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Good Bank - Bad Bank

What a turbulent three weeks of the New Year it has been! It began with the hope that major stock markets around the world (led by the US Dow Jones Index), were beginning to thaw. But what promised to be a sneak preview to a turn-around, rapidly changed course; over the past week, the US Banking system teetered on the brink of collapse for the third time in four months. Citi finally accepted the fait accompli that its days as a Universal Bank  were numbered. Bank of America’s much vaunted acquisition of Merrill Lynch almost came unstuck!

The US Treasury and Federal Reserve (along with the FDIC) have made multiple attempts at resuscitating the credit markets. After the TARP approach of investing in Banks’ preferred stock and (subsequently) using the back-stop guarantee mechanism, the latest thinking among US Government bureaucrats is to segregate the “bad” assets on Banks’ balance sheet from the good ones or what is popularly being termed the "Good Bank – Bad Bank" model.

Sheila Bair, Chairperson of the US FDIC , has mooted the idea of a “Bad Bank”, which would aggregate and consolidate the toxic assets on all US Banks’ balance sheets (read here) - an idea that was earlier espoused by US Federal Reserve Chairman, Ben Bernanke and is also gaining support among President-elect Obama’s economic advisors. Across the Pond, the UK Treasury Chief, Alistair Darling and his team of policy makers have been discussing a similar option, in the face of Bank stocks getting hammered on the London Stock Exchange.  UBS actually put the concept to test in November 2008, when it spun off about $ 60 Bn in toxic assets into a separate entity with $ 6 Bn in equity (the jury is still out on the efficacy of such a move – write back to me if you have more insights).

Is creating a Bad Bank the solution to the crisis? Will this help focus Government recovery efforts like the Resolution Trust Corporation (RTC), which helped tackle the US Savings and Loans (SnL)  crisis in the late ‘80s? The Washington Post has a very interesting article on the subject and suggests adopting the Swedish Bank rescue model of 1991.

Personally, I am not a very enthusiastic supporter of the Bad Bank proposition. The Swedish Bank crisis or even the US SnL disasters were events of much lesser magnitude. The US ultimately lost only about $ 150 Bn in the RTC led SnL rescue. As of today, about $ 350 Bn of TARP funds have already been deployed in battling the credit crisis, not counting the Citi and Bank of America asset guarantees of almost $ 400 Bn!

Nobel Prize winner and Economics professor at Princeton University, Paul Krugman, who is also a noted columnist for the New York Times, has made a good point about the lack of clarity around the proposition (read here). 

I am keen to hear your views, as this debate livens up next week, even as the US is preparing for a historic Presidential inauguration amidst an even more historic and unprecedented economic crisis!    



I agree that the bad bank model most likely won't work, simply because the toxic assets will sit on the bank's books for a long time before eventually being sold or written off. The USG 90% guarantee against losses is a bad deal for the US taxpayer. More importantly, I question whether it is enough of an incentive for private investors to buy the toxic assets.

Better idea: Nationalize the biggest banks with the most toxic assets (80% solution). The shareholders and bondholders will take 0. Tough medicine but it needs to be taken. Recapitalize the nationalized banks and, once healthy, sell them to the capital markets.

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