Don't We Have Enough Bad Banks?

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The latest proposal from Treasury and the FDIC, to hive off the bad assets of “otherwise healthy” financial institutions into a “bad bank,” rings familiar in our not too distant memory. This familiarity stems from the fact that it is effectively the same scheme proposed by former Treasury Secretary Paulson last August. The original idea behind TARP was to have the Fed purchase the toxic assets from the banks, which would in theory “get them lending again.”

A similar idea was first proposed in October of 2007. Does nobody remember MLEC? This was to be the SUPER-SIV which would take the bad assets from the “otherwise healthy” structured investment vehicles created by the banks. Each time a variant of the plan to unload the toxic assets has stalled, it has stalled for precisely the same reason. Nobody has answered the most fundamental question: At what price?

At what price will the assets be hived off, sold to the Fed, or put into a “bad bank?” The SUPER-SIV idea, originally proposed in late 2007 by Citibank, J.P. Morgan and Bank of America, and meant to be a private sector solution, went nowhere because nobody could agree on price. Paulson’s plan from last summer went nowhere because, for all the wisdom at Treasury and the Fed, nobody could square the competing objectives between keeping the taxpayer safe (READ, DON’T OVERPAY!) and providing meaningful help to the banks (READ, OVERPAY!).

Paulson should be commended for at least digging in on this point of not having the taxpayers overpay for junk, but he loses points on naïvete in that he never took the thought experiment to its natural conclusion. To wit, there is no price that can both help the banks and protect taxpayers.

It now appears that, with the economic news cascading downward every day, the banks could be about to win this game of chicken. The latest proposal being floated from the Obama administration is to create an FDIC run bad bank that will take “toxic” assets off of bank balance sheets. The question of what price remains unresolved. Market prices? Model prices? Made up prices?

Treasury Secretary Geithner told the Senate Finance Committee “I think you need to look at a mix of those types of measures,” conceding that “they all have limitations.” [Comptroller of the Currency John Dugan agrees, telling Bloomberg one of the “real key issues” will be “which assets to take from open institutions and how much you pay for them.”] Hold on a minute! We’ve been working on this for 6 months, and we’re no closer to a solution?

The gambit of the bankers seems clear enough: eventually the public and the government will be so spooked that the nice sentiment of protecting the taxpayer will be cast aside. With the latest proposal, nobody seems to be making so much fuss about the quaint idea of “protecting the taxpayer.”

Before hooking taxpayers for these rotten loans, officials have a responsibility to consider carefully whether or not it will do any good. The premise has been that the banks are viable and should be saved, and once they don’t have the capital adequacy problems the bad assets have created, they will get back to the business of lending. That is, apart from the bad assets, they are “otherwise healthy.” Everything depends on this being true. It is almost certainly false.

To understand why it is false requires understanding how banks work at the micro level. It requires understanding the mindset of the folks sitting in a room, a credit committee, deciding whether or not to accept the risk posed by a particular transaction. It is difficult for policymakers to understand the dynamic that drives the credit-making process within these large banks. Over the past 20 years I worked for two institutions that together have racked up nearly $100 billion in losses due to bad bets on structured products. The sad truth is that these institutions are irredeemable; money spent shoring up their capital is money, if not completely wasted, then certainly inefficiently spent.

These banks are made up of individuals who made disastrous bets and crippled their institutions. Their stocks and net worth have been decimated, their friends have been fired, and worse, their bonuses have been reduced. They are shell-shocked, risk averse, and for those that remain, the vow of “never again” becomes the new culture. So, like all things cyclical, they go from taking foolish risks to taking no risks.

Remember that in the beginning of the crisis it was the subprime mortgage assets causing all the trouble. Then it gravitated outward to LBO loans and other institutional credits. Now consumer lending is causing the headaches. These institutions are not “otherwise healthy.” They are “otherwise troubled” not least because of more bad assets that may not be on the radar screen now, but because the individuals running these banks cannot easily recover from this horrible experience. Apologies to the Joker, but for the big lenders, the credit crisis has “changed things… forever.”

What then to do? If the big banks cannot be saved, money spent pumping up their capital, or purchasing their bad assets at inflated prices, will never trickle down into new lending. Nor will it stave off “systemic collapse”, the great bogeyman of our time. This was the AIG con job. If AIG failed, the reasoning went, many of its creditors would become insolvent. But if in the summer of ’08 AIG was insolvent, then some of its creditors were similarly insolvent. Maybe Goldman Sachs, maybe Morgan Stanley. The over $150 billion spent to save AIG in order to avoid systemic collapse looks like a more dubious investment every day.

Goldman has denied having materially unhedged exposure to AIG. The NY State Insurance Commissioner pointed out, correctly I believe, that the life and annuity subsidiaries of AIG are adequately capitalized to meet their obligations. What good then has come of this investment? The rest of the TARP funds look similarly questionable.

Readers might also visit Wells Fargo’s web page where one sees an advertised 30-year, fixed rate of 5.5%. This is within 1% of the lows for the past 40 years. So it is tempting to ask, in the face of these very reasonable rates, what credit crisis? But the Obama administration clearly feels both the need and a mandate to do something big, and a big, bad bank starts to looks inevitable. Before heading down this path, we might consider an alternative, equally large but perhaps less profligate.

Indeed, one possibility has been overlooked. Instead of creating yet another bad bank, or keeping alive the walking wounded, why not create a good bank? Treasury and the Fed could take one of the many trillions sloshing around the various bailout schemes and create a federally chartered, taxpayer-owned lending institution that would ensure that some basic level of credit products are available. A trillion dollars goes a long way. With a 10% capital-to-assets ratio this institution would have a lending capacity of two-thirds of US GDP.

Policymakers can then decide what credit products this bank will make available. They could start with 30-year, fixed rate, 20%-down owner-occupied mortgages. Student loans to accredited colleges might be next. Perhaps the commercial paper of investment grade corporations. Loans to Vegas croupiers-turned-real-estate-moguls, private label credit card securitizations, and 10-year auto loans for cars that last 6 years? Save those for the next cycle.

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