the capital markets backed by full faith and credit. The new bank would have a significant advantage though in one respect; it obviously would have a far more favorable balance sheet then the banks who would still be retaining all those toxic assets on their ledgers. But ultimately, once the new bank stimulates demand and therefore supports home prices, homeowners who are underwater on their mortgages may be able to see a light at the end of the tunnel and have less incentive to abandon their investment. Foreclosures in that case would decrease and the value of the present assets would stabilize and begin to improve.
A new bank will however create competition for new business, but that’s a good thing; banks will naturally be forced back into the business of lending once a new competitor enters the market for mortgage originations.
