Creating a "bad"/aggregator bank organized by the government to hoover up the bad assets from bank balance sheets sounds like it could be an excellent step toward restoring confidence in the financial system and freeing up credit.
Unfortunately, where the rubber meets the road, there is a rather fiendish question that needs to be ironed out - price.
The answer is in the price, my dear Watson
Transfer the assets to the government bank at too low a price and it could spark another round of bank losses and produce insolvencies. Too high a price, and the operation amounts to a transfer of wealth from taxpayers to financial institutions.
The intuitive answer is that assets should be transferred at fair value. That might get full credit in an academic setting, but if the fair value for these assets was known and widely accepted, we wouldn’t be facing a crisis of this magnitude. The market for these assets only provides scant clues -- it’s highly illiquid.
A banker’s proposal
Deutsche Bank (NYSE: DB ) has offered up an interesting proposal that bypasses the need to set a price up front for toxic assets: Banks could segregate their good assets (not just financial assets, but essentially all of their going-concern activities) into separately capitalized subsidiaries that would then be spun off.
All that would remain at the original holding company would be the units holding the bad assets -- some of which would be insolvent. The government would acquire the holding companies and liquidate them over time.
That still leaves open questions regarding whether such a plan is voluntary and who will participate. The government has already implemented loss guarantees on over $400 billion in assets with Citigroup (NYSE: C ) and Bank of America (NYSE: BAC ) . Wells Fargo (NYSE: WFC ) recently stated it doesn’t need further TARP assistance, and JPMorgan Chase (NYSE: JPM ) looks to be on a relatively sound footing.
Beyond these elephants ...
... the government should focus on redressing or shuttering ailing regional and local lenders. I’m not a fan of state intervention, but we need a catalyst to deal with a banking sector that has pockets of insolvency. In January, bank failures accelerated to the fastest pace since the start of the crisis, but at only 6 in 2009 and 27 since Indy Mac kicked off, we are far from the number required to "clear the system."
We don’t want to go through the next few years with "zombie" banks, the way the Japanese did in the 1990s, and I think we want to avoid bank nationalizations on the scale of the U.K. with Royal Bank of Scotland (NYSE: RBS ) and Lloyds (NYSE: LYG ) -- if we can. Perhaps a government-led bad bank is the least offensive solution to a rotten problem.
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