Trial Balloons: Insuring The Bad Assets

The Administration is obviously floating ideas to assess potential reactions, particularly from Congress.  Today’s front page WSJ article on banking should be seen in this light.  It’s obviously not a fully-fledged proposal, but the concepts are there to elicit opinions and I don’t think it’s particularly helpful if we hang back.

The article raises the possibility that bad assets from banks will be divided into two parts, (a) bought by an aggregator bank, and (b) insured against further losses by the government.

We’ve covered the general principles of an aggregator bank and good/bad bank splits elsewhere.  Let me focus here on the specific (and credible) permutations in the WSJ article.

The bad bank would only be for assets that have already been marked down heavily by banks.  These the aggregator would buy at this (low) book price.  Hopefully, there would be less overpaying than in the original Paulson concept, but the pricing is still murky.

The heart of this proposal is the insurance idea.  This would be (much) larger than, but along the same lines as the Citigroup II deal in November and the Bank of America deal in January.  The problems with this approach are threefold.

  1. There is not enough potential upside for taxpayers.  Throwing in relatively few warrants, as with Citi and BoA, does not make much of a difference – even if the strike price is more favorable than in TARP I.
  2. There is not enough explicit recapitalization.  Proponents hope that cleaning up the balance sheets in this way will bring in coinvestment from the private sector.  But this seems likely to come slowly and in small amounts in the foreseeable future.
  3. There will be nowhere near enough transparency in this structure.  The insurance provided by the government will almost certainly be too cheap relative to the risks, but evaluating this properly will be impossible for outsiders.  (To see what I mean, look at the details of the Bank of America deal.)

Putting limits on bank executive pay make us all feel better, but it will not address the fundamental issues.  The government will ride in to save the banking system.  Shouldn’t the taxpayer get a fair return on his/her investment in this venture – particularly as the whole banking system clean-up is likely to cost us over 10 percent of GDP, so “potential upside” really means “limiting our total losses” and “making sure not all the ensuing profits fall into the hands of already-rich private parties”? 

And wouldn’t we like to feel confident that many incompetent bank executives will lose their jobs, while someone breaks up the “too big to exist” banks? (Our current proposal is along these lines is here, but of course there are other reasonable options.)

5 responses to “Trial Balloons: Insuring The Bad Assets

  1. Prof. Johnson —

    Could you please comment on Willem Buiter’s “Good Bank” proposal?

    http://blogs.ft.com/maverecon/2009/01/the-good-bank-solution/

  2. Tom Krebsbach

    Forget the idea of ring-fencing the bad assets. Here’s the proper algorithm.

    1. Particularly for big banks, audit the books to identify bad assets and near-bad assets.

    2. Have aggregator bank purchase these at best estimate of market value.

    3. Recapitalize banks in exchange for preferred stock and warrants.

    4. Repeat steps 1 through 3 every four months until economy recovers and banks are out of trouble.

    5. Have Aggregator bank liquidate purchased assets over period of 3-5 years at best price available.

    6. CONDITIONAL REIMBURSEMENT – Require banks over an extended term to reimburse government for any loss it takes on liquidation of assets. Require government to provide tax credit to banks for any excess profit it gains from sale of assets.

  3. ~ nemo – ditto

    I have made similar suggestions where the basic concept is that bad assets are not purchased but appropiated from what are clearly insolvent banks. The best solutions will not be found by thinking inside a pear shaped square.

  4. Pingback: Transparency And Power « The Baseline Scenario

  5. The FDIC has absolutely no experience in managing “toxic assets.”

    Accordingly, the “bad bank” as being proposed will be another governmental disaster.