[lbo-talk] James Kwak: Bad Banks for Beginners

Michael Pollak mpollak at panix.com
Fri Jan 23 00:15:44 PST 2009


[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



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