Bad Bank Strategy Faces Valuation Hurdles
On the surface, a “Bad Bank” to soak up all the “bad” assets banks have created in recent years seems like a plausible way to free these institutions from the mark-to-market earnings hits the assets are bound to inflict.
The truth is the federal government is going to have an extremely difficult time making a bad bank work. Published reports are surfacing now that seem to confirm the unlikelihood of a bad bank, as evidenced by this Reuters report:
CNBC reported there were round-the-clock meetings between government officials and senior bank executives over the “bad bank” idea, but the talks had hit a snag because consensus could not be reached over how it would work.
The Wall Street Journal added additional information in the Jan. 30 paper:
Under the concept being discussed, the government “bad bank,” possibly run by the FDIC, would buy only assets banks have already marked down heavily. This could avoid crushing the value of other assets held by banks. It could also potentially sidestep the pricing dilemma because banks have already recognized the low value of the assets being purchased. …
The remaining troubled assets — likely a sizable amount — would be covered by a type of insurance against future losses. This would apply to mortgages, mortgage-backed securities and other loans that banks are holding until they mature. Banks have probably given these assets an overly optimistic value because they plan to hold them. This would be similar to a structure set up recently to protect Citigroup Inc. and Bank of America Corp., in which the government and the bank would share future losses on a set pool of assets.
In addition, the Treasury is also likely to make more capital injections into banks.
The problem is valuation of the assets. At this week’s financial services conference sponsored by Citigroup, bank executive after bank executive circled back to the same hurdle to a bad bank: valuation. Each bank executive — from KeyCorp, US Bancorp, M&T, M&I, and others — said essentially the same thing, which is that the success of a bad bank will be determined by the valuation the federal government gives to the troubled assets. If the federal government offers “fair value” for the assets, the banks will support the initiatives (and moral hazard will come into sharp focus); if the banks offer to buy the troubled assets at something closer to the market value, banks will balk. Banks would probably accept some haircut on their assets, but how much?
That’s probably why the Obama administration is gravitating toward a bad bank for previously marked-down assets. Such a bank would help, although not to the degree that it alone will solve this mess. Hurdles remain.
