Paul Sheehan is CEO of Hong Kong hedge fund Thaddeus Capital. He arrived in the alternatives world with a unique background, having in the past worked as a bank examiner at the Federal Reserve in the US, followed by stints as a bank equity analyst at the ill-fated firms Bear Stearns and Lehman Brothers. His first commentary on the crisis was titled 'Credit crisis needs a Churchill' and was published in October 2008. Here he takes a look at the United States' good bank/bad bank plan.
Is the good bank/bad bank strategy a good idea?
The world is more than 12 months into a broad and mounting credit crisis. Despite the expenditure of hundreds of billions of dollars, the guarantee of many hundreds of billions more, and a series of desperate actions designed to alleviate the failure of some of the globe's largest financial institutions, confidence is far from restored and the banking system continues to flirt with disaster.
A new model for dealing with moribund banks appears to be making its way towards implementation in the United States, and possibly in the UK as well: the "Good Bank, Bad Bank" structure, or "Aggregator Bank". Good bank/bad bank as a strategy has a long and varied history, having been used in modified forms in the US (as part of the resolution of Continental Illinois), Sweden, Mexico, Thailand, and even China, where earlier this decade the non-performing assets of major state banks were distributed to four large asset management companies as part of the recapitalisation of the banking system.
Under this structure, the remaining toxic assets within banks would be sold to a special purpose entity (the "bad bank"), funded under government auspices and able to hold assets to their eventual maturity. The remaining "good banks", freed from the burden of their past mistakes, would again be respectable, credit-worthy, and, one presumes, eager to lend once more.
Who could possibly object to such a plan, aside from the unlucky taxpayers who will have to pick up the tab? As with most things financial, the devil lies in the detail; specifically, the mechanism by which assets can be sold by privately-owned banks to a government-funded bad bank.
Recall that all of the banks which would participate in such a scheme now claim to be solvent and well-capitalised and if their regulators did not agree with such an assessment, they would be in many jurisdictions legally-obligated to seize them. Not an earnings call goes by without a chorus of bank CEOs and CFOs proclaiming that: "We are very happy with our asset marks, and we believe they are conservative, and probably significantly understate the true value of our assets."
This is evident bosh.
If bankers truly believe that their assets are now written-down to attractive levels and will gain in value, why on earth would they want to exchange these pearls at their book value for near-zero-yielding cash? Liquidity is no longer a reason to do so, now that the US TALF and TLGP facilities and their national counterparts across the world will effectively allow banks to finance and hold these assets to maturity.
The inescapable conclusion is that if banks are anxious to participate in such a plan, and if governments believe that it would be of help to those same banks, the values of assets still held on the books must still be far too high, not only versus the current market price, but compared to the "held-to-maturity valuation" about which everybody talks about but nobody can actually pin down.
If, however, banks are still mis-marking their assets, then buying these assets at prices approximating their true market value (assuming that a single public buyer has a mechanism for determining such a level), will be very likely to reveal the insolvency of a majority of the largest Western banks. Therefore, any good bank/bad bank plan which involves market pricing must compel banks to sell bad or suspect assets, or they will be reluctant to participate, and it must also include provision to make up the realised losses with new equity, or to amortise them over some extended schedule.
The best aspect of this type of market-based good bank/bad bank plan is not the establishment of the bad bank entity itself, but the fact that banks are compelled to sell their toxic assets into the market and quantify the amount of losses. The current lack of any transparency around the true level of bad assets and hence capital in the banking system is the major contributing factor to the now-endemic mistrust of financial institutions.
In the absence of good information on who is solvent, curtailment of interbank lending and hoarding of risk-free assets makes perfect sense for each individual player, but its collective result has been a worsening of the credit crunch. We need to quantify these losses in order to address them, resolve their owners if necessary, remove suspicion from those banks which remain healthy, and move on.
The Geithner plan which has been sketchily outlined overnight does not appear to force banks to sell what it terms "legacy assets," and while it promises market pricing based on private investments it also offers unspecified government funding in order to "leverage private capital." This seems suspiciously as though the government-either through explicit guarantees or via non-recourse loans-will still take the brunt of the risk on these assets, and therefore casts doubt on whether the sale prices of assets under the programme are truly open market ones.
If the bad bank purchases generate falsely-inflated market prices, these will be used to mismark other similar assets on the books of other institutions, such as investment funds, pensions, and insurance companies, all to the detriment of transparency and proper allocation of capital throughout the economy. In addition, the existence of a single aggregator bank entity means that there will be no competition to buy and manage these assets, which could ultimately lower the realised value and raise losses.
Banks receiving assistance from the government should be required to sell their dubious assets through a public auction process open to all comers. Although banks may complain about the "fire-sale prices" they receive, they will be free to buy the troubled assets of others as and when they see compelling value.
Instead of a single bureaucratic bad bank, the experience of RTC auctions would lead us to expect bids from a diverse group of banks, pension funds, hedge and private equity players, and even corporates anxious to restructure their own debts. Using many different market participants and strategies to fund and work out bad assets should not only speed the process of recovery, but result in higher recoveries and less losses for the economy as a whole. As an added benefit, the surge of purchase and workout activity will generate much-appreciated financial sector jobs for those unwilling recent alumni of investment and commercial banks.
Let a thousand bad banks bloom.