Good Bank, Bad Bank; Good Plan, Better Plan

There is a growing consensus that Washington has two options if it wants to end the credit freeze and restore confidence in our banking system. One is to, in effect, nationalize the major banks, which would be hugely expensive and would undermine our free-market system. The other is the “bad bank” solution, under which the government would print enormous amounts of money to buy all these banks’ “toxic” assets and to put them into a huge new financial institution that would operate under federal control and sell them off over time. This is a better idea than nationalization, but the proposals along these lines being bandied around Washington would all be prohibitively expensive and probably ignite inflation.

However, there is more than one way to pull off a “good bank/bad bank” rescue, and a look at two examples from the 1980s may help show a path forward.

In 1988, as a young analyst at the investment bank Drexel Burnham Lambert, I worked on two major “bad bank” transactions. In the first, the Federal Deposit Insurance Corporation seized First City National Bank of Houston. The government put up $1 billion to create a “bad bank” that took on First City’s bad energy and commercial real estate portfolios; it was able to liquidate those assets over the next 15 years, recouping much of the money it had invested in the bailout. And First City was quickly able to raise $500 million of private capital and get a new lease on life (although it faltered a few years later because of unrelated bad loans).

That success led to a second government-orchestrated rescue that year. The bad commercial real estate and home mortgage portfolios of Mellon Bank of Pittsburgh were transferred to a bad bank called Grant Street National. While the government oversaw the transaction, the money Grant Street used to buy Mellon’s troubled assets came from private investors looking for long-term profits. By 2005, Grant Street’s liquidation was also successfully completed, at a profit.

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. And the government and the outside investors who took up those loans could afford to be far more patient than the banks that held them.

The lessons for today? So far, the Treasury and the Federal Reserve have done a good job of consolidating the commercial and investment banking sector into four giants: Bank of America, Citigroup, JPMorgan Chase and Wells Fargo. But based on those banks’ continued depressed stock prices and the high cost of credit they are being forced to pay, it is clear that the market is not yet convinced of their health.

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.

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.

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.

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.

The government, not the banks, would choose which liabilities it would take responsibility for. Presumably, federal officials would assume notes and bonds with maturities roughly in line with the real durations of the troubled assets they are taking off the banks’ hands, mainly 3 years to 10 years. This would allow the government to pay down these liabilities through the cash flow that will be generated from the troubled assets themselves. The bad banks would have a proper match between assets and liabilities, a critical ingredient for managing any investment pool.

The bad banks would then be able to work out their troubled assets over time rather than sell them in a fire sale — similar to the successful solution imposed on the savings and loans that were taken into the Resolution Trust Corporation in the 1990s. The government could hire professional money managers, working under an incentive-heavy compensation plan, to oversee the liquidation. (Disclosure: firms like mine might be potential candidates for such a job.) This would be far wiser than leaving it to government bureaucrats, who might simply seek to sell as many assets as quickly as possible and close the files.

The benefit to the good banks would be substantial: they would retain strong asset bases, they would no longer be burdened by toxic securities, and because they would be able to trust their fellow-banks’ balance sheets, they could safely extend credit to one another and to American businesses and households. With their equity capital remaining intact, they would easily meet domestic and international capital requirements.

The economy would benefit because the credit squeeze could finally end, as the good-bank employees could concentrate on lending rather than simply surviving. And because no new money would be printed, inflation would be much less of a concern.

Insurance companies, smaller banks, money-market funds and other institutions that are the primary holders of these banks’ intermediate-term liabilities would also receive an enormous benefit: in place of “weak” debt they now hold from troubled banks, they would have securities guaranteed by the Treasury.

There are two other issues. First, for the four major banks, the good bank/bad bank transactions should be mandatory; the industry will stabilize only if the four work in tandem. Second, the government should hedge its bets by getting stock warrants — a certificate giving the holder the right to purchase stock in the future at a guaranteed price — equal to a significant percentage of each good bank’s common equity (although certainly not a majority share).

After all, assuming the good bank/bad bank asset transfers were successful, the stock prices of the good banks are likely to soar, as they will be the four best capitalized and cleanest banks in the world. The government, in turn, could sell the warrants to private parties, another bonus for taxpayers. And as those private investors exercised the warrants, they would infuse even more common equity capital into the banks, which is of course what they really need.

With a clean balance sheet and the best capital ratios in the world, the resulting good banks – still under majority private ownership – could get back to doing what our economy most desperately needs from them: start making new loans.

Originally published at NYU Stern on Finance and reproduced here with the author’s permission.

2 Responses to "Good Bank, Bad Bank; Good Plan, Better Plan"

  1. Richard E. Kaplan   February 4, 2009 at 12:36 pm

    The present financial meltdown of the banking system has provided proof of the fact that FDR saved the capitalist system in the 1930’s. Unregulated investments in the market by banks in the 1920’s contributed to the need for laws in the 1930’s separating commercial and investment banks in an effort to allow investment strategies. Given the collapse of markets in 1929 and the run on the banks later, the future of investment banks was doomed without a regulatory system. Only with regulation would the public trust an investment banking system to exist along side normal commercial banks (depository banks). The financial laws passed under Reagan, Clinton and Bush(s) destroyed the protections that preserved capitalism. FDR saved capitalism and the other presidents named above handed the financial markets to socialism. It was the Glass Steagall Act that allowed investment banks to exist at all given the temperment of the times. When Glass Steagall was repealed along with the weakening of regulations from Reagan through Clinton to Bush this deregulation allowed investment banks to buy the assets of commercial banks leveraged by average bank accounts and home mortgages). The bailout is a bitter pill to swallow but the FDIC did not have enough money to bail out the commercial banks if they failed. Money grabbed from commercial banking activity by investment banks had to be replaced. It was done under the guise that the banks were going to buy toxic assets with this money. In reality it was to restore capital in commercial banks; to preserve the banking system at the expense of doing away with investment banks (that were previously saved by the Glass Steagall Act). That is why you see no activity buying mortgages after the money was sent to the banks. Blaming the crisis on poor mortgages is the straw man. Greenspan like Mellon under Cooledge and Hoover, undermined confidence in the American financial system that must be restored. Unfortunately, even when restored the world financial leaders will no longer take their lead from America.

  2. Guest   February 4, 2009 at 7:23 pm

    They didn’t just magically take the bad assets off of the books, the FDIC nationalized both of the banks–wiping out shareholders. You can call it FDIC takeover if “nationalization” is too scary a word for you, but the same thing happens, gov’t takes over, separates the bad assets, shareholders get wiped out and the bank gets spun off in an offering of some sort (call it “raising private capital” if you want to). Thus, the taxpayers get both the downside and the upside.And, nationalization won’t cost a thing. As most of the big banks are insolvent, the takings clause means you don’t have to pay a dime for the banks.