Is the 'Aggregator' Bank a Good Idea? That All Depends...

Congress is known for serving its legislation half-baked, so it’s surprising expectations are relatively high that it might dish up a palatable “aggregator” bank--that is, one that can be a practical mechanism for buying distressed bank assets, freeing up balance sheet capacity, and enabling lending. The practical problems are formidable; they don’t involve how to structure a “bad bank” (that’s been done before), but rather how to price and purchase securities and loans without making current bank solvency problems worse.

Structurally, the Resolution Trust Corporation (RTC) is the model for most proposals being aired. Recall that the RTC, which Congress created in 1989 to dispose of the real estate assets and high-yield securities of insolvent thrifts and savings institutions, was so successful that it closed shop after only five years, having disposed acquired assets of nearly $400 billion from 747 failed companies.

But the RTC didn’t aggregate assets purchased from going concerns; rather, it was the receiver of assets from failed institutions. Which is to say, it owned the assets it planned to eventually sell. Today, as long as the Federal government intends to provide assistance instead of resolution, its “bad bank” must purchase assets at better than market if solvent banks are to have any reason to sell distressed and other assets. How much more than market? That’s difficult to say or to budget, even if it were politically feasible.

Pricing issues are the centerpiece of the whole debate. Price doesn’t always equal value, especially in current volatile, speculative markets. Price is transactional. Value often isn’t. Mark-to-market accounting uses price as its basis to report a value for a company’s net assets, but in highly distressed and illiquid markets, that accounting value may be appreciably less than indicated by economic value based on expected discounted cash flows.

Take a look at an example, and you’ll see. Consider the accompanying chart, below, from Bank of New York Mellon’s presentation last Wednesday at the 2009 Citigroup Financial Services Conference. In the fourth quarter, the company wrote down its $5 billion portfolio of Alt-A residential MBS by $1.24 billion, or roughly 25%. That’s equivalent to the discount investors would demand if BoNY were to sell the portfolio today. In fact, the company intends to hold the portfolio to maturity. Using identical assumptions, its “expected loss” due to cash flow impairment is only $208 million, or just 4% of the portfolio’s face value. Difference between the mark-to-market loss and the internal, expected loss: $1 billion.

Bank of New York’s disclosure suggests the company believes that mark-to-market accounting has overstated its losses, and that it will recoup the losses as markets normalize. For the markets generally, mark-to-market accounting has caused financial services companies to book losses of as much a $2 trillion by some estimates, while the expected loss is probably only a fraction of that amount. Which is more realistic--or relevant to government policy?

Though these may be “toxic” assets, as popularly described by the media, portfolio managers are, quite reasonably, loath to sell performing assets at a market price of 75 if they can reasonably expect to realize a value of 95 if held to maturity.

To accumulate assets for its “bad bank”, the government could possibly direct the sale of certain bank assets (private-label mortgage-backed securities below some credit rating, say). That’s been tried before, when the Office of Thrift Supervision required the sale of all high yield “junk” bonds during the thrift crisis. Naturally, prices cratered, which helped eviscerate the capital of many solvent institutions, and greatly increased the final cost to taxpayers.

But it created a lot of business at the RTC--and substantial profit to investors that bought RTC assets at deep discounts.

Perhaps the large disconnect between low market prices for risk assets and the much higher value of unimpaired discounted cash flows reflects speculation that the government will repeat past errors?

What do you think? Let me know!