‘Good Bank -Bad Bank’ – Is there any other way out?

The proposal to take the toxic/lousy assets of the US banking system into a ‘bad bank’ and leaving the performing/good assets with the existing banks had initially received a positive response from the street wise it appears has run into a block – how to value these assets?

As one expert explains:

“Say a bank has a security it wants to sell to the bad bank. The face value is $100. The bank holds it at a value of $85. The market thinks it’s worth $65.

Banks will want the government to purchase assets for as high a price as possible, or at least to find some middle ground above depressed market values.

Buying the security at, or close to, $100 means the government would recapitalize the bank while transferring losses from shareholders to taxpayers.

Well, future taxpayers. They will be the ones who pay down the debt the government hopes to sell to fund this transfer, and make good on any losses. That debt, meanwhile, could prove stifling to the economy, and the losses pushed onto taxpayers could further undermine government finances.

‘Postpone the Pain’

“Creative pricing of toxic assets will only postpone the pain, extend the duration of the crisis, and present a bigger bill,”...

If the government purchases the security at $85, the future losses and bill to the public purse would be less. The problem is that this price could cause banks to recognize as permanent their losses on other securities. Right now, they claim those losses are temporary.

Such a move would cripple banks’ regulatory capital ratios. Plenty of banks could still fail. In that case, banks and taxpayers both get hit.

Buying the security at the market price of $65 means banks and the financial system immediately face a day of reckoning. While bank balance sheets would get unclogged, many wouldn’t be able to, or willing to, face the losses.

Nationalizing Banks

“If the government elects to pay fair market value, the bank will likely not elect to participate as capital hits would be too dear,” …

That could force the government to nationalize banks or seize them as part of the process of buying up assets. Either way, shareholders would get wiped out.”

So what we have is a ‘Damn if you! Damn if you don’t!’ situation.

According to various reports:

• It is estimated that the falling US and British financial institutions have received $1trn. from the government (taxpayers), sovereign wealth funds and other investors.
• Bank losses from the write-offs of bad loans and busted derivatives tally up to $1.5 trillion so far. In addition, $5 trillion to $10 trillion worth of off-balance-sheet businesses such as structured investment vehicles -- leveraged lending vehicles used by big banks to fatten their profits in boom times -- are being forced back to banks' balance sheets by regulators. Rules require banks to keep a base of real shareholder capital amounting to 10% of those funds. So banks need to find up to $1 trillion within the next year to meet that objective.
• Add the $1.5 trillion in losses to $1 trillion in needed new reserves, and you can see that banks need as much as $2.5 trillion in new capital to remain solvent under current rules. Consider that the entire world banking system had only $2 trillion in shareholder capital in 2007, before everything blew up.
• When you add the $500 billion from sovereign wealth funds to the $500 billion from the first tranche of the Troubled Assets Relief Program, it's only $1 trillion. That's already been provided. So that leaves a gap of $500 billion to $1.5 trillion.

And the feeling one gets is that nobody still has an idea on the depth of toxic assets in the system as a whole while individual institutions may have an idea about their position but may not want to disclose it fully.

The complication that has been brought in to the bailout approach is truly mind-boggling and it is becoming very clear that everyone is clueless.

Is there a simpler approach?

Now that it is very apparent that the taxpayers and public (present and future) at large are the suckers in this game and are going to foot the bill (which anyway is going to run into a few trillions of dollars), why not take a simpler approach.

The primary cause has been mortgages – and at the root are the ‘sub – prime’ mortgages. If the bad loans have been identified as they should have been by now, the government can take over these loans into its books and tell the banks that it will pay the monthly installments as per the original agreement with the borrower. If the average tenure/maturity is about 15 years say the government gets reasonable time to raise these trillions over a much longer period. As regards the banks these become performing assets and as the government instead of doling out only to the banks can also dole out to the mortgagees by giving them the actual ownership of their homes. While this would be akin to a grant and some may raise moral hazard issues, but what morality is left in the present plans? Further taxpayers and citizens will feel better knowing that they have helped fellow citizens than the unscrupulous financial institutions. Politically too it might find favor as relevant constituencies are addressed.

Given that the mortgage repayments are now to come from the government the derivatives based on the mortgages will also stabilize and the banks can reckon these mortgages in their books at face value thereby avoiding any major need for recapitalization because of loan loss provisions. The derivative products, given the government backing may turn liquid and find its value too.

Am I missing something? Look forward to your comments and response.

Disclosure: No Positions

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