Wednesday, March 11, 2009

The Bad Bank: We're only going to have one shot at this

I've written several times about the Bad Bank plan. I believe its critical to restoring confidence in our financial system, and while I don't expect it to "fix" the recession, I do think its a necessary ingredient to the U.S. economy finally moving forward. I've made some loose proposals in the past about how the Bad Bank could work, but after continued thought, I'm proposing an even more detailed idea. Again, this is in the spirit of exchanging ideas, I'd love to hear your comments.

I'll start with some assumptions.

  • Banks and other financial institutions have two flavors of problem assets: loans which are not marked to market and securities which are.
  • The point of the Bad Bank is to improve bank balance sheets both in terms of reduced leverage as well as visibility.
  • Buying assets at so-called "market" levels does not serve the above purpose.
  • While protecting tax payers is obviously important, creating a Bad Bank which doesn't materially improve financial conditions is a waste of time and money.

Note that because loans and securities are being accounted for differently, it creates a material difference in how much the Bad Bank must pay to actually improve a bank's balance sheet. More on this later.

We start by hiring four asset managers. Say its PIMCO, Blackrock, Fidelity, and Accrued Interest (of course! Its my damn plan). Each would be given $100 billion to manage, and would also be given access to a Fed-based credit line of $200 billion each. The loans would be TALF-style, no re-margining, term loans that can be repaid at any time. Each firm would be paid a hedge-fund style fee, i.e., with a performance-based element.

For securities, banks and other financial institutions (I'd open it up to pretty much anyone) there would be weekly auctions. On Monday, firms would submit the securities they'd like to sell. There would be some kind of limit on how much any one bank could put out for the bid on any given week just to keep it manageable. The four firms would then be required to put some kind of bid on each item on Friday. No passing. No more of this "there is no market" stuff.

The sellers would be permitted to put a reserve price, but on no more than half of the bonds offered for sale. What wouldn't be helpful is for firms to put their entire liquidity portfolio out for the bid and then pull everything back after getting a price. That wouldn't improve transparency at all.

The price though won't come in cash, but in stock. More on this later.

Now for the really tricky part. Loans. I'm talking your old-fashioned bank-held whole loans. Mrs. Smith's mortgage. Those are not marked to market, and thus are currently held at par less some reserve for loan losses. Bank of America, for example, only has a 3.5% allowance for losses on their home equity portfolio. As mentioned above, unless these assets are purchased near book value, there's no point in buying them at all.

So here is my radical solution. The Bad Bank buys all non-delinquent residential loans at full face value.

Now wait, don't get too angry just yet. Banks who wish to sell residential whole loans to the Bad Bank must build pools of loans that meet certain criterea. This would be relatively easy for residential loans. For example, if Bank of America wants to sell $100 billion in home equity loans to the Bad Bank, they can't just sell the $100 billion of ugliest shit they have. There would be min/max average FICO, OLTV, average loan size, etc. required. We wouldn't have to make these restrictions overly stringent, but it would assure that the Bad Bank wouldn't wind up with just toxic waste.

Commercial loans and delinquent residential loans would go through the same bidding process as securities. This probably means that banks won't be selling many of these loans, but that's OK. We don't need to completely bleach bank balance sheets, just a good rinse off will do.

As I said above, banks wouldn't get cash, at least not in whole. They'd get stock. Remember that banks aren't suffering for a lack of cash. Banks have some $673 billion in excess reserves...

What they lack is certainty and transparency. So the government buys securities and commercial loans at whatever the bid-determined price is in exchange for stock in the Aggregator Bank. For loans, the bank would get 75% of the face value of their loans in shares and 25% in a subordinated residual.

The principal value of the common stock of the Aggregator Bank would be fully guaranteed by the Treasury. It would pay a dividend equal to all interest on all securities as well as 75% of the interest from whole loans. The other 25% would be retained and potentially paid back to the original bank (the subordinated interest holder), assuming the loan portfolio as a whole met some pre-determined performance standard.

Notice that if the selling bank realizes reasonable performance on their loans, then they are no worse off for having participated in the program. This incentives "good" banks to participate, thus freeing up loanable funds. If loan performance is poor, then the Aggregator Bank retains the excess interest and principal to mitigate tax payer losses.

Notice that this plan doesn't involve any real cash outlay. The Aggregator is trading stock for assets, with the government standing behind the Aggregator's stock. Over time, the government should hold an IPO of the Aggregator's shares, with banks permitted to sell their shares for cash at whatever price the market will bear. Over time, share buy backs would be held with principal returned from the loans. At some point there would have to be some sort of closing transaction as eventually the entire loan portfolio would have paid off.

Now I know what the complaints will be. Tax payers take most of the risk and don't have a lot of upside. True. Problem is that in order to actually fix the problem, tax payers have to take most of the risk. You can't erase risk from the system, only redistribute it. If you want less risky banks, then tax payers have to front the risk. Honestly with my plan, tax payers take on less risk that simply handing cash over to banks, which is what we've been doing so far.

In fact, I fear its a misplaced desire to "protect" tax payers which will ultimately cause the Bad Bank to fail. If the Bad Bank only buys good loans or only buys bad loans at punitive levels, it won't help the situation.


asphaltjesus said...

I think you are onto something with your plan, but I still have issues dealing mostly with the continued lack of transparency on the bank's side.

In general, the plan *still* allows the banks to hold the unknown assets as ransom. There's no knowing anything about the assets until the bank says so. Which they won't do at anything near par.

Fair Value said...

Why do we insist on making this so f'ing complicated. If we truly thought creating a bad bank were some sort of panacea, then instead of creating a "new" bad bank, break up the existing shit-mired-to-big-to-succeed banks into good and bad banks. Sort of what MGIC (or was that FGIC) was going to do a while back. BAC good/BACrap bad. Citi good/Shiti bad. Etc.

Oh, and while they are breaking up, a holiday on trading their shares would be smart.

cap vandal said...

How are whole loans causing a problem? Seriously.

All the worst stuff ended up securitized. The remainder is the best of business that was underpriced.

Whole loans funded with FDIC insured deposits work fine.

It is only when you get investment banks involved that things start to devolve.

A whole loan is worth the greater of the collateral and the ability and willingness of the debtor to pay. As long as they are performing, let em book at amortized cost.

In Debt We Trust said...

This guy gets it right:

2:13 (Dow Jones)

Comments from the chiefs at Citi (C) and Bank of America (BAC) certainly played a roll in this week's vicious short-covering rally. But what'd they have to lose?

"If they can fool us long enough, credit spreads will come in and recovery will become a self-fulfilling prophecy," Roger Ehrenberg, managing partner of IA Capital Partners, says.

"Otherwise, Congress (read: the US taxpayer) will bail them out once again...Therefore, they are motivated to throw caution to the wind, be super-positive and hope for the best."

Accrued Interest said...


If it were only securities that are a problem, then regional banks would be golden. Its only the bid boys that got burned with CDOs and that sort of shit.


Quarterly profits and solvency have been divorced (perversely in my mind). Supposedly Bear Stearns was profitable the quarter they went under...

In Debt We Trust said...


Didn't you get the memo? The US authorities can trigger a super bull rally in equities!

All they need to do is invite the bond vigilantes back in and chase the treasury bulls into equities.

This can be easily accomplished by increasing the size of the stimulus programs 10x. China can help out by dumping their treasuries.

Hmm. Oh wait. That scenario has several problems associated with it....

I'm curious to know how the Fed intends to keep interest rates low AND trigger an equity rally. After all, how can they tie benchmark interest rates like Libor and TED to rising yields? Housing isn't going to recover anytime soon - not when ppl are being laid off left and right.

GestaltU said...
This comment has been removed by the author.
GestaltU said...

It behooves us to step back and survey the situation. What is the objective?

If the objective is the short-term stabilization of the financial system, then a 'bad bank' plan is appropriate, and your sounds better than most I've studied.

However, I strongly submit that it is time for a major cleansing of the financial system and the economy. I'm no nihilist, but I submit that a solution based on a propagation of the same irresponsible 'heads I win, tails you lose' attitudes that got us into this mess is a recipe for a much larger disaster a short way down the road. The 'bad bank' solution inexorably leads to the exacerbation of ex ante moral hazard that had its origins in the bail-out of LTCM.

There is a long list of policy mistakes responsible for this crisis (repealing Glass-Steagall is definitely near the top!), but perhaps the most influential culprits are:

1) the enormous amplification of the principal-agency problem that results from securitization in general

2) the expectation of people in western cultures that they are entitled to live beyond their means

I, for one, am not willing to mortgage my kids' futures any more than I already have to perpetuate what Institutional Risk Analytics aptly called a "hideous public subsidy of the global transactional class, a transfer of wealth from American taxpayers to the institutional investors who hold the bonds and derivative obligations tied to the zombie banks, AIG and the GSEs".

I will accept nothing less than the nationalization of insolvent institutions, including a complete wipe-out of shareholders who stood to benefit if the banks bets had paid off. Bondholders should also accept a hair-cut in order to increase capital adequacy ratios to levels that adequately protect depositors, and bond-holders should be on the hook for any further losses that accrue in the future. When did senior bank debt become sacrosanct, anyway? Was it always risk-free, and if so why did investors receive such a spread to Treasuries for so long?

I accept that any bond hair-cut would trigger normal CDS settlements. I'll sleep at night knowing that banks that made irresponsible bets take the heat.

The 'tide' will go out and we'll see once and for all if Blankfein and Mack have been swimming naked along with the rest of the rat pack.

The 'global transactional class' will lose disproportionately under this scenario. But please remember that these same entities were the primary beneficiaries of the 25-year debt orgy that is now coming to a close. So don't lose too much sleep worrying about them.

I can not accept any solution that mortgages our childrens' futures to service the unsustainable lifestyle of Western fat-cats. Let them eat cake.

Unknown said...

I feel it could be a solid plan but I don't know if it needs to be that complicated. However, I feel banks need to be more transparent. It is essential without a doubt to moving forward in a positive direction.

owner of Cheap Checks Company

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