Bad Banks? Bad Idea?

30 January 2009

Jose D. Roncal

www.financialspeculation.com

Lawmakers are looking for a quick fix for the banking and credit markets. No fix will be clean or easy. Every option comes with big hits to taxpayers, partisan bickering and the fact that no one knows what will work. Topping the agenda is a plan for creating a so-called Bad Bank, an entity where we could dump all the toxic assets that are currently sitting on bank balance sheets and damming up the flow of credit.  By "dump," we mean purchase them from one bank and relocate them to the Bad Bank.

As you recall, a portion of Paulson's original $700 billion TARP proposal was to buy up these bad assets, but he changed his mind and bought preferred shares of banks instead.  So, Paulson, how's that working for you?  Never mind, we can read the news.

The Bad Bank plan may allow the government to rewrite some of these bad mortgages and lessen the crisis that has stripped more than 1.3 million Americans of their homes. But establishing a government-owned bank is not going to eliminate all the problems. For instance, why should we believe that simply purchasing toxic assets from one balance sheet and moving it to another will get the banks to start lending again?  

First of all, who decides how much the banks will be paid for their bad assets? We all know that each mortgage-backed security is actually just a package made from bits and pieces of countless bad mortgages. No one knows what's in each one, much less how much each one is worth, so who decides the value?

If the Bad Bank takes on a hefty portion of these troubled securities, what happens to the private bank that originally owned the assets? We expect it means that many will be found to be insolvent and need to be shut down, or be partly nationalized, or completely taken over.

There's tough talk on Capital Hill about tightening up regulations and oversight of the financial industry. Some lenders may end up under government control and executives booted to the curb. We're all for that, but we don't favor a wide-scale nationalization of the banking industry. House Financial Services Chairman Barney Frank agrees that the government should not take on the role of running banks.

There are plenty of lawmakers as well as pundits weighing in with options,  like the suggestion that the government should over-pay for the bad assets and hope that the market will eventually rebound. We're sure that bank shareholders and debt holders would love that idea. But taxpayers, millions of whom are now collecting unemployment checks, will still be expected to cover the costs of the mess—the one that was created by poor (predatory) lending decisions made at financial institutions where many over-compensated executives are still employed and still receiving bonuses.

If the economy continues to tank and mortgage-default rates continue to soar, the value of the bad assets sitting on the Bad Bank's balance sheet will continue to fall leaving taxpayers holding the biggest bag of foreclosures in real estate history.   

It's time to send the regulators in to do a thorough evaluation of banks' books and try to set a reasonable value to their assets. Yes, that's going to reveal a slew of insolvent banks, but that won't come as any surprise.

It's predicted that the Federal Deposit Insurance Corp. (FDIC) may be the one running the whole operation. That would make sense since it's always been their responsibility to take bad assets out of banks and manage and sell them.

The clean up process won't be simple and it won't cheap. It could cost somewhere in the neighborhood of $4 trillion—equivalent to nearly 1/3 of U.S. GDP. The actual cost will depend on how many banks participate and how much the Feds end up paying for the deteriorating assets.  It will be painful, but as new Treasury Secretary, Tim Geithner and others have stated, there may not be any other options available.

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