A New Attempt To Build A "Bad Bank"

Creating a "bad bank" is on the wish list of an extraordinarily large number of regulators and members of Congress. It is a sort of miracle cure to the problems in the banking industry. The toxic assets on financial firm balance sheets can be swept under a rug owned by the federal government. Banks would stop having huge losses and would be able to stop raising new capital. With better balance sheets, the same banks would be more likely to lend money to businesses and homeowners.

The "bad bank" is such a remarkable creation that it is a wonder that it has been on the back burner for so long.

According to Bloomberg, "The Federal Deposit Insurance Corp. may manage the so-called bad bank that the Obama administration is likely to set up as it tries to break the back of the credit crisis." No one has a concrete plan for valuing toxic assets that is likely to be acceptable to Congress, regulators, and the banks. Some of the asset classes do not trade at all. Others are not worth more than a few cents on a dollar.

The hardest question the government has to ask itself is whether most of these assets will recover in value at all. No one knows that answer to that for certain. So, any opinion is a guess, and a risky one if the taxpayer is going to pick up the check for buying the paper and putting it into a bad bank.

The greatest fiction about a bad bank is that it keeps the government from nationalizing the banking system. While the Treasury is not likely to take outright control of any of the banks which would sell it assets, the issue remains of what the government gets for that service. Some of these asset pools carry nominal values in the hundreds of billions of dollars. Even the largest US banks like Citigroup (C) and Bank of America (BAC) have market caps below $50 billion. Buying paper that is worth a sum which is much greater than a financial firm’s market value begs the question of why the taxpayer does not get most of the equity in these companies for taking most of the risk.

Is the bad bank a good idea? Probably. But, the value equation of how America’s largest financial firms pass their assets to the government is almost certainly going to work in the favor of the banks and against the interests of the Treasury.

Douglas A. McIntyre