One bank to buy them all, one bank to find them,
One bank to price them all, and in the darkness bind them.
Toxic assets that is. A US ‘bad bank’ that would help separate the banking system’s good assets from the bad ones is looking increasingly likely.
It’s far from an easy fix, however. For a start, the scope of the bad assets can be quite large — see for instance, Deutsche Bank’s estimate of US banks’ current collective balance sheet below. Perhaps even more onerous will be the difficulty in pricing these loans and securities.
The New York Times is running an article that explains that particular difficulty well, using the example of a single mortgage-backed bond:
The wild variations on the value of many bad bank assets can be seen by looking at one mortgage-backed bond recently analyzed by a division of Standard & Poor’s, the credit rating agency.
The financial institution that owns the bond calculates the value at 97 cents on the dollar, or a mere 3 percent loss. But S.& P. estimates it is worth 87 cents, based on the current loan-default rate, and could be worth 53 cents under a bleaker situation that contemplates a doubling of defaults. But even that might be optimistic, because the bond traded recently for just 38 cents on the dollar, reflecting the even gloomier outlook of investors.
The interesting thing here is that since banks carry loans on a book value basis, if the US ‘bad bank’ were to buy that bond at the current market price of 38 cents on the dollar, the bank in question would have to take a write-down on the asset. Even if the bad bank bought it at the S&P valuation of 87 cents — the bank would still have to take a 10-cent cut. All of which means that even if toxic assets are taken out of the banks, there’s no guarantee they’ll be capitalised enough to start lending again. So, in addition to buying up potentially trillions worth of bad assets, the US may well have to fork out for more capital injections.
Deutsche Bank are suggesting an interesting alternative to the ‘bad bank’ that they think would circumvent this problem:
One way that would avoid some of these difficulties, and one that we would recommend, is to first establish a holding company with smaller capitalized subsidiaries that are carved out of both the good assets – such as the retail branch network, the agency MBS portfolio, or the custodial services department – as well as a unit with the bad assets. Then the good subsidiaries would be sold off into the market, with the holding company holding only the unit with the bad assets. The aggregator bank would then take over the holding company along with the residual bad assets. This would avoid the problem of having to value the bad assets in order to purchase them for the aggregator bank, or mark them to market from an accounting viewpoint. It is likely that the government would have to apply regulatory pressure on banks to sell the good assets into the market. The residual bank could possibly have a negative net asset value, if the original whole bank were insolvent. The aggregator bank would then gradually dispose of the bad assets over a longer horizon, to avoid a forced liquidation at prices below their true value. We think this would go some way toward restoring the banking system to health.
Related links:
Risks are vast in revaluation of assets — New York Times
Why Meredith Whitney thinks a “bad bank” is a bad idea – FT Alphaville
A big bang plan to clean up US banking system – FT
Who’s afraid of the big bad bank? – FT Alphaville