Will the “Bad Bank” Plan Work?

Posted January 30, 2009 by Bernz

As discussions continue in the White House and on Capitol Hill about what the next steps should be in helping banks survive the current economic crisis, one idea that keeps floating to the top is the “bad bank” plan. The Treasury or the Federal Deposit Insurance Corporation would set up a new bank to buy up all of the so-called “toxic” assets carried by major financial institutions. This would allow all of the other banks to cleanse their balance sheets and give them the liquidity they need to continue operating, according to the theory.

badbank1The “toxic” assets include the bundled derivatives and mortgage-backed securities that got the banks into trouble in the first place. The complexity of the assets became so great that banks, regulators, and auditors were unable to place a value on them as they could no longer be directly tied to individual mortgages. As mortgage failures increased during the recent real estate collapse, the assets’ worth looked dismal. The market for them dried up and banks were left holding the proverbial bag.

Dumping these assets into a single bank for whatever valuation they can scrape up seems like a bad plan on the surface. If no one will buy the assets, then their value is nil. However, there may be a method to the madness after all.

Over time, the vast majority of the underlying mortgages will be paid back. Once the mortgages are settled, the assets based on those mortgages will once again have real value. If a federal institution has deep enough pockets to wait out the current crisis, they most likely will be able to realize the value of the “toxic” assets. This longer-term return on investment can be returned to funds being used to bail out the banks. This is a win all around. Liquidity is restored to the markets. Banks once again have capital to lend to individuals and companies, and the taxpayer gets an investment return on public funds.

Buying up the troubled assets from the banks isn’t the sole solution to the problem but it certainly would help turn it around.

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More on this topic (What's this?)
Are Bank Stocks Such a Good Buy? (naked capitalism, 8/17/10)
Lax Basel III Rules to Spur Further Bank Consolidation, Meaning More TBTF? (naked capitalism, 9/1/10)
More debate on the Bad Bank... (Consequences Unintended, 2/4/09)
Read more on Bad Bank, Banking at Wikinvest

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This entry was posted on Friday, January 30, 2009 at 7:20 am and is filed under Debt, Financial Goals, Misc. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.

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