‘Bad Bank’ Idea Surfaces

Sorry to throw Krugman at you two days in a row, but he seems to be the only one making sense on the latest fun issue to leak out of Washington: the old ‘bad bank’ idea is back in town. Here is his Op-Ed piece this morning: Op-Ed Columnist – Wall Street Voodoo

As someone who actually worked on bad bank finance for a few long and miserable months back in 1990 [the bank I worked for had lost its shirt in bad real estate] I can tell you that the only way to make this concept viable is to eliminate the bad assets while they are still on the bank’s balance sheet. The shareholders have to take the hit.

Before that, back in the days of the Savings and Loan debacle, which was another GOP excessive deregulation inspired runaway disaster the US government set up the Resolution Trust Corporation to manage the debris caused by the collapse of the S & L industry. The old S & L banks had been stodgy savings institutions. They were banks in name only and had a specific role: they took in deposits and made mortgage loans. They were the poor step children of the banking system. Deregulation suddenly enabled them to do all sorts of exciting things and they started creating new financial instruments and funky deposit accounts with gusto. The problem was that their management was hopelessly unable to manage the new fast paced balance sheets that resulted. So the entire industry sank into the abyss of rotten real estate valuations, and the government has to bail them out. Hundreds of institutions were closed. Billions of shareholder value was written off.

Sound familiar?

The bad bank idea hinges on the fact that the assets transferred to the newly created ‘bad bank’, in the S&L case this was the RTC, are moved at market value. Not book value. If you move the assets at book value you are subsidizing the old shareholders who therefore avoid responsibility for the loss that was created on their watch. This is a classic case of ‘moral hazard’. The supposed discipline of the market, where the shareholders are forced to be responsible for their actions, is eliminated in such a case. By moving the assets at market value you force the shareholders to be accountable while freeing up the bank’s balance sheet from the drag of owning bad assets. Most often the bank is insolvent anyway even after that bad assets are eliminated co the next step is to liquidate the bank entirely by conducting sales of its branches and other assets. This is what the RTC did en masse. It liquidated several hundred dead banks over a period of a few years. Eventually it was able to sell off the real estate it had assumed and then it too was wound up.

Krugman is absolutely right to say the key is the valuation. In today’s example a bank like Citibank is effectively bankrupt: its assets are worth less than its liabilities if the market value of its real estate is taken into account rather than its book value. So the sensible thing is to close Citibank up and sell off its assets.

However the example of Lehmann hangs over us. No one wants a repeat of the credit market failure that followed the collapse of Lehmann.

That leads to only one obvious policy choice: nationalize Citibank to keep it afloat while the bad assets are isolated and sold off. Then ‘privatize’ it at some point in the future, probably two or three years from now, when it is once again solvent and can fend for itself in the market place.

Unfortunately the Obama administration seems not to understand this. So fearful is everyone of the word ‘nationlization’ that, despite it being the best and cheapest route to success, it is not being considered. Instead the government is planning to hand over cash to the current shareholders.

That’s bad policy.

That’s nuts.