The Government’s "Bad Bank" Plan Will Fail

If the rules of the game aren’t stable, private capital won’t sit down to the table.

This week, to much anticipation (and with few specifics), Treasury Secretary Geithner announced his new plan to redress the banking sector through a “bad/ aggregator bank” that would remove soured credit assets from bank balance sheets. The twist is that this bank would be a public-private effort, as the government hopes to bring private investors into the fold to purchase these assets. As a proponent of free markets, I should be encouraged by this; however, I think the plan is doomed to fail.

Before I explain why, let me show you why it is critical for banks to get to grips with their bad assets. Take a look at the amounts of level 3 assets (the hardest to value) on the books of these banks, and then compare that with their tangible net worth. No wonder these organizations have been swallowed and/or have seen their share prices decimated over the past year:

Company

Date

Level 3 Assets (in billions of $U.S.)*

Level 3 Assets as a % of Tangible Book Value

Citigroup (NYSE: C  )

09/30/2008

$157.5

443%

Morgan Stanley (NYSE: MS  )

11/30/2008

$86.2

302%

Merrill Lynch (now part of Bank of America (NYSE: BAC  ) )

09/26/2008

$55.3

225%

Goldman Sachs (NYSE: GS  )

11/28/2008

$66.0

155%

JPMorgan Chase (NYSE: JPM  )

12/31/2008

$130.5*

96%

Wachovia (being acquired by Wells Fargo (NYSE: WFC  ) )

10/30/2008

$25.2

131%

*Approximate value.Sources: Company SEC Filings and press releases; Standard & Poor’s Capital IQ.

Distressed prices and complexity aren’t the problem
Mr. Geithner could well be wasting his time trying to convince investors to come in with him to buy up bad assets. The problem isn’t that prices are depressed -- all things equal, that’s what makes them attractive to "vulture" investors. It’s not that the assets are fiendishly difficult to value (which they are); figuring out what complex assets are worth and betting on your estimate is what investors are paid to do.

The problem is the legal risk created by well-intentioned but economically illiterate lawmakers. Congress’ unhealthy obsession with avoiding home foreclosures creates a regulatory risk that trumps the economic risk associated with mortgage-related assets.

For example, there is a bill in the Senate that would allow bankruptcy judges to modify the terms of first-home mortgages -- including the rate and the principal amount. This would necessarily impact investors who own mortgage-backed securities collateralized by those mortgages. Unintended consequences, anyone?

Furthermore, as long as the government continues to obstruct the free market, the housing market will not clear. This incentivizes investors to stay on the sidelines rather than buy up assets.

Listen to investors’ message
If the government wants to lure investors to buy up toxic assets, it must first provide assurances that the contracts these securities represent will be respected and that lawmakers won’t pull the carpet out from under their feet. Without these assurances, I fear debt investors will simply respond to Mr. Geithner’s plan the same way stock investors have treated bank shares -- by staying far away.

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Fool contributor Alex Dumortier, CFA, has no beneficial interest in any of the other companies mentioned in this article. JPMorgan Chase is a current Motley Fool Income Investor selection, and Bank of America is a former pick. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.


Read/Post Comments (5) | Recommend This Article (19)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 13, 2009, at 7:56 AM, pondee619 wrote:

    "Merrill Lynch (now part of Bank of America (NYSE: BAC))

    09/26/2008 $55.3 225%"

    Is that 225% of the assets of Merrill Lynch or 225% of the assets of BAC, now that the two have merged?

    Same question re: Wachovia and Wells Fargo.

  • Report this Comment On February 14, 2009, at 11:31 AM, may132007 wrote:

    Can you tell us the Level 3 Assets as a % of Tangible Book Value for Bank of America and Wells Fargo? Not sure why they were left out of the table.

    Thanks

  • Report this Comment On February 14, 2009, at 7:07 PM, TMFAleph1 wrote:

    may132007 & pondee619,

    BofA didn't disclose its Level 3 assets as part of its fourth quarter results and its 10-K for the year ended Dec. 31, 2008 isn't available yet. At Sep. 30, 2008, its ratio of Level 3 Assets to Tangible Book Value was 241%.

    Bear in mind that Sep. 30th is prior to the government's two capital infusions in BofA totaling $45 billion. It is also prior to the closing date of the Merrill acquisition.

    With respect to Wells Fargo, the lender didn't disclose its Level 3 assets with its fourth quarter results, either. For Wells Fargo, the ratio of Level 3 assets at Sep. 30, 2008 was 171%.

    The qualifying remarks I made for BofA hold true for Wells Fargo: Sep. 30, 2008 precedes the government's $25 billion capital infusion and the closing of the Wachovia acquisition.

    Cheers!

  • Report this Comment On February 14, 2009, at 7:09 PM, TMFAleph1 wrote:

    I forgot to mention that Wells Fargo's 10-K for the year ended Dec. 31, 2008 (which I expect will include the breakdown of assets into Levels 1, 2 & 3) isn't available yet, either.

  • Report this Comment On February 17, 2009, at 9:48 AM, BRUCEKRASTING wrote:

    I agree. The paln on the table is going to fail. Look at the markets again this morning. We are weeks away from falling into an abyss.

    I wrote an "Alternative plan to the bad bank" recently.

    Any thoughts on this approach would be appreciated.

    Bruce Krasting

    http://brucekrasting.blogspot.com

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