Bad Bank, Bad Idea; Good Bank, Good Idea 17
by:
James Wood February 15, 2009
About this author:
- Profile <http://seekingalpha.com/author/james-wood> & More
Articles<http://seekingalpha.com/author/james-wood/articles>
Secretary Geithner has proposed the formation of a "bad bank" to buy $1
trillion or more of troubled loans and securities off the books of banks and
get credit moving.
This idea deceives the public, will not work and provides
all the wrong incentives to bankers. This is a rehash of the idea former
Secretary Paulson first proposed and then quickly abandoned. A good idea is
to create a "good bank". Let's first look at why I am opposed to Secretary
Geithner's idea for a "bad bank".
Geithner hopes the purchase of toxic assets by the "bad bank", funded in
part with private capital, will get the banks to lend again. He is not even
making the claim this makes economic sense. This is a fatal flaw causing the
idea to fail from all points of view.
1. *Geithner's description of the "bad bank" is not "honest".* He says "bad
bank" will use partially private equity. No private equity is going to
invest in the "bad bank" if it is run for non economic purposes. The key is
the price of the toxic assets. As a generalization, the current market value
of the toxic assets is probably somewhere between 5% and 20% of nominal
value. If the "bad bank" pays more than this, private investors will not
invest. If the banks sell these toxic assets for this value, there will
probably be an enormous unfavorable P & L impact as most banks have not
really marked all of their toxic assets down to real market value even
though they should have through mark to mark regulations. So probably the
assets will be purchased for much more than their current value, so no
private sector participation unless there is a behind the scenes guarantee
of the government to bail out the private sector investor in the "bad bank".
Furthermore, the "bad bank" is made to sound more like a commercial
transaction that is only partially dependent upon the taxpayer. The truth is
the taxpayers absorb all the costs of the "bad bank" from 3 or 4 directions
that are not obvious to the quick reader.
bubbles, this one finally blew up starting in 2006 with the home mortgage
market financing. As in every bubble, banks have learned again that easy,
low cost financing is not a substitute for good credit. While banks lent 10
to 15 times their capital in the 1970's, banks were lending in 2007 30 to
100 times their capital when you take into account derivatives and off
balance sheet financing such SIVs.
Every bank is now deleveraging to get its risk profile back in order. Even
if they wanted to fund themselves through the traditional source of
securitized transactions, banks are drying up with the new recognition of
the danger they can be. Home equity issuance is off 98%. Securitized auto
loans were down 40% in 2008. Student loan issues were down 43% in 2008. Credit
card financings were down 21%. About the only one still provided this type
of securitized financing is Ginnie Mae and Fannie Mae
(FNM<http://seekingalpha.com/symbol/fnm>
). Both have lost all their capital and are bombs which will explode (again)
very shortly. In short, buying up all the bad debts of the banks will not
jump start lending again, because the current bad assets are not the real
cause of not lending more now.
3. *The Geithner plan creates all the wrong incentives for the banking
sector, which ultimately will increase the cost and defer the day we resolve
the problem*. A government plan which says we want to bail out everyone in
trouble rewards the imprudent and leaves the bill to be paid by the
prudent. This
is not the American way. This is not smart. Even the porn industry has said
it should get a bail out too. The press reports
GM<http://seekingalpha.com/symbol/gm>is going to say "I go broke if
you do not bail me out".It hasnot been able to provide a plan where it
can credibly say it can work its
way out of the problem. We need incentives that promote success, not failure
as the current Geithner plan does. Ironically, the new government plan to
rein in compensation of top executives in banks may have the effect to cause
some banks not to take government financial aid. This shows the structure of
incentives determines the type of outcome. A wrong structure of the Geithner
incentives means there will be a bad outcome from their use.
A completely different approach (albeit unusual) is to use some of the
government stimulus money to provide seed money for a series of new
commercial "good banks". This could provide the right incentives, bring in a
lot capital and funding and thereby really provide loans to businesses that
need it for their everyday operation.
1. *The Idea.* Provide $1 billion dollars each for 20 new regional
commercial banks (pick your number here on initial capital and number of
banks). There are vast sums of private money on the side looking for good
investments. The equity could probably be increased tenfold very quickly
from private sources. Then it should be easy to find indebtedness of 10
times that from debt markets. In short, the government money should be
multiplied 100 times in terms of funds available for lending to needy
Americans and American business. I think $20 billion of government seed
capital would realistically be turned into $2 trillion of lending capacity.
The new good banks would be prohibited by law from engaging in what would be
called investment banking today. They would be old fashioned commercial
banks that lend their customer deposits and a modest amount from external
sources. No derivatives (e.g. CDO's SDS), no stock brokerage (think Merrill
in B of A (BAC <http://seekingalpha.com/symbol/bac>)), no lending for stock
acquisition or other non self liquidating type loan. The focus is to provide
working capital and equipment and mortgage financing for individuals and
businesses. These banks would be staffed with professional "Commercial"
bankers who would work for a decent living. Investment bankers who think
they have the right to up to 50% of the gross fee income as a bonus would be
prohibited from employment.
2. *What will happen?* Since the new good banks have money to lend, they
will be the first choice for everyone. They can be like Warren Buffett and
cherry pick good deals that deserve credit, but they will not ask for
warrants for stock like Buffett gets.
3. *The effect on existing banks?* The new good banks will make things
harder for the existing banks. The existing banks will argue that rather
than helping, the creation of new good banks increases the chances that the
existing banks will go broke. Yet, that is the way the system works, i.e.
competition. When it is clear that there is no bail out from the government,
you can be sure that these bankers will devote their energies to
surviving. Most
will survive, many will not survive. But now a clear signal has been given
that stimulates them to do what they can to save themselves, as opposed to
finding ways for the government to bail them out.
4. *Resolution Trust type work out bank*. There needs to be a bank or
organization that assumes control of the assets and liabilities of the
bankrupt banks. This does not have a political purpose to save existing
banks in risk of bankruptcy. It is strictly a workout mechanism for the
banks that will be going broke. It widely speculated that 1,000 banks will
go broke in the next two years and some of the biggest banks are likely to
be among these. If Citibank (C <http://seekingalpha.com/symbol/c>) and B of
A fail, there may be no choice but to nationalize them. However, they should
be rapidly converted into the type of bank described above as a "good bank". It
will be better to do this and take the losses than continually pump money
into them as we are doing with AIG <http://seekingalpha.com/symbol/aig> and
the "bad bank" idea of Secretary Geithner and without real hope of getting
the money back.
In summary, the feel good plan to pump money into the banks to stimulate
lending will not work. It is illusory to think the world will get out of
this problem without pain for most people. Yet, well intended schemes like
the Geithner plan delay and make more expensive the solution. The nation
would do better to bite the bullet and let fail those who cannot succeed on
their own. The government can provide more effective help to needy borrowers
by creating new, healthy banks than pouring endless money into unhealthy
banks that continue to be run by the same people who bankrupted the banks
through their excesses and imprudence. As a people, Americans are
resourceful. When bankers know they will not be bailed out by the
government, most of them will become very effective in finding a solution
for their bank - if there is a solution. And if there is no solution to a
specific bank's problem, the people of the United States should not put the
next generation's money into it.
*Stock position: None.*
all the wrong incentives to bankers. This is a rehash of the idea former
Secretary Paulson first proposed and then quickly abandoned. A good idea is
to create a "good bank". Let's first look at why I am opposed to Secretary
Geithner's idea for a "bad bank".
Geithner hopes the purchase of toxic assets by the "bad bank", funded in
part with private capital, will get the banks to lend again. He is not even
making the claim this makes economic sense. This is a fatal flaw causing the
idea to fail from all points of view.
1. *Geithner's description of the "bad bank" is not "honest".* He says "bad
bank" will use partially private equity. No private equity is going to
invest in the "bad bank" if it is run for non economic purposes. The key is
the price of the toxic assets. As a generalization, the current market value
of the toxic assets is probably somewhere between 5% and 20% of nominal
value. If the "bad bank" pays more than this, private investors will not
invest. If the banks sell these toxic assets for this value, there will
probably be an enormous unfavorable P & L impact as most banks have not
really marked all of their toxic assets down to real market value even
though they should have through mark to mark regulations. So probably the
assets will be purchased for much more than their current value, so no
private sector participation unless there is a behind the scenes guarantee
of the government to bail out the private sector investor in the "bad bank".
Furthermore, the "bad bank" is made to sound more like a commercial
transaction that is only partially dependent upon the taxpayer. The truth is
the taxpayers absorb all the costs of the "bad bank" from 3 or 4 directions
that are not obvious to the quick reader.
2. *New conservative credit standards and the lack of new securitized
funding are the real causes of the inability of the banks to lend, not the
current bad assets*.
Every financial bubble is based on lots of low cost
money. Securitization is what provided lots of low cost money. Like allbubbles, this one finally blew up starting in 2006 with the home mortgage
market financing. As in every bubble, banks have learned again that easy,
low cost financing is not a substitute for good credit. While banks lent 10
to 15 times their capital in the 1970's, banks were lending in 2007 30 to
100 times their capital when you take into account derivatives and off
balance sheet financing such SIVs.
Every bank is now deleveraging to get its risk profile back in order. Even
if they wanted to fund themselves through the traditional source of
securitized transactions, banks are drying up with the new recognition of
the danger they can be. Home equity issuance is off 98%. Securitized auto
loans were down 40% in 2008. Student loan issues were down 43% in 2008. Credit
card financings were down 21%. About the only one still provided this type
of securitized financing is Ginnie Mae and Fannie Mae
(FNM<http://seekingalpha.com/symbol/fnm>
). Both have lost all their capital and are bombs which will explode (again)
very shortly. In short, buying up all the bad debts of the banks will not
jump start lending again, because the current bad assets are not the real
cause of not lending more now.
3. *The Geithner plan creates all the wrong incentives for the banking
sector, which ultimately will increase the cost and defer the day we resolve
the problem*. A government plan which says we want to bail out everyone in
trouble rewards the imprudent and leaves the bill to be paid by the
prudent. This
is not the American way. This is not smart. Even the porn industry has said
it should get a bail out too. The press reports
GM<http://seekingalpha.com/symbol/gm>is going to say "I go broke if
you do not bail me out".It hasnot been able to provide a plan where it
can credibly say it can work its
way out of the problem. We need incentives that promote success, not failure
as the current Geithner plan does. Ironically, the new government plan to
rein in compensation of top executives in banks may have the effect to cause
some banks not to take government financial aid. This shows the structure of
incentives determines the type of outcome. A wrong structure of the Geithner
incentives means there will be a bad outcome from their use.
A completely different approach (albeit unusual) is to use some of the
government stimulus money to provide seed money for a series of new
commercial "good banks". This could provide the right incentives, bring in a
lot capital and funding and thereby really provide loans to businesses that
need it for their everyday operation.
1. *The Idea.* Provide $1 billion dollars each for 20 new regional
commercial banks (pick your number here on initial capital and number of
banks). There are vast sums of private money on the side looking for good
investments. The equity could probably be increased tenfold very quickly
from private sources. Then it should be easy to find indebtedness of 10
times that from debt markets. In short, the government money should be
multiplied 100 times in terms of funds available for lending to needy
Americans and American business. I think $20 billion of government seed
capital would realistically be turned into $2 trillion of lending capacity.
The new good banks would be prohibited by law from engaging in what would be
called investment banking today. They would be old fashioned commercial
banks that lend their customer deposits and a modest amount from external
sources. No derivatives (e.g. CDO's SDS), no stock brokerage (think Merrill
in B of A (BAC <http://seekingalpha.com/symbol/bac>)), no lending for stock
acquisition or other non self liquidating type loan. The focus is to provide
working capital and equipment and mortgage financing for individuals and
businesses. These banks would be staffed with professional "Commercial"
bankers who would work for a decent living. Investment bankers who think
they have the right to up to 50% of the gross fee income as a bonus would be
prohibited from employment.
2. *What will happen?* Since the new good banks have money to lend, they
will be the first choice for everyone. They can be like Warren Buffett and
cherry pick good deals that deserve credit, but they will not ask for
warrants for stock like Buffett gets.
3. *The effect on existing banks?* The new good banks will make things
harder for the existing banks. The existing banks will argue that rather
than helping, the creation of new good banks increases the chances that the
existing banks will go broke. Yet, that is the way the system works, i.e.
competition. When it is clear that there is no bail out from the government,
you can be sure that these bankers will devote their energies to
surviving. Most
will survive, many will not survive. But now a clear signal has been given
that stimulates them to do what they can to save themselves, as opposed to
finding ways for the government to bail them out.
4. *Resolution Trust type work out bank*. There needs to be a bank or
organization that assumes control of the assets and liabilities of the
bankrupt banks. This does not have a political purpose to save existing
banks in risk of bankruptcy. It is strictly a workout mechanism for the
banks that will be going broke. It widely speculated that 1,000 banks will
go broke in the next two years and some of the biggest banks are likely to
be among these. If Citibank (C <http://seekingalpha.com/symbol/c>) and B of
A fail, there may be no choice but to nationalize them. However, they should
be rapidly converted into the type of bank described above as a "good bank". It
will be better to do this and take the losses than continually pump money
into them as we are doing with AIG <http://seekingalpha.com/symbol/aig> and
the "bad bank" idea of Secretary Geithner and without real hope of getting
the money back.
In summary, the feel good plan to pump money into the banks to stimulate
lending will not work. It is illusory to think the world will get out of
this problem without pain for most people. Yet, well intended schemes like
the Geithner plan delay and make more expensive the solution. The nation
would do better to bite the bullet and let fail those who cannot succeed on
their own. The government can provide more effective help to needy borrowers
by creating new, healthy banks than pouring endless money into unhealthy
banks that continue to be run by the same people who bankrupted the banks
through their excesses and imprudence. As a people, Americans are
resourceful. When bankers know they will not be bailed out by the
government, most of them will become very effective in finding a solution
for their bank - if there is a solution. And if there is no solution to a
specific bank's problem, the people of the United States should not put the
next generation's money into it.
*Stock position: None.*
Posts
