Bad Bank, Worse Idea
Well the campaign for bank nationalization seems to have hit a wall. The current and best rumors in Washington now are that the Obama Administration favors setting up a ‘Bad Bank” to deal with our banking woes. My quick response: bad idea!
A bad bank is an organization set up for the specific purpose of buying, managing and, eventually, selling or holding until maturity assets that have extremely uncertain value. The so called ‘toxic’ assets that are weighing down the banking system are obviously such assets. They consist mainly of derivatives like Mortgage Backed Securities whose value is now virtually unknowable because the market for them has collapsed. Since there is no extensive trading of MBS’s going on we have no idea what they are worth. That means that the banks who were dumb enough to purchase them have a corresponding uncertainty: they have no idea what their balance sheets are really worth. In turn this implies that the banks may or may not be insolvent [that is they may have insufficient capital to meet their obligations]. An insolvent bank is a dead bank.
Notice the string of implications and uncertainties in that logic. The point is that no one, not even the most savvy financier, has any real notion of the value of these MBS assets. As long as this remains the case no one who is fiscally conservative will do business with a bank whose balance sheet is loaded with them. Similarly the banks themselves will be highly unwilling to lend since to lend is an application of capital that might be required to cover losses on the toxic assets.
So we find ourselves stuck. Without trading we cannot fix an asset value. But without a value no one is confident enough to trade. While confidence is low the credit system grinds to a halt and takes the economy down with it.
There are two ways forward. The first is to relieve the banks of their rotten portfolios and thus remove the uncertainty. This cleans up their balance sheets and leaves them back to normal and thus focussed on regular banking activities like lending rather than special case management issues like cleaning out bad assets. This seems to be the method the Obama folks prefer. The second option, which achieves the same goal eventually, is nationalization. I have written tons about nationalization before so I won’t re-hash the arguments here.
My objection to the bad bank method is that it rewards current shareholders by preventing them being wiped out. In nationalization the government ousts, at minimal or no value, the existing shareholders and injects enough equity to cover any losses stemming from bad assets. As those bad asset portfolios are liquidated or sold the bank’s balance sheet returns to health, thus allowing the bank to be sold back to private hands. This process usually takes a few years. In the interim the government employs managers to run the bank. The bad bank method keeps the current management in place and, because it relieves the balance sheet of rotten assets, stops the existing shareholders from incurring any more losses. So the shareholders benefit at the taxpayer’s expense. And this is the central issue for me. Why should the taxpayer bail out the shareholders whose negligent oversight allowed the banks to accumulate the bad assets?
It appears we have an ideological problem. The Wall Street types who clutter up Obama’s team are too close to the market philosophy that brought us to this point to see the benefits of nationalization. As I have said before they see it as ‘Un-American’. They maybe right, but that doesn’t mean it isn’t the correct policy. Bad banks work to protect current shareholders, they do not correct market failures. A management and shareholder class chastened by nationalization is unlikely to repeat this mistake. In contrast the beneficiaries of a bad bank are highly likely to muck it up again.
One last point: if you want an objective measure of who the likely winner in a bad bank is going to be just check the stock market reaction. The moment it leaked out that the bad bank policy was the front runner as our solution the equity markets for bank stocks shot up. They clearly see who’s going to win. And that’s exactly why we shouldn’t go down that road.
Addendum:
I should have addressed the problems of valuation more clearly. My issue is that since there is no market for this junk there is no way that we can avoid overpaying for it. Think of this way: no bank will willingly sell its assets for anything below what it ‘guesses’ those assets are worth. So to force them to sell we will inevitably end up paying more than what the bank thinks they’re worth. Else why would the bank sell? To do so would be a voluntary liquidation of equity and diminution of capital. Simple account procedures prevent he government from buying the assets at anything other than book value: anything else and the bank takes a loss which is exactly the opposite outcome from that desired. There is a way out of this of course. If the government thinks the assets are worth less than book value then it could hand over cash, and then also take an equity stake to offset the equity loss thus generated. But this is called nationalization. So we are back to my original argument.
Bad banks are just bad ideas.
