A Bad bank is a bad idea!

This article explains how the bad bank solution would cost taxpayers a bundle by selling toxic assets to the bank which are not marketable anywhere else at any reasonable price.


A bad bank is a very bad idea
By Rolfe Winkler
February 2nd 2009
When rumors surfaced on Wednesday that the Obama administration may create a "bad bank" to buy toxic assets, financial stocks soared. Of course bank shareholders were happy; the plan is likely to be a titanic taxpayer hand-out. It has to be to achieve the administration's goal of keeping banks in private hands.To understand the banking crisis, and Obama's emerging solution, all you need to know is one equation: Assets = Liabilities + Equity. This equation explains why banks are dropping like flies.A bank's assets are the loans it makes to borrowers. Its liabilities are the dollars it borrows from lenders and depositors to fund those loans. Shareholder equity is what's left over.During the bubble, banks made loans for houses at vastly inflated prices. Say, for instance, a bank lent $1 million to a borrower buying a Miami condo in 2006. The borrower promised to repay $1 million over the life of the loan, so the bank valued this asset at $1 million.Flash forward to 2009, and the condo is now worth $500,000. The borrower defaults because he'd rather lose the condo than pay a million-dollar mortgage on a property now worth half that.The bank forecloses on the condo and sells it for what it can get, the current market value of $500,000. The bank's asset, the loan, has fallen from $1 million, which the borrower owed, to $500,000, the amount recovered. A 50% loss.If borrowers default en masse, then the value of the bank's assets drops precipitously. Its liabilities, however, are fixed. The bank still owes its lenders and depositors the amount it borrowed. So bank shareholders, literally the owners of the bank's equity, have to absorb the losses. In our equation above, one side must equal the other. Since liabilities are fixed, assets and equity decline by a like amount.If losses are too big and the bank's equity cushion too small, bank shareholders are wiped out.Losses systemwide are, of course, huge. According to the Case-Shiller index released this week, home prices have fallen 25% in the nation's biggest metro areas since their peak.And bank equity cushions are tiny. Citigroup, for instance, had over $50 of assets (by another calculation over $200) for every $1 of tangible common equity. With leverage that high, assets need only fall 2% for equity to be wiped out entirely. Is it any surprise that Citi's stock has dropped more than 90% from its high?The Western world's entire financial system is suffering this sickness - huge asset losses and no equity to absorb them.What to do?Normally when a bank fails, the Federal Deposit Insurance Corp. resolves the issue. But the severity of the downturn and the degree of leverage on big bank balance sheets mean all of them have effectively collapsed. It would appear the government has no choice but to nationalize them.Unless, miraculously, bank asset values go back up, wiping out losses. But how can this happen? Our Miami condo is not going to sell for $1 million, so who on Earth would buy the loan for that much?It appears taxpayers will. The administration's "bad bank" would buy up the bad assets clogging bank balance sheets.Shareholders are thrilled because Sheila Bair, head of the FDIC and the likely CEO-in-waiting of the bad bank, has made clear her intention to overpay for the assets.Take our example above. The government might buy the million-dollar loan for close to a million dollars - even though the condo itself is still worth just $500,000. But that's no longer the bank's problem. Since taxpayers now own the asset, they take the half-million dollar loss.While government reports suggest the bad bank will spend $1 trillion to $2 trillion to buy toxic assets, Goldman Sachs estimates that $4 trillion may ultimately be needed. And banks are likely to sell their most toxic trash to the bad bank, meaning the public's losses will be massive - certainly hundreds of billions of dollars, based on current fair value estimates.With taxpayers in line to absorb so much bad debt, is it any wonder bank stocks soared?The problem at the core of all this is the administration's goal: It wants to avoid nationalizing banks at all costs, even if that requires a huge transfer of wealth from the public in order to inflate asset prices artificially. But this solves nothing. Unless assets are marked down, they won't trade and the economy will calcify.Marking down assets means losses have to be recognized. A better solution than forcing them onto taxpayers would be to nationalize the banks outright, wiping out shareholders and forcing bank creditors to absorb their share of losses. Yes, such a solution would be very painful, but it would be a solution.Bailing out banks - not to mention borrowing $1 trillion to fund "stimulus" and endless money-printing by the Fed - are not solutions. All of these simply represent more borrowing to re-inflate a debt bubble that sooner or later needs to deflate.The American economy is collapsing under the weight of too much debt. We will not rescue it by piling on more.Rolfe Winkler, CFA, blogs at OptionARMageddon.com.http://www.nydailynews.com/opinions/2009/02/02/2009-02-02_a_bad_bank_is_a_very_bad_idea.html?page=0