Wednesday, February 11, 2009

Bad “bad bank”

The task of a bad bank should be to sell their good assets to the good banks and to other potential buyers as to the “vulture” funds. When Chairman Bernanke’s approach is followed: “to set up and capitalize so-called bad banks, which would purchase assets from financial institutions in exchange for cash and equity in the bad bank”, we get exactly the incentive problem that caused yesterday’s jitter in the markets: how to value the toxic assets. The pricing of such asset categories too low would make many big banks insolvent while purchasing at an inflated price above market values means the taxpayers handing a subsidy to the banks.

In the banking crisis of Finland in the beginning of the 1990s, the “bad banks” were fallen angels, banks fallen to the control of the government, which sold their good assets to the remaining healthier banks and to foreign financiers. Thereafter the bad banks managed their portfolio of sour loans and real estate holdings as every bank is accustomed to do.

Pretty soon after the first fallen angel emerged, all banks were offered a capital loan on equal terms in proportion to their risk-weighted assets and off-balance commitments. Such funding was junior enough to count as tier I capital: interest could only be paid after the receiving banks had fulfilled their other commitments, but dividends on preference shares and common stock could be distributed after the banks had paid interest on the capital loans.

In practice, the government’s capital loan offer funded “mating”. During the consolidation process the banks were able to raise private co-finance, both equity and long-term debt, in the financial markets. Those banks that did not find a stronger partner ended up as bad banks.

Besides the customary political process, the delay in solving the Finnish banking crisis was caused by the lack of a government agency that received fallen angels. But, the USA has an experienced government agency for that purpose, the FDIC.

US Treasury Secretary Geithner need allocate the remaining TARP funds to the FDIC. What the USA is lacking is a government offer for funding that would facilitate the amicable mating ritual on equal terms for every partner.

It is not the purpose of a government agency to profit from solving the banking crisis. It was astounding to read in today’s press Chairman Bernanke to have announced yesterday that the Fed expects to make big profits from its increased role in the credit markets.

The task of the Fed and other federal agencies is to breathe new life to the speculative confidence of private actors as well as strengthening credit creation. This follows from Keynes’s analysis in Chapter 12 “The state of long-term expectation of his General Theory (p. 158): “the recovery requires the revival of both”. The whole chapter eloquently covers the difficulty of valuing long-term investments in the stock market.

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