[One esp. interesting point: the whole concept of a bad bank requires overpaying for assets. If the bad bank pays for assets at the currently low market value, then it would be a good bank, and the supposedly good bank would be insolvent.]
http://baselinescenario.com/2009/01/21/bad-bank-aggregator-bank-beginners/
January 21, 2009 The Baseline Scenario [blog]
"Bad Banks" for Beginners
[For a complete list of Beginners articles, see the Financial Crisis
for Beginners page.]
What is a bad bank? . . . No, I don't mean that kind of bad bank, with
which we are all much too familiar. I mean the kind of "bad bank" that
is being discussed as a possible solution to the problems in our
banking sector.
In this sense, a bad bank is a bank that holds bad, or "toxic" assets,
allowing some other bank to get rid of these assets and thereby become
a "good bank."
To understand this, you need to understand what a bank balance sheet
looks like. I've covered this elsewhere, but for now a simple example
should do. Let's say that the Bank of Middle-Earth has $105 in assets
(mortgages, commercial loans, cash, etc.), $95 in liabilities (deposit
accounts, bonds issued, other financing), and therefore $10 in capital.
The assets are things that have value and theoretically could be sold
to raise cash; the liabilities are promises to pay money to other
people; and the capital, or the difference between the two, is
therefore the net amount of value that is "owned" by the common
shareholders. Next assume that the assets fall into two categories:
there are $60 of "good" assets, such as loans that are still worth what
they were when they were made (no defaults and no increased probability
of default) and $45 of "bad" assets, such as loans that are delinquent,
or mortgage-backed securities where the underlying loans are
delinquent, etc. Say the bank takes a $5 writedown on these bad assets,
so it now counts them as $40 of assets, but if it actually had to sell
them right now they would only sell for $20 because no one wants to buy
them. (When a bank has to take a writedown and for how much is a
complicated subject; suffice it to say that in many cases banks have
assets on their balance sheet at values that everyone knows could not
be realized in the current market, and this is completely legal.)
Right now the bank balance sheet has $100 in assets, $95 in
liabilities, and $5 in capital, so it is still solvent. However,
everyone looking at the bank thinks that those $40 in bad assets are
really only worth $20, and is afraid that the bank may need to take
another $20 writedown in the future. So no one wants to buy the stock
and, more importantly, no one wants to lend it money, because a $20
writedown would make the bank insolvent, it could go bankrupt,
stockholders would get nothing, and creditors (lenders to the bank)
would not get all their money back. Because no one wants to lend it
money, the bank itself hoards cash and doesn't lend to people who need
money.
Although not necessarily to scale, this is roughly what the banking
systems of the U.S. and several other major economies look like right
now.
How does a bad bank solve this problem? There are two basic models: one
in which each sick bank splits into a good bank and a bad bank, the
other in which the government creates one big bad bank and multiple
sick banks unload their toxic assets onto it.
Bank mitosis
In the first model, the Bank of Middle-Earth splits into two: a Bank of
Gandalf and a Bank of Sauron. The Bank of Gandalf gets the $60 in good
assets, and the Bank of Sauron gets the $40 in bad assets (that may
only be worth $20). The Bank of Sauron will probably fail. But the Bank
of Gandalf no longer has any bad assets, so people will invest in it
and lend money to it, and it will start lending again.
This model has one tricky problem, though: How do you allocate the
liabilities of the old bank between the two new banks? Luigi Zingales
says the simplest solution is to do it on a proportional basis. Because
the Bank of Gandalf gets 60% of the assets, it gets 60% of the
liabilities. So if the Bank of Middle-Earth owed someone $1, now the
Bank of Gandalf owes him 60 cents and the Bank of Sauron owes him 40
cents. Now the Bank of Gandalf has $60 in assets, $57 in liabilities
(60% of $95), and $3 in capital; the Bank of Sauron has $40 in bad
assets (that are really only worth $20) and $38 in liabilities. Instead
of one sick bank with $100 in assets that isn't doing any lending, you
have a healthy bank with $60 of assets that is lending, and what
Zingales calls a "closed-end fund holding the toxic assets" whose
creditors will probably get some but not all of their money back. The
tricky part is that this is a good deal for shareholders in the Bank of
Middle-Earth and a bad deal for creditors to the Bank of Middle-Earth,
and so it's illegal for banks to divide up the liabilities like this.
Zingales recommends legislation to make it possible, but I suspect that
even were Congress to pass such a bill, there would still be lots of
lawsuits challenging its constitutionality.
I started with Zingales's version of bank mitosis because it
illustrates the principle neatly, but the legal complication makes it
difficult to implement in practice. Another way to divide one back into
two is to find separate funding for the Bank of Sauron. This is what
UBS did in November, with the support of the Swiss government. UBS had
$60 billion in bad assets that it unloaded onto the new bad bank. To
pay for those bad assets, however, the bad bank needed $60 billion. How
did it get it? First UBS raised $6 billion in new capital by selling
shares to the Swiss government. Then it invested those $6 billion in
the bad bank - that became the bad bank's capital. Then the Swiss
central bank loaned the bad bank $54 billion. (There is little chance
that any private-sector entity would lend a self-confessed bad bank
money, but this was in the public interest.) Because shareholders get
wiped out first, that effectively means that UBS was taking the first
$6 billion in losses, and any losses after that would be borne by the
Swiss government. This constitutes a subsidy by the Swiss government to
UBS, but one that was justified by the need to stabilize the financial
system. At the end of the transaction, UBS had diluted its shareholders
by 9% (because of the new shares sold to the government) and had a $6
billion investment in the bad bank it was likely to lose, but it had
cleaned its balance sheet of $60 billion in toxic assets.
One issue in this version is how to value the assets that are being
sold to the bad bank. If they are sold at market value ($20 in the
Middle-Earth example), then the parent bank has to take a writedown
immediately, which arguably defeats the purpose of the whole
transaction (because that could render the parent bank immediately
insolvent). In that case, the parent bank would need to be
recapitalized (presumably by the government) immediately, and the "bad
bank" would actually be not that bad, since it is holding assets it
bought on the cheap. If they are sold at the value at which they are
carried on the parent bank's balance sheet, then the bad bank is
essentially making a stupid purchase (overpaying for securities it
expects to decline in value) for the public good. In the UBS case,
forcing UBS to provide the $6 billion in capital was a way of forcing
UBS to suffer at least some of the loss that the bad bank was expected
to incur.
Big Bad Bank
The second model, which has been proposed by Sheila Bair, Ben Bernanke,
and others, is the "aggregator" bank. Instead of splitting every sick
back into a good bank and a bad bank, in this model the government
creates one Big Bad Bank, which then takes bad assets off the balance
sheets of many banks. (This doesn't necessarily have to be created by
the government; the Master Liquidity Enhancement Conduit - bonus points
for anyone who remembers what it was for - was supposed to be funded by
private-sector banks. But in today's market conditions, the government
is the only plausible solution.) In this plan, the capital for the Big
Bad Bank is provided by the Treasury Department (perhaps out of TARP),
and the loan comes from the Federal Reserve, which has virtually
unlimited powers to lend money in a financial emergency. Once this Big
Bad Bank is set up and funded, it will buy toxic assets from regular
banks, which will hopefully remove the uncertainty that has hampered
their operations.
Yes, the Big Bad Bank is similar in concept to the original TARP
proposal, and it faces the same central question: what price will it
pay for the assets (the issue discussed two paragraphs above)? If it
pays market value, it could force the banks into immediate insolvency,
so recapitalization would have to be part of the same transaction. If
it pays current book value (the value on the banks' balance sheets), it
will be making a huge gift to the banks' shareholders. There has been
talk of forcing participating banks to take equity in the Big Bad Bank
(as in the UBS deal), presumably to make them shoulder some of the
overpayment. In any case, the money the government puts in, up to the
market value of the assets purchased, is a reasonable investment for
the taxpayer; but there will need to be additional money, either to
recapitalize the remaining banks (which, if done at market prices,
would lead to government majority ownership), or to overpay for their
assets. Pick one.
One last issue: Creating a bad bank works nicely if you can draw a
clear line between the good assets and the bad assets. My theoretical
Bank of Gandalf above only has good assets, so there are no doubts
about its health. But what if you can't? This crisis started in
subprime mortgage-backed securities, and it's pretty clear that things
like second-order CDOs based on subprime debt are deeply troubled. But
as the recession deepens, all sorts of asset-backed securities - such
as those backed by credit card debt or auto loans - start losing value,
and then even simple loan portfolios lose value as ordinary households
and businesses that were creditworthy just a few years ago go into
default. Put another way, if it were possible to neatly separate off
the bad assets, then the second Citigroup bailout would have worked,
since that provided a government guarantee for $300 billion in assets.
Yet Citigroup's stock price, even after Wednesday's huge rally (up 31%)
is still below the price on November 21, the last trading day before
that bailout was announced. Clearly no one believes that Citigroup had
only $300 billion in bad assets.
The goal of a bad bank is to restore confidence in the good bank, and
it's not clear how much of the parent bank's assets have to be
jettisoned before anyone will have confidence that only good assets are
left. One potential problem with the Big Bad Bank is that banks could
be tempted to underplay their problems, sell only some of their bad
assets, hope the rest are all good, take the bump in their stock price
. . . and then show up two quarters later with more bad assets. If
investors suspect that is going on, and that the banks are still
holding onto bad assets, then the scheme will fail. The solution to
that problem is to overpay for the assets, which gives banks the
incentive to dump all of them onto the Big Bad Bank . . . and then we
are back where we started.
Update: Citigroup's division into a good bank (Citicorp) and a bad bank
(Citi Holdings, which includes the $300 billion in assets guaranteed by
you and me) is more symbolic than anything else at this point, because
they are still just divisions of one company. So if Citi Holdings goes
broke, the creditors can demand money from Citicorp, which defeats the
purpose of a good/bad separation. The goal here was more to communicate
what the bank's long-term strategy is (the hope is to either sell off
or run off everything in Citi Holdings) in hopes of convincing
shareholders that the management knows what they are doing.
Written by James Kwak
January 21, 2009 at 8:48 pm