When Is A Bad Bank Good?

The TARP may soon come full circle as the notion of a “bad bank” for taking control of toxic assets gains momentum on Capitol Hill. The bad bank, sometimes referred to as an “aggregator bank,” would purchase bad securities from healthy banks and from those unhealthy institutions requiring major restructuring or more drastic measures. The theory is that moving the bad assets off of bank balance sheets would enable them to lend money again while still maintaining their capital requirements. Under the TARP model developed under Secretary Paulson, the federal government became the banks’ preferred shareholder, and some argue that hindered banks’ lending capacity because of the expectation that those shares would be bought back and, in effect, repaying the government. The bad bank model removes that burden but is likely to have stringent lending requirements to get loans flowing again on Main Street.

Estimates for the cost of a bad bank range from $1-3 trillion. Clearly, the second half of the TARP—at $350 billion or possibly even less, when all the IOUs are paid—is not enough to support such an enterprise. Both Speaker of the House Nancy Pelosi (D-CA) and Vice President Joe Biden indicated in interviews this weekend that banks will probably need more money than currently in the TARP. Federal Deposit Insurance Commission Chairman Sheila Bair and Federal Reserve Chairman Ben Bernanke have both commented on the merits of establishing a bad bank. Bair, in particular, noted that private equity money is likely to flow into banks again once the most troubled assets are removed and suggested that raising private funds might possibly be a requirement for utilizing the bad bank option.

When asked during his confirmation hearings last week about reviving the Resolution Trust Corporation (RTC) to act as the bad bank, Treasury Secretary-designate Tim Geithner explained how today’s situation is different but said there were important insights from the RTC approach to disposing of troubled assets. The RTC took over assets from failed institutions, whereas the bad bank model would remove bad assets from otherwise healthy institutions.

Proposals for a new TARP or a bad bank could emerge this week. If they do, there will be renewed interest at Treasury on how to value, manage, securitize, and resell troubled assets.

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Prof. Samuel D. Bornstein - January 27, 2009 6:09 PM

Timothy Geithner, President Obama's choice to be Treasury secretary, stated that the Obama administration is considering a solution to the Economic Crisis that will return to the original intent of the Troubled Asset Relief Program (TARP) which was to purchase the "troubled assets."

The Federal Reserve Board and the Federal Deposit Insurance Corp. are openly advocating a government-backed "bad bank" or "aggregator bank" to acquire hundreds of billions of dollars of these "troubled assets" which have been clogging the balance sheets of banks and freezing the credit markets.

While these troubled assets remain on the books of the banks, the write-downs and losses will continue to cause economic havoc and drain the strength of the financial sector. In effect, the US government (taxpayers) will be bearing the loss on these "toxic" mortgages. The growing concern is that these losses will continue to materialize as defaults increase with the projected 8 million foreclosures expected over the next four years.

The underlying troubled assets are the toxic mortgages such as Alt-A, Option ARMs, Interest-Only, etc. that are interwoven into the Mortgage Backed Securities, Collateral Debt Obligations, and other derivative investments that are leveraged into investments valued in the trillions of dollars worldwide. Since the valuation of these toxic assets depends on the Borrower's ability to make the monthly mortgage payments, the key to a solution of this Economic Crisis is the Borrower!

Everyone is betting that the Borrower will default and foreclosures will follow. The high rate of foreclosure should have been expected because the Borrower has no concept of managing money and is like a "Boat without a Paddle". He is in desperate need of "Financial Guidance" in this complex economic environment that requires "informed" financial decision-making. The Subprime Mortgage Crisis, out-of-control consumer spending and credit card usage, and the spike in foreclosures and bankruptcies provide evidence of that fact. Even after loan modification, the re-default rate was 60% within 6 months!

The solution is a program of Immediate and Specific Financial Guidance that will help the Borrower "naturally" be able to make the monthly mortgage payment, without "bailout" or extensive loan modifications which have proven to be a failure. This program is NOT the so-called Financial Literacy initiative that simply disseminates "information", but rather it is a program that will help the Borrower "understand" how to manage money and avoid the pitfalls that have previously caused financial distress.

bornsteinsong @aol.com 732-493-4799

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