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Is a Bad Bank a Good Idea?

I want to discuss Good Bank, Bad Bank; Good Plan, Better Plan by Max Holmes, an adjunct professor of finance at the Stern Graduate School of Business at New York University and the chief investment officer of an asset management firm.

It starts with two examples with which Mr. Holmes implies the possibility a solution to the frozen credit market that leaves the financial system intact.

The two bailouts differed in details. But both succeeded because when all of the bad assets were removed from the troubled bank’s balance sheet, it was immediately able to raise new capital. This allowed management to focus on getting back to business without the distraction of dealing with underperforming loans.

The conditions under which they occurred were different than our current conditions too…but that’s okay, because the point of the examples was to show

…there is more than one way to pull off a “good bank/bad bank” rescue…

Instead of printing up money to create a huge, unwieldy “bad bank,” I would recommend creating separate bad banks for each of these four institutions (and perhaps some others), and financing them by having the government assume an amount of each good bank’s corporate debt equal to the value of the troubled assets put into the bad banks.

We really should stop here. There is no fundamental difference between having a single "huge unwieldy" and four institutions that, collectively, cover the same institutions and debt. An adjunct professor of finance and chief investment officer of an asset management firm must know this. But rather than speculating on why someone I have no personal knowlege of would suggest otherwise, I’ll look at his suggestion…and maybe then return to speculate.

It would work this way: The managements of each of the four banks would be given a one-time opportunity to sell any assets (from vanilla domestic corporate bonds to the most exotic foreign derivatives) to a new bad bank owned entirely by the government. The only condition would be that the four big banks would have to convey the assets at year-end, audited book values, not at some guess of what they might be worth down the road.

"Convey" is an interesting choice of term because it has a specific legal meaning which is somewhat different from the "pick that thing up and take it over there" meaning that regular humans intend on the rare occasions they use the word "convey."

While these assets are “toxic” to the banks right now because they are illiquid, volatile and at depressed prices, the government can hold on to them until they regain value, making it an investment for the taxpayer that could pay off handsomely in the end. The public would have transparency, as it would know what the assets are and how they are liquidated over time.

And yet much of the problem is the "assets" were not asset at all.

The ultimate value of credit default swaps would be zero (which means someone, somewhere, lost the money they paid for them), or whatever amount they paid out due to the underlying debt defaulted (which means the debt holder loses, and the swaps issuer loses).

Most important, however, the government would pay for these troubled assets not by printing new cash, as under most current bad-bank proposals, but by taking on an equal dollar amount worth of each bank’s “liabilities” — that is, notes, bonds and other obligations that the bank owes to other lenders or investors.

And if you take on responsibility for bank’s debt, you kick the "print more money" can down the road a bit. I grant you that. But you still have to deal with those toxic assets. How do you value the debt the banks themselves issue when the fundamental uncertainty of the stability of their balance sheets remain?

Is this where we speculate on why an adjunct professor of finance and chief investment officer of an asset management firmwould pretend there’s a difference between 4 and 1 + 1 + 1 + 1? I believe it’s because people really believe the way you look at something makes it change.

Which means I really believe people are insane.

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