Bad Bank, Bad Idea; Good Bank, Good Idea

Secretary Geithner has proposed the formation of a “bad bank” to buy $1 trillion or more of troubled loans and securities off the books of banks and get credit moving. This idea deceives the public, will not work and provides all the wrong incentives to bankers. This is a rehash of the idea former Secretary Paulson first proposed and then quickly abandoned. A good idea is to create a “good bank”. Let’s first look at why I am opposed to Secretary Geithner’s idea for a “bad bank”.

Geithner hopes the purchase of toxic assets by the “bad bank”, funded in part with private capital, will get the banks to lend again. He is not even making the claim this makes economic sense. This is a fatal flaw causing the idea to fail from all points of view.

1. Geithner’s description of the “bad bank” is not “honest”. He says “bad bank” will use partially private equity. No private equity is going to invest in the “bad bank” if it is run for non economic purposes. The key is the price of the toxic assets. As a generalization, the current market value of the toxic assets is probably somewhere between 5% and 20% of nominal value. If the “bad bank” pays more than this, private investors will not invest. If the banks sell these toxic assets for this value, there will probably be an enormous unfavorable P & L impact as most banks have not really marked all of their toxic assets down to real market value even though they should have through mark to mark regulations. So probably the assets will be purchased for much more than their current value, so no private sector participation unless there is a behind the scenes guarantee of the government to bail out the private sector investor in the “bad bank”.

Furthermore, the “bad bank” is made to sound more like a commercial transaction that is only partially dependent upon the taxpayer. The truth is the taxpayers absorb all the costs of the “bad bank” from 3 or 4 directions that are not obvious to the quick reader.

2. New conservative credit standards and the lack of new securitized funding are the real causes of the inability of the banks to lend, not the current bad assets. Every financial bubble is based on lots of low cost money. Securitization is what provided lots of low cost money. Like all bubbles, this one finally blew up starting in 2006 with the home mortgage market financing. As in every bubble, banks have learned again that easy, low cost financing is not a substitute for good credit. While banks lent 10 to 15 times their capital in the 1970’s, banks were lending in 2007 30 to 100 times their capital when you take into account derivatives and off balance sheet financing such SIVs.

Every bank is now deleveraging to get its risk profile back in order. Even if they wanted to fund themselves through the traditional source of securitized transactions, banks are drying up with the new recognition of the danger they can be. Home equity issuance is off 98%. Securitized auto loans were down 40% in 2008. Student loan issues were down 43% in 2008. Credit card financings were down 21%. About the only one still provided this type of securitized financing is Ginnie Mae and Fannie Mae (FNM). Both have lost all their capital and are bombs which will explode (again) very shortly. In short, buying up all the bad debts of the banks will not jump start lending again, because the current bad assets are not the real cause of not lending more now.

3. The Geithner plan creates all the wrong incentives for the banking sector, which ultimately will increase the cost and defer the day we resolve the problem. A government plan which says we want to bail out everyone in trouble rewards the imprudent and leaves the bill to be paid by the prudent. This is not the American way. This is not smart. Even the porn industry has said it should get a bail out too. The press reports GM is going to say “I go broke if you do not bail me out”. It has not been able to provide a plan where it can credibly say it can work its way out of the problem. We need incentives that promote success, not failure as the current Geithner plan does. Ironically, the new government plan to rein in compensation of top executives in banks may have the effect to cause some banks not to take government financial aid. This shows the structure of incentives determines the type of outcome. A wrong structure of the Geithner incentives means there will be a bad outcome from their use.

A completely different approach (albeit unusual) is to use some of the government stimulus money to provide seed money for a series of new commercial “good banks”. This could provide the right incentives, bring in a lot capital and funding and thereby really provide loans to businesses that need it for their everyday operation.

1. The Idea. Provide $1 billion dollars each for 20 new regional commercial banks (pick your number here on initial capital and number of banks). There are vast sums of private money on the side looking for good investments. The equity could probably be increased tenfold very quickly from private sources. Then it should be easy to find indebtedness of 10 times that from debt markets. In short, the government money should be multiplied 100 times in terms of funds available for lending to needy Americans and American business. I think $20 billion of government seed capital would realistically be turned into $2 trillion of lending capacity.

The new good banks would be prohibited by law from engaging in what would be called investment banking today. They would be old fashioned commercial banks that lend their customer deposits and a modest amount from external sources. No derivatives (e.g. CDO's SDS), no stock brokerage (think Merrill in B of A (BAC)), no lending for stock acquisition or other non self liquidating type loan. The focus is to provide working capital and equipment and mortgage financing for individuals and businesses. These banks would be staffed with professional “Commercial” bankers who would work for a decent living. Investment bankers who think they have the right to up to 50% of the gross fee income as a bonus would be prohibited from employment.

2. What will happen? Since the new good banks have money to lend, they will be the first choice for everyone. They can be like Warren Buffett and cherry pick good deals that deserve credit, but they will not ask for warrants for stock like Buffett gets.

3. The effect on existing banks? The new good banks will make things harder for the existing banks. The existing banks will argue that rather than helping, the creation of new good banks increases the chances that the existing banks will go broke. Yet, that is the way the system works, i.e. competition. When it is clear that there is no bail out from the government, you can be sure that these bankers will devote their energies to surviving. Most will survive, many will not survive. But now a clear signal has been given that stimulates them to do what they can to save themselves, as opposed to finding ways for the government to bail them out.

4. Resolution Trust type work out bank. There needs to be a bank or organization that assumes control of the assets and liabilities of the bankrupt banks. This does not have a political purpose to save existing banks in risk of bankruptcy. It is strictly a workout mechanism for the banks that will be going broke. It widely speculated that 1,000 banks will go broke in the next two years and some of the biggest banks are likely to be among these. If Citibank (C) and B of A fail, there may be no choice but to nationalize them. However, they should be rapidly converted into the type of bank described above as a “good bank”. It will be better to do this and take the losses than continually pump money into them as we are doing with AIG and the “bad bank” idea of Secretary Geithner and without real hope of getting the money back.

In summary, the feel good plan to pump money into the banks to stimulate lending will not work. It is illusory to think the world will get out of this problem without pain for most people. Yet, well intended schemes like the Geithner plan delay and make more expensive the solution. The nation would do better to bite the bullet and let fail those who cannot succeed on their own. The government can provide more effective help to needy borrowers by creating new, healthy banks than pouring endless money into unhealthy banks that continue to be run by the same people who bankrupted the banks through their excesses and imprudence. As a people, Americans are resourceful. When bankers know they will not be bailed out by the government, most of them will become very effective in finding a solution for their bank – if there is a solution. And if there is no solution to a specific bank’s problem, the people of the United States should not put the next generation’s money into it.

Stock position: None.

Comments

[FrugalSam:]

Sounds great. I wonder why the powers that be continue to rehash the same old ideas when there are so many good ones out there ?

Feb 15 09:44 AM

[CautiousInv...:]

A well reasoned and nicely written article.

Why the "good" bank scheme will not be implemented is because Geithner and company are hostages to markets and holders of both equity and debt.

Feb 15 10:04 AM

[commr51:]

This is the best article on the subject that I have read to date, and contains what appears to me to be the only plan that could actually work.

It amazes me how many have called for proposals that would just reinforce and perpetuate the excesses of the past - including the suspension of mark to market (as if transparency were the enemy to a resolution of this mess).

Feb 15 10:22 AM

[css1971:]

This would only work if the government were calling the shots. They aren't and haven't been for decades. The banks call the shots.

Feb 15 10:22 AM

[tinman:]

I wonder about your assertion "the current market value of the toxic assets is probably somewhere between 5% and 20% of nominal value" -- doesn't this assume toxic loan failure rate between 80 and 95%? Unless you're simply pointing out that there is no liquid market for them which is exactly what the TARP was originally supposed to address.

Personally, I'd put a few bucks into a clearing house fund that invested in just these assets right now. Absent a total meltdown, the I expect the failure rate will be much lower than 80%.

Feb 15 10:26 AM

[prudentinve...:]

Excellent article and a great concept.

The "bad bank" concept, is predicated on taxpayer guarantees to the private equity involved. This passes the potential losses to taxpayers, but leaves the potential profits to private investors. Ingenious, but disingenuous. No wonder it is favored by the rich, the famous, and the well-connected, and hence by the mainstream punditry.

Feb 15 10:48 AM

[morph366:]

Some excellent suggestions - especially this one

"The new good banks would be prohibited by law from engaging in what would be called investment banking today. They would be old fashioned commercial banks that lend their customer deposits and a modest amount from external sources. No derivatives (e.g. CDO's SDS), no stock brokerage (think Merrill in B of A (BAC)), no lending for stock acquisition or other non self liquidating type loan."

For those banks that want to engage in investment banking there should be no kind of publicly funded safety nets - they would literally have to fail when they screw up and all shareholders/debt holders of such institutions would need to formally acknowledge that there is no recourse to any taxpayer backstops.
Also legislation would need to ensure that the good new banks do not engage in counter-party risk with any of these investment banks.

Feb 15 11:19 AM

[atavist.avatar:]

This is not a reasoned article. Without knowing how the Treasury Secretary is going to induce private equity pools to buy the assets which are toxic to the banks and therefore the country, his plan is impossible to judge. Perhaps the author has open shorts on bank stocks.

Feb 15 11:47 AM

[James Wood:]

There are really only three options:
1) sell at or below market to encourage private investors, but as the article pointed out, many banks may not want to sell at market because they have not adequately marked down the assets or selling at market will not do anything favorable for their balance sheet.
2) Buy at above market. Which private firm is going to buy assets above market? They can buy assets at market without the treasury assistance.
3) It is not inconceivable that the Treasury will guarantee losses to private investors, which then goes back that it is all simply a disguised government bailout where the taxpayer pays.

There are really no other options. There is no hidden agenda in the writer's listing of the options.


On Feb 15 11:47 AM atavist.avatar wrote:

> This is not a reasoned article. Without knowing how the Treasury
> Secretary is going to induce private equity pools to buy the assets
> which are toxic to the banks and therefore the country, his plan
> is impossible to judge. Perhaps the author has open shorts on bank
> stocks.

Feb 15 12:01 PM

[MJJP:]

I am sure there would in fact be investors in the bad bank. These assests that are termed toxic may not in fact be toxic. Just because the value is down at the momemt their value will in fact rise in the future. If for nothing else than the rise in inflation that everyone is predicting.

Feb 15 12:44 PM

[GoinGreyer:]

I am of the opinion, that the people we all just elected, do not have a enough of a background to understand our situation much less a solution. They delegate to someone they trust, interprete. So when people who do attempt to discuss ramifications and decions, they gloss over or ask someone elses to get them to owe them one.

I think our decision making processes is what is flawed in our society. We tend to put ourself first ( as opposed to the greater good ), and want satisfaction now and deny ( ignore ) a future exists.

I also think most of us won't really do anything but duck and cover. We will not voice our concerns nor tell our elected officials we really care.

Feb 15 08:48 PM

[netemcee:]

Many people have touted this idea. For example:

online.wsj.com/article...

I think an even better idea is rather than starting a bunch of new government banks, why not dig through the roster of existing private banks for the most well run responsible small and mid-sized banks and give them a bunch of really cheap capital to help them grow. If the government is going to help businesses then it should be supporting the most financially responsible institutions and stop bailing out the inept and corrupt mega-banks and facilitate the closure of those that truly are bankrupt (ie AIG).

Feb 15 09:08 PM

[Dr. Granvil...:]

This article is one of several I have read recently supporting some sort of federal takeover of one or more large banks in America. Unfortunately, the bank bailout plan announced by Secretary Geithner made two things very clear. 1) He does not want to put a fair market value on bank’s bad loans and toxic assets and 2) he doesn't want to "officially" take over the banks no matter what. As more and more Federal money flows into these institutions, the Federal government will solidify its de facto control of these banks that would be insolvent without tax payer dollars. The Federal government will "own" these banks, stockholders' investments will essentially be eliminated and the toxic assets will be written off or removed from the banks' balance sheets. This is inconsistent with growing sentiment in America to let the banks fail and be taken over by the Federal government.

The other alternative is outright nationalization, a swift decisive write down of toxic asset values through bank reorganization where bank management is replaced, common stock holders' investments are wiped out and tax payer dollars are used to keep the restructured banks going. This is essentially the same outcome. The only question is how we get there.

Regardless of the approach, a lot more than the remaining $350 billion of bail out money will be needed and all banks will not be saved. This is going to be a painful expensive process but we will end up with better banks and a more secure and better regulated financial services industry in America.

Dr. Granville M. Sawyer, Jr.
Professor of Finance
Bowie State University

Feb 15 09:15 PM

[Drew Horn:]

Dr. Sawyer:

You miss the basic idea. Your points #1 & #2 focus on what Sec. Geithener ideas are ( or will be). The point is that he is probably wrong and needs to change his positions. There is little sense in criticisizing the guy in charge if you are unable say he is wrong.

Drew Horn, Boston


On Feb 15 09:15 PM Dr. Granville M. Sawyer Jr. wrote:

> This article is one of several I have read recently supporting some
> sort of federal takeover of one or more large banks in America. Unfortunately,
> the bank bailout plan announced by Secretary Geithner made two things
> very clear. 1) He does not want to put a fair market value on bank’s
> bad loans and toxic assets and 2) he doesn't want to "officially"
> take over the banks no matter what. As more and more Federal money
> flows into these institutions, the Federal government will solidify
> its de facto control of these banks that would be insolvent without
> tax payer dollars. The Federal government will "own" these banks,
> stockholders' investments will essentially be eliminated and the
> toxic assets will be written off or removed from the banks' balance
> sheets. This is inconsistent with growing sentiment in America to
> let the banks fail and be taken over by the Federal government.
>
>
> The other alternative is outright nationalization, a swift decisive
> write down of toxic asset values through bank reorganization where
> bank management is replaced, common stock holders' investments are
> wiped out and tax payer dollars are used to keep the restructured
> banks going. This is essentially the same outcome. The only question
> is how we get there.
>
> Regardless of the approach, a lot more than the remaining $350 billion
> of bail out money will be needed and all banks will not be saved.
> This is going to be a painful expensive process but we will end up
> with better banks and a more secure and better regulated financial
> services industry in America.
>
> Dr. Granville M. Sawyer, Jr.
> Professor of Finance
> Bowie State University

Feb 16 10:50 AM

[henarl:]

Federal Reserve Bank, Horrible Idea.

Feb 16 03:31 PM

[Aristophanes:]

I've put forward in most of my other posts the concept that to solve the problem what needs to be done is:

1) Break the CDO contracts and value them mortgage by mortgage using "boots on the ground" evaluations.

2) Sell them to local or regional thrifts. (Maybe setting up new ones isn't such a bad idea, but it reeks a little of the Fannie & Freddie guarantee al over again). Lousy assets will sell for a lousy price. Good ones for a good price.

3) Ban mortgage securitization. No more black box products with interlocking, hidden risk. Ban them outright and the mortgage industry will be streamlined and efficient without Wall St. middlemen anymore.

Feb 16 06:50 PM

[User 191457:]

James, I like your analysis, but what about splitting up some of the existing banks into viable smaller units (sans troubled assets) rather than creating a new bank from scratch? An RTC might be a suitable vehicle to achieve this. Even temporary nationalization of troubled banks would be better than the current gradual nationalization by instalment.

Feb 25 12:39 AM