Bad Bank, Bad Idea; Good Bank, Good Idea 17 comments<http://seekingalpha.com/article/120681-bad-bank-bad-idea-good-bank-good-idea#comments_header> by: James Wood February 15, 2009 | about stocks: SPY<http://seekingalpha.com/symbol/spy>/ XLF <http://seekingalpha.com/symbol/xlf>
James Wood Add to Your WatchlistIn Your Watchlist About this author: - Profile <http://seekingalpha.com/author/james-wood> & More Articles<http://seekingalpha.com/author/james-wood/articles> Become a *Contributor* Submit an Article <http://seekingalpha.com/contribute_an_article?source=submit_article> [image: back to yahoo finance] <http://finance.yahoo.com/> [image: add to my yahoo]<http://us.rd.yahoo.com/my/atm/Seeking%20Alpha/Seeking%20Alpha%20US%20Market/*http://add.my.yahoo.com/rss?url=http://seekingalpha.com/sector/usmarket.xml> [image: back to cake]<http://seekingalpha.com/article/120681-bad-bank-bad-idea-good-bank-good-idea#> - Font Size: - Print - Email - TweetThis<http://twitter.com/home?status=Reading:%20Bad%20Bank,%20Bad%20Idea;%20Good%20Bank,%20Good%20Idea%20http://seekingalpha.com/a/2l49> Secretary Geithner has proposed the formation of a “bad bank” to buy $1 trillion or more of troubled loans and securities off the books of banks and get credit moving. This idea deceives the public, will not work and provides all the wrong incentives to bankers. This is a rehash of the idea former Secretary Paulson first proposed and then quickly abandoned. A good idea is to create a “good bank”. Let’s first look at why I am opposed to Secretary Geithner’s idea for a “bad bank”. Geithner hopes the purchase of toxic assets by the “bad bank”, funded in part with private capital, will get the banks to lend again. He is not even making the claim this makes economic sense. This is a fatal flaw causing the idea to fail from all points of view. 1. *Geithner’s description of the “bad bank” is not “honest”.* He says “bad bank” will use partially private equity. No private equity is going to invest in the “bad bank” if it is run for non economic purposes. The key is the price of the toxic assets. As a generalization, the current market value of the toxic assets is probably somewhere between 5% and 20% of nominal value. If the “bad bank” pays more than this, private investors will not invest. If the banks sell these toxic assets for this value, there will probably be an enormous unfavorable P & L impact as most banks have not really marked all of their toxic assets down to real market value even though they should have through mark to mark regulations. So probably the assets will be purchased for much more than their current value, so no private sector participation unless there is a behind the scenes guarantee of the government to bail out the private sector investor in the “bad bank”. Furthermore, the “bad bank” is made to sound more like a commercial transaction that is only partially dependent upon the taxpayer. The truth is the taxpayers absorb all the costs of the “bad bank” from 3 or 4 directions that are not obvious to the quick reader. 2. *New conservative credit standards and the lack of new securitized funding are the real causes of the inability of the banks to lend, not the current bad assets*. Every financial bubble is based on lots of low cost money. Securitization is what provided lots of low cost money. Like all bubbles, this one finally blew up starting in 2006 with the home mortgage market financing. As in every bubble, banks have learned again that easy, low cost financing is not a substitute for good credit. While banks lent 10 to 15 times their capital in the 1970’s, banks were lending in 2007 30 to 100 times their capital when you take into account derivatives and off balance sheet financing such SIVs. Every bank is now deleveraging to get its risk profile back in order. Even if they wanted to fund themselves through the traditional source of securitized transactions, banks are drying up with the new recognition of the danger they can be. Home equity issuance is off 98%. Securitized auto loans were down 40% in 2008. Student loan issues were down 43% in 2008. Credit card financings were down 21%. About the only one still provided this type of securitized financing is Ginnie Mae and Fannie Mae (FNM<http://seekingalpha.com/symbol/fnm> ). Both have lost all their capital and are bombs which will explode (again) very shortly. In short, buying up all the bad debts of the banks will not jump start lending again, because the current bad assets are not the real cause of not lending more now. 3. *The Geithner plan creates all the wrong incentives for the banking sector, which ultimately will increase the cost and defer the day we resolve the problem*. A government plan which says we want to bail out everyone in trouble rewards the imprudent and leaves the bill to be paid by the prudent. This is not the American way. This is not smart. Even the porn industry has said it should get a bail out too. The press reports GM<http://seekingalpha.com/symbol/gm>is going to say “I go broke if you do not bail me out”.It hasnot been able to provide a plan where it can credibly say it can work its way out of the problem. We need incentives that promote success, not failure as the current Geithner plan does. Ironically, the new government plan to rein in compensation of top executives in banks may have the effect to cause some banks not to take government financial aid. This shows the structure of incentives determines the type of outcome. A wrong structure of the Geithner incentives means there will be a bad outcome from their use. A completely different approach (albeit unusual) is to use some of the government stimulus money to provide seed money for a series of new commercial “good banks”. This could provide the right incentives, bring in a lot capital and funding and thereby really provide loans to businesses that need it for their everyday operation. 1. *The Idea.* Provide $1 billion dollars each for 20 new regional commercial banks (pick your number here on initial capital and number of banks). There are vast sums of private money on the side looking for good investments. The equity could probably be increased tenfold very quickly from private sources. Then it should be easy to find indebtedness of 10 times that from debt markets. In short, the government money should be multiplied 100 times in terms of funds available for lending to needy Americans and American business. I think $20 billion of government seed capital would realistically be turned into $2 trillion of lending capacity. The new good banks would be prohibited by law from engaging in what would be called investment banking today. They would be old fashioned commercial banks that lend their customer deposits and a modest amount from external sources. No derivatives (e.g. CDO's SDS), no stock brokerage (think Merrill in B of A (BAC <http://seekingalpha.com/symbol/bac>)), no lending for stock acquisition or other non self liquidating type loan. The focus is to provide working capital and equipment and mortgage financing for individuals and businesses. These banks would be staffed with professional “Commercial” bankers who would work for a decent living. Investment bankers who think they have the right to up to 50% of the gross fee income as a bonus would be prohibited from employment. 2. *What will happen?* Since the new good banks have money to lend, they will be the first choice for everyone. They can be like Warren Buffett and cherry pick good deals that deserve credit, but they will not ask for warrants for stock like Buffett gets. 3. *The effect on existing banks?* The new good banks will make things harder for the existing banks. The existing banks will argue that rather than helping, the creation of new good banks increases the chances that the existing banks will go broke. Yet, that is the way the system works, i.e. competition. When it is clear that there is no bail out from the government, you can be sure that these bankers will devote their energies to surviving. Most will survive, many will not survive. But now a clear signal has been given that stimulates them to do what they can to save themselves, as opposed to finding ways for the government to bail them out. 4. *Resolution Trust type work out bank*. There needs to be a bank or organization that assumes control of the assets and liabilities of the bankrupt banks. This does not have a political purpose to save existing banks in risk of bankruptcy. It is strictly a workout mechanism for the banks that will be going broke. It widely speculated that 1,000 banks will go broke in the next two years and some of the biggest banks are likely to be among these. If Citibank (C <http://seekingalpha.com/symbol/c>) and B of A fail, there may be no choice but to nationalize them. However, they should be rapidly converted into the type of bank described above as a “good bank”. It will be better to do this and take the losses than continually pump money into them as we are doing with AIG <http://seekingalpha.com/symbol/aig> and the “bad bank” idea of Secretary Geithner and without real hope of getting the money back. In summary, the feel good plan to pump money into the banks to stimulate lending will not work. It is illusory to think the world will get out of this problem without pain for most people. Yet, well intended schemes like the Geithner plan delay and make more expensive the solution. The nation would do better to bite the bullet and let fail those who cannot succeed on their own. The government can provide more effective help to needy borrowers by creating new, healthy banks than pouring endless money into unhealthy banks that continue to be run by the same people who bankrupted the banks through their excesses and imprudence. As a people, Americans are resourceful. When bankers know they will not be bailed out by the government, most of them will become very effective in finding a solution for their bank – if there is a solution. And if there is no solution to a specific bank’s problem, the people of the United States should not put the next generation’s money into it. *Stock position: None.* Related Articles - Finally Some Good News for Homebuilders?<http://seekingalpha.com/article/128478-finally-some-good-news-for-homebuilders?source=article_lb_articles> Mar 30, 2009 - CalPERS Private Equity Investment Returns on Course for Serious Deterioration<http://seekingalpha.com/article/128467-calpers-private-equity-investment-returns-on-course-for-serious-deterioration?source=article_lb_articles> Mar 30, 2009 - Does Financial Regulation Work?<http://seekingalpha.com/article/128476-does-financial-regulation-work?source=article_lb_articles> Mar 30, 2009 - Seven Uncomfortable Predictions for the Economy<http://seekingalpha.com/article/128472-seven-uncomfortable-predictions-for-the-economy?source=article_lb_articles> Mar 30, 2009 - Rally Looking Extended: Time for a Pause?<http://seekingalpha.com/article/128469-rally-looking-extended-time-for-a-pause?source=article_lb_articles> Mar 30, 2009 Related Stocks: - SPY <http://seekingalpha.com/symbol/spy?source=article_lb_stocks>, XLF<http://seekingalpha.com/symbol/xlf?source=article_lb_stocks> Almost Finished... 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