I continue to be amazed that the “Bad Bank” concept that was the impetus for the 700billion dollar bailout has yet to be used. I looked for Pros and Cons of this concept. The dominant con seems to be paying too much for the assets or “nationalization”. But what I found even less was a decent explanation as to the impact of getting these off the market. The conversation linked above is stunningly devoid of detail and value.
Let me explain it as I understand it (this comes from a conversation with a high level banker). This may help you translate the talking heads. The impact on the economy is elevated in the negative and the positive because of a combination of existing laws.
The first is the debt to asset ratio of a “bank”. I have heard that this ratio is 10:1. In other words, if a bank holds 10billion in assets they can lend as much as 100billion. The problem came into play that these Mortgaged Backed Securities were considered assets (which seems odd since they are a rollup of lending so I must be missing some element). So when these assets began to default, their overall value was reduced. Based on the “Mark to Market” laws passed with Sarbanes–Oxley this loss of value must be accounted for on a companies balance sheet. I do not know that this is a bad idea, as some state. In the example I was given, a bank value lost because of these assets was 26billion dollars. This would mean that the bank had to reduce it outstanding debt by 260billion dollars. This number was more than there entire market capitalization. Therefore, they are bankrupt. But are they? Hence the argument against Mark to Market. The loans outside of these assets still have value and still may be repaid.
So there is argument against the practice but it exists. So the Bad Bank concept tries to reverse the problem. If the bad assets can be bought form the banks; even at a cheap price; the spiral starts to reverse. The assets that are purchased are removed from the bank’s books. The impact of removing that bad asset allows for a ten-fold multiplier in lending. But the impact spreads rapidly. With a new price set on the assets banks can rebalance their books. Some may now be able to hold the assets. With the death spiral stopped the assets may being to trade. If not the government can against but some assets off the market. Again setting a new price. Once these assets being to sell again on the market the government could sell the assets into a rising market at higher prices to offset the other bailout funding.
Well that’s what I think I know. And it made sense. So maybe that is why the government never did it. Instead they forced money onto the banks in exchanged for preferred stock. This devalued the shareholders and left the assets on the books. What I found interesting in the video above was the reasoning for the change in policy… World opinion. Europe was injecting money into banks for equity. It was decided that all of the major countries should follow a similar policy. Two problems. It sounds like an all eggs one basket solution. Additionally, we are listening to European Socialists on how to solve a banking issue caused by accounting practices in the U.S.
I am still hoping that government can follow a basic premise and buy low and sell high.