A Really Bad Bank: Welfare as We Know It Now
According to press accounts the Obama administration has decided to create a "bad bank" which would buy up much of the bad debt held by the banks. This is almost certainly a really bad idea, unless of course you happen to run a major bank or own lots of stock in one.
The basic deal is simple. Most of the banks are bankrupt. Their liabilities exceed their assets. However, this is not immediately apparent because they have not written down the value of their bad assets.
Now our bad bank comes along and offers to buy up the junk. Suppose it pays what the junk is worth. In that case, the bank will then have to incur a big loss and show everyone that it is insolvent.
The banks will not voluntarily sell their junk for what it's worth, if it means putting them out of business. Therefore, we can assume that the bad bank will pay more than the junk is worth. This is welfare as we know it now.
While the more obvious way to deal with the problem is to simply take over the bankrupt banks, and then put their junk in a bad bank, like with we did with the bankrupt thrifts in the 80s, there is a relatively easy way to limit the extent to which the bad bank is simply bank welfare.
We can just attach a clawback provision, under which the bank will be forced to make up any money that the bad bank loses on their junk, plus a penalty. For example, if Citibank sells $100 billion in junk, and the bad bank ends up selling it for $70 billion, then Citibank has to cover this $30 billion loss, plus a 20 percent penalty ($6 billion). This structure will both ensure that Citibank doesn't run off with our money and also discourage banks from trying to mislead the bad bank about the true value of their junk. (Senator Dodd proposed a similar measure in the debate over the TARP.)
It will be important to see the details of the bad bank plan, but it is hard not to be suspicious. The most simple and obvious way to deal with bankrupt banks is to do the same thing that we did in the 80s with the S&Ls: take them over, get their books in order, and then resell them to the private sector. If the Obama administration opts for the far more complex bad bank route (without first taking the banks over), then there are grounds to fear that the motive is handing taxpayer dollars to banks, not rescuing the financial system.
Another protection for the taxpayer would be to require that any mortgages held by the "bad bank" become recourse mortgages that can only be discarged or modified by a bankruptcy court.
Mortgage holders would then no longer be able to "walk away" from the properties with impunity just because they are underwater, even though they have other assets.
January 28, 2009 1:39 PM | Reply | Permalink
Good post Dean.
But I still don't understand how the government can possibly assume CDS obligations. I believe that the CDSs are held mostly by a few money center banks (Citi,Goldman,Morgan, etc) plus AIG and a few large foreign banks (UBS, etc). If these aren't declared null and void, then I guess the US will have to shovel several TRILLION dollars into the system.
I just don't see this can work.
January 28, 2009 1:41 PM | Reply | Permalink
Listen. Washington does not really care about the banks as such. They just don't want to do anything that might cause the market to totally tank (DOW at 1000) and all those big investors/political donors to loose their shirts. Which is what would happen if Washington actually nationalized any of them.
C
January 28, 2009 2:34 PM | Reply | Permalink
The "bad bank" is a bad idea.
Letting banks go bankrupt is a bad idea.
Nationalizing the banks is the least bad idea. We simply have to go that route, in my opinion.
But give the banks the option -- file for bankruptcy protection, or accept being nationalized. Either way, shareholders get squat, and management loses the opportunity to legally steal money. Tough shit.
The government can run the banks in the short term, pass new regulations, then break them into small regional banks and do a series of IPOs in another decade. Whatever.
The "bad bank" idea only makes sense if we delude ourselves into thinking that things really aren't that bad, and this whole thing will blow over in a year or 18 months. Well, things really ARE that bad, and Great Depression 2.0 won't be over for at least 5 years. Deal with it.
-- ARG
January 28, 2009 2:44 PM | Reply | Permalink
Let's not call it "nationalization" of the banks.
Just let the banks fail, and let the FDIC step in to do what it was chartered to do. Same difference.
Then, while the FDIC is running all these banks, we can pass new laws and regulations for the banking business, and then break these "too-big-to-fail" banks into much smaller entities, which can emerge as new non-government run businesses.
-- ARG
February 2, 2009 6:17 PM | Reply | Permalink
Dean Baker says;
At the moment of takeover we will surely give present day management their walking papers sans bonuses, golden parachutes, etc.?
January 28, 2009 2:56 PM | Reply | Permalink
One hopes.
January 28, 2009 3:00 PM | Reply | Permalink
We had this same discussion last fall in the build up to TARP. What has changed is the idea of nationalizing the banks is not so heretical today. That is some progress.
January 28, 2009 3:27 PM | Reply | Permalink
The problem with buying bad loans has always been in trying to assign a correct value to them. There is a good argument that the current selling price is really below their "true" value based on the likelihood of default because selling pressure has depressed prices. OTOH, buying loans at face value is obviously way overpaying. Yet, most people recognize that getting these loans off the books of the holders is the best way to deal with the problem. So here's an idea:
Have a kind of auction. Announce that once per month (or whatever frequency you like) the Federal government will buy $X billion worth of bad loans. Any bank who wants to sell can submit a listing of the loans it wishes to sell and the price it wants. The government would then review all the offers and choose the best deals for the taxpayers until the allocated money is used up. Thus, no one is being forced to sell at less than they want, but there's a built-in incentive to offer them at the lowest price they can. Market forces at work.
January 28, 2009 3:28 PM | Reply | Permalink
The problem with this suggestion is that the loans would then have a visible market value. If the banks had to declare their true market values they would be insolvent. In fact citi and BoA are legally bankrupt and admitting this fact could trigger even more chaos in the markets. Hence the need for the government to "do something". Most here agree that something should be nationalization, but even that might not work.
January 28, 2009 5:26 PM | Reply | Permalink
Perhaps, but because of selling pressure the market value is considerably below what I'll call their rational value based on risk of default. In fact, with current interest rates being so low, those loans should rationally be selling at a premium. The gap between the rational value and the book value is a lot smaller than the gap between market price and book value. If banks could unload them at close to this rational value they might jump at the chance. The government, with no pressure to sell, could simply hold the loans until market prices rose to rational levels, then sell at these prices. We might even make a profit on the deal.
January 28, 2009 5:50 PM | Reply | Permalink
The value of these securities is the expected discounted cash flow of the future stream of payments.
For example, a mortgage backed security which is a mezzanine tranche of a batch of mixed prime and subprime mortgages, would have a value equal to the expected payments, foreclosure proceeds, and mortgage prepayments allocated to that tranche. It has nothing to do with the current market for mortgage backed securities, which is disfunctional because they were bought by buyers who were led to believe they were liquid and discovered differently.
January 28, 2009 5:58 PM | Reply | Permalink
But I was responding to a suggestion that would in effect create market value for these instruments, not claiming that they had market value.
I think these mortgages are in bigger trouble then even some of the pessimists claim. There is something like $11.6 trillion in RRE mortgages that are backed with equity that may be as low as $7 trillion (at the end of the bubble deflation). If that translates into losses (and it would if every underwater mortgage holder made the economically rational choice of defaulting) then any tranche above .5 will be in trouble. No one is talking about $4 trillion in loses in this sector alone.
January 28, 2009 8:14 PM | Reply | Permalink
According to http://www.thetruthaboutmortgage.com/average-loan-to-value-could-rise-to-109-percent-this-year/ there are $12.7 trillion worth of homes carrying $12.1 trillion worth of mortgages. So we are not underwater on average yet. Nor are we likely to see home prices drop another 50%.
According to the Case Shiller data, the indexes have rolled back to where they were in about 2004, with some variation depending on city. But mortgages from earlier than 2004 should not be underwater.
The ease with which the homeowner can walk away from a mortgage varies from state to state, ranging from relative impunity in California, Arizona, Nevada and Florida to requiring a bankruptcy in many other states of the Midwest and Northeast.
January 28, 2009 11:04 PM | Reply | Permalink
I seem to recall having read there's an additional variation among states in their treatment of 1st mortgages, namely ---
That in some states a homeowner may be able to walk on a purchase money mortage (typically, a 1st mortgage used to buy the house) but not on a non-PMM 1st mortgage (typically, a 1st mortgage used to refinance the PMM in order to enjoy lower rates or extract equity).
January 29, 2009 3:32 AM | Reply | Permalink
True. And the treatment of 2nd mortgages and home equity lines of credit also varies depending on the state and the circumstances surrounding how the loan was obtained.
Since mortgages are being traded in interstate commerce, it would seem useful to standardize the terms and conditions of mortgages nationally into a less profuse variety than exists today. This would make it easier for investors to analyse the risks associated with the various tranches of mortgage backed securities and generally improve transparency.
January 29, 2009 9:43 AM | Reply | Permalink
Let us play I told you so.
Goldman-Sachs analysts estimate banks could lose up to $4 trillion dollars on bad loans and this is excluding CRE and LBOs in their calculation.
http://www.cnbc.com/id/28918543
January 29, 2009 7:48 PM | Reply | Permalink
Why not nationalize the auto industry? Or even porn?
January 28, 2009 4:34 PM | Reply | Permalink
at least porn would be profitable
January 28, 2009 6:09 PM | Reply | Permalink
Nationalize health care and GM could probably hand its bailout money back to congress pronto.
January 30, 2009 4:36 PM | Reply | Permalink
The bailout of the financial industry should be viewed as an investment on the part of the US taxpayer. The goal of an investmetn should be that at the end, once the toxic assets get cleaned out, that the taxpayers have gotten the best return possible for that investment and the banks are in the best position to survive profitably. Currently the mission of the banks is to return the most value to their shareholders, regardless of the value to the American taxpayer. The American taxpayer therefore needs to become the shareholders of the bank. Nationalization is the only way align these interests to the necessary extent.
January 28, 2009 6:46 PM | Reply | Permalink
As for an auction, who thinks that any bank holding any significant amount of toxic stuff would have an incentive to offer it at anything but a huge markup? Oligopoly in action.
January 28, 2009 7:50 PM | Reply | Permalink
Bad bank, no toaster
Nouriel Roubini seconds Dean's comments in CNBC interview
"Davos - Mountains of Doom"
http://www.cnbc.com/id/15840232?video=1015456793&play=1
January 28, 2009 8:12 PM | Reply | Permalink
Clawbacks baby; Atswhatimtalkingabout! These malfeasers can't walk away unscathed...
January 28, 2009 8:40 PM | Reply | Permalink
You and I and everyone else on this board will be dead by the time a "clawback" takes place.
The idea behind the "bad bank" is that it would hold these "assets" for -- forever, think Methusalah. When the time comes to calculate the "clawback" no one will remember what we paid for them originally.
See, the liberal's favorite poster-bank -- the Home Owners' Loan Corporation.
January 28, 2009 9:40 PM | Reply | Permalink
Well, the RTC made money, they say. But I don't believe them when they say it.
January 28, 2009 9:57 PM | Reply | Permalink
Best thing to do is just let the bad banks go bankrupt, audit and settle up their books with a sharp eye out for criminal wrongdoing, then fill the Penitentiaries with successful prosecutions.
The method you advocate is the reason we wound up with the last eight years of Bush. He should'a gone to prison over that S&L thing.
January 28, 2009 10:01 PM | Reply | Permalink
The method you advocate is the reason we wound up with the last eight years of Bush. He should'a gone to prison over that S&L thing.
?
I believe you are confusing George W. Bush with his brother Neil at Silverado Savings & Loan in 1988? If so, here's a tip: Neil Bush was never president of the United States.
Or are you saying that if Neil had gone to prison, their father George Herbert Walker Bush wouldn't have won re-election? Neil didn't go to prison, and G.H.W. Bush didn't win re-election. Clinton won instead.
January 28, 2009 11:05 PM | Reply | Permalink
Yeah, yeah, you're right, I'm wrong.
Well then Neil should have gone to the pen. That should have been enough to effect history given the razor thin margins.
January 29, 2009 9:47 AM | Reply | Permalink
An off-topic quaere for anyone interested:
Why does the United States Treasury continue to issue bills (obligations due within a year)? Is it that there's not enough demand farther out on the curve or is it that it doesn't want to pay the extra 2-3%?
January 29, 2009 8:16 AM | Reply | Permalink
Dean,
One hesitates to reason from a strong point of ignorance. My problem is that I do not have enough information about the so-called "toxic assets" to understand how a portfolio of those "toxic assets" might be classified into meaningful categories let alone form any opinion as to the value of each type of asset. The information I have collected in my limited time to research this issue leads me to believe that the "toxic assets" held by banks may be purely a bundle of debt obligations which might be readily cataloged as to the nature of the debt obligation or the nature of the debtors.
It appears to me that a substantial portion of the "toxic assets" may be hybrid in nature and comprised of a fractional interest in a fund comprised of (a) a bundle of mortgages, (b) a sum of money reflecting premiums collected on the sale of credit default swaps (CDS), and (c) the credit default swap obligation to pay in the event a default occurs. The capital behind the credit default swaps of course would be the bundle of mortgages and the cash on hand. Such a "toxic asset" would be difficult to classify or to value and is likely to be worthless.
Moreover, the the CDS premium cash may have been used to pay all or part of the interest due to holders of fractional interests in the fund. The fractional interest holders may be classified into "tranches" and the a small group may have collect virtually all of the cash from the CDS premiums.
Hello, Mr. Ponzi.
Is there a Mr. Pecora in the house?
All debate over the TARP seems pointless absent more information on the exact nature of the "TOXI ASSETS".
January 29, 2009 1:55 PM | Reply | Permalink