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Tuesday, May 12, 2015

Good Bank, Bad Bank

An idea we're bound to hear more of as the Greek debt drama unfolds is the (now quite old) idea of consolidating bad debt into a specially created entity, the "bad bank."

Yes, the bad bank. A bank of ill repute.

This seemingly ludicrous artifact of the banker's mentality is not as ridiculous as it sounds. It has recently found favor in Slovenia and Uruguay but actually has been proven-in-practice in Sweden, Finland, Belgium, Ireland, Spain, France, Germany, Switzerland, and the United States (Mellon Bank, 1988), among others.

Think of a doctor who's managing a cancer patient. The patient has an invasive cancer that's spread to every tissue of the body. Imagine how great it would be if, through some high-tech miracle of science, all the patient's cancer cells could be persuaded to migrate to a single organ (the left kidney, say), where they could be removed in a single operation, saving the patient. That's sort of the spirit of the "bad bank" methodology.

There are many variations on the "bad bank" scheme. For example, does each bank set up its own bad-bank holding unit? Or do you set up a bad super-bank (a single Big Bad Bank) that buys toxic assets from all the other banks? Greece would do the latter, of course. If successful, the balance sheets and credit ratings of the vast majority of banks would improve overnight, while toxic debts are ring-fenced in a single bad bank, where they can be managed intensively by a dedicated team with the (quite unique) "workout" skills necessary for managing and mitigating Non-Performing Loans. Meanwhile, investors seeking high returns (in return for high risk) can often be induced to buy "bad bank" stock; this happened in the case of Mellon Bank's Grant Street unit (a bad bank that lasted only a few years and took no commercial deposits). Early investors in Grant Street did quite well in the end.

Bad banks are not really in the banking business, per se, but are a specialized type of asset management company, with a goal (usually) of no longer existing after some definite time period.

The critical question (aside from achieving a clear distinction, in the first place, between bad assets and good assets, which wasn't always easy in the 2008-2009 U.S. financial meltdown) is always how the bad bank should value the assets its acquires; that is, how much should it pay for the "bad assets," and who shares in the pain of acquiring them? If the bad bank buys the assets for their market value (which might be quite low), the sellers (the good banks) can be pressed into insolvency and will need immediate recapitalization (for example, by the government buying shares of the good bank); the resulting writedowns damage the books of the good banks, defeating the purpose of the bad bank. If, on the other hand, the bad bank buys the toxic assets for their book value, the good banks get a gift while the bad bank has made, in essence, a terrible purchase (and needs capitalization). Either way, capitalization has to come from somewhere. The market won't rush to invest in a bad bank, usually (Mellon's Grant Street experiment notwithstanding), so the government becomes involved at some point.

Usually (but not always), the valuation question gets worked out so as to favor the good banks; that is to say, the bad bank overpays for distressed assets. Erring on the side of overpayment turns out to be necessary in order to flush out the toxic waste from good banks. Otherwise, good banks may tend to retain (on a "hopeful" basis) a certain amount of borderline junk they think they can rehabilitate profitably. Then, a few months or a year later, the impairments begin to show up on the good banks' books and investor sentiment sours, defeating the whole point of the bad-bank expedient.

Properly done, consolidation of toxic assets in an aggregator bank benefits the health of the greater system, because it has been shown, for example, that creative under-reporting of risk by banks tends to occur at the worst possible times (when the system is under stress, or in crisis), a problem the banking industry (around the world) can't seem to fix (and regulators seem unwilling to fix). By getting toxic assets off the books, the removal of distressed assets into a bad bank lets good banks go back to less creative (honest) reporting and relieves the need to penalize new loan customers who must ordinarily share the weight of bad loans by suffering harsher credit requirements and/or higher rates. The entire system becomes less brittle, more robust, more resilient.

What does it look like in practice? In 2008, UBS had $60 billion in bad assets that it unloaded onto a new bad bank. To pay for the bad assets, the bad bank needed $60 billion. First, UBS raised $6 billion in new capital by selling shares to the Swiss government; then it invested that $6 billion in the bad bank – and that became the bad bank’s capital. Next, the Swiss central bank loaned the bad bank $54 billion. The way it worked out was that UBS took a $6 billion hit (and their shareholders got diluted by 9%), while the government guaranteed the rest, essentially providing a subsidy to UBS ("cash for trash"). The pain was thus split (unevenly) between UBS, its shareholders, and the government (which is to say, the taxpayers of Switzerland).

Ironically, because of the sheer complexity of doing so, there's probably not time enough to implement a bad-bank scheme ahead of a Greek default, so it may be something the Greeks will turn to as part of a post-default recovery project, possibly after fully nationalizing the Bank of Greece (currently only 35% government-owned), which would, in itself, be another avenue of pain-sharing. (The government would no doubt dilute BoG shareholders during a takeover.) At a later time, after the banking system is well into recovery, the government could re-privatize BoG through issuance of new shares (which, because of the recovery, would be well received by the market and generate a huge windfall of capital for the government).

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