'Bad Bank' Model Is Disastrous - This Approach Is Needed

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.

Comments

[Stimpy]

You have no idea what you are talking about.

The fact of the matter is that a "bad bank" is workable, and it is the best of a difficult set of choices.

The problem of moral hazard can be managed (if not disposed of) by having the banks pick the price the assets are sold to the aggregator (with in a range ), while at the same time selling the aggregator CONTROL via warrants.

Those warrants will be held in trust until the actual performance of the loans is known.

If the loans cost the taxpayer money (ie: the price at which they are sold to the Aggregator is too high in the first place) , the government can sell all or some of the warrants into the market (in 5 years) to defray the loss to the taxpayer.

If the loans make money (not impossible if the sentiment is changed systemically) the warrants are returned to the banks and shareholders see no dilution.

Incentives between shareholders, management and the taxpayers are aligned under this plan in an interesting way.

The value of the bank, the management team running it, and the constituant shareholders become a function of the performance of the assets--which is what THEY SHOULD HAVE BEEN ALL ALONG.

The Agg bank thus rents the zero cost balance sheet to the banks and the question of taxpayer participation is left for later, when there is more information available (and less urgency) as well.

Again, the best of a bad set of choices.

2009 Feb 02 09:52 AM

[railguy]

Concur with comments about the "bad bank." That is only a "sucker play" for taxpayers/Federal Govt. However, the "good bank" idea may simply create another layer of Govt. bureaucracy. It seems easy enough to condition future Govt. aid on renewed lending, and we hould try that first.

2009 Feb 02 09:54 AM

[Prof. Samuel D. Bornstein]

The Bad Bank and the 2 Ton Elephant in the Room

Under the "Bad Bank" scenario, the taxpayers will own these “Troubled Assets” which are comprised of "Toxic" mortgages.

In effect, the US government (taxpayers) will be bearing the loss on these “toxic” mortgages. The growing concern is that these losses will continue to materialize as defaults increase with the projected 8 million foreclosures expected over the next four years. It seems that the key to this crisis IS THE BORROWER!

The underlying “troubled assets” are the “toxic” mortgages such as Alt-A, Option ARMs, Interest-Only, etc. that are interwoven into the Mortgage Backed Securities, Collateral Debt Obligations, and other derivative investments that are leveraged into investments valued in the trillions of dollars worldwide.

Since the valuation of these “toxic” assets depends on the Borrower’s ability to make the monthly mortgage payments, the key to a solution of this Economic Crisis is the Borrower!

Everyone is ignoring the “2 Ton Elephant in the Room”. Many agree that the contributing factor to most of our problems is the consumer's lack of financial understanding. He is like a "Boat without a Paddle" when it comes to managing money and making money choices. Everyone is betting that the Borrower will default and foreclosures will follow. The high rate of foreclosure should have been expected because the Borrower has no concept of managing money.

It can be argued that the Borrower’s lack of knowledge in financial management was the primary cause of the Subprime Mortgage Crisis which precipitated the Credit Crunch and our current economic woes.

We have tried foreclosure moratoriums, loan modifications, bailouts, in the belief that these initiatives will save the Borrowers. The fact is that these measures have failed and are not working! These measures are only postponing the inevitable defaults. The evidence is that Re-default is occurring anyway at a rate of 60% within 6-8 months.

Let's finally address the real issue which requires developing a program of "Immediate and Specific Financial Guidance" to help the Borrower understand how to manage his financial affairs.

The Borrower is in desperate need of "Financial Guidance" in this complex economic environment that requires "informed" financial decision-making. The Subprime Mortgage Crisis, out-of-control consumer spending and credit card usage, and the spike in foreclosures and bankruptcies provide evidence of that fact. Loan modification or "Bailout" will not work. Even after loan modification, the re-default rate was 60% within 6 months!

The solution is a program of Immediate and Specific Financial Guidance that will help the Borrower "naturally" be able to make the monthly mortgage payment, without "bailout" or extensive loan modifications which have proven to be a failure. This program is NOT the so-called Financial Literacy initiative that simply disseminates "information", but rather it is a program that will help the Borrower "understand" how to manage money and avoid the pitfalls that have previously caused financial
distress.

Borrowers, both small business and individual, require Immediate and Specific Financial Guidance in order to avoid default and foreclosure. As the Borrower is successfully guided to avoid default, the financial and housing markets will respond favorably. The result will be a reversal of the downward trend in the valuation of the “troubled assets”.

If we are successful, we can turn this crisis “all around” and stimulate the economy “naturally” rather than by “bailout” which does not guarantee success.

As part of the Bad Bank solution, the US Government can mitigate the losses on these “Troubled Assets” by providing a program of “Immediate and Specific Financial Guidance” which will help guide the Borrower to avoid default and make the monthly mortgage payments.

Instead of the expected losses, the US government (taxpayers) will benefit from the unexpected gains that will result as these investments grow in value.

Samuel D. Bornstein
Professor of Accounting & Taxation
Kean University, School of Business, Union, NJ
Tel: (732) 493 - 4799
Email: [e-mail]

2009 Feb 02 10:43 AM