Outside the Beltway

In the discussion section of Steve Verdon’s Obama the Fear Monger post, commentor Drew and I had a brief debate about the possibility of using TARP funds to create new banks rather than try to rescue old ones. In today’s Wall Street Journal, Paul Romer of the Stanford Institute for Economic Policy Research makes this argument as well, with more sophistication than I could muster. The core of his argument is:

The government has $350 billion in Troubled Asset Relief Program (TARP) funds that it can use to encourage new bank lending. If this money is directed to newly created good banks with pristine balance sheets, it could support $3.5 trillion in new lending with a modest 9-to-1 leverage. Right out of the gate, the newly created banks could do what the Fed has already been doing — buying pools of loans originated by existing banks that meet high underwriting standards.

If the TARP funds go to existing banks, much of them will end up stuck in financial institutions that are still bad after the transfer. We know from the previous round of TARP that giving more capital to bad banks generates very little net new lending.

Proposals for turning existing banks into good banks — recapitalizing them, nationalizing them, transferring the toxic assets off their balance sheets, or insuring the toxic assets — require prices for all these hard-to-value assets or, worse still, prices for derivative contracts on the toxic assets. (Calling the derivatives “insurance” doesn’t make them any easier to price.) Without reliable market prices for the hard-to-value assets, any proposal for turning bad banks into good banks could lead to huge transfers of wealth between taxpayers and bank shareholders.

Since I was proposing this as well, I obviously agree with the sentiment. The key question is whether we think it is even possible to salvage some of our large troubled banks. If it is, then it probably makes sense to do so and tap into their existing relationships and expertise (tarnished though it is). But if you think — as I do — that they cannot be saved given the finite resources that can be committed due to political constraints, then this approach, as ugly and messy as it seems may turn out to be the most promising.

Hat tip: Matt Yglesias

Economics and Business

Banking, Matt Yglesias, Steve Verdon, TARP

16 responses to “Start New Banks”

Dave Schuler

February 6, 2009 at 10:55 am

I think that the solution to the “toxic asset” problem is the one that Credit Suisse has hit upon: identify the most toxic, transfer at least some of them to top management in lieu of bonuses. That gets them off the banks books and, however they’re valued, compensates appropriately.

I don’t have a problem with creating new national banks in theory but in practice I think I do. Not all private banks are equally under water, some aren’t in bad shape at all. The reason that they’re not lending is less because they’re underwater than because they’re uncertain. Is creating new competition for the good actors using tax dollars a good policy?

Will new national banks make things more certain? I doubt it.
DC Loser

February 6, 2009 at 11:01 am

I’m glad somebody else is bringing this up. I was saying this very same thing months ago. Why should we be left holding the bag on the bad assets when it would be better to start new banks that has zero bad loans. I guess my opinion didn’t count.
Steve Plunk

February 6, 2009 at 11:34 am

Toxic is too strong a word for these assets. Behind every bad loan is a real house with real value. The balance sheet problem banks are encountering comes from the inability to value these loans when they are bundled. Get the valuation problem solved and a market can be found to sell them. A simple relaxation or suspension of mark to market rules months ago could have headed off much of this problem by holding off panic.

As with most complex problems the solutions are complex. There is no single cure and no silver bullet to put the beast down.

This problem started with housing and will likely end with a restoration of housing. Rather than waste money on pork stimulus and silly public works boondoggles our various levels of government could stimulate housing by relaxing land use rules and reducing building taxes. If the new administration would promise not to raise taxes or increase regulation for four years business confidence would return. Allowing free exploration and development of energy resources could renew business and consumer confidence. All of these proposals would come on the cheap compared to the plans being considered.
Drew

February 6, 2009 at 12:16 pm

I guess I’ll state the case once more, then let it rest. The choice seems to rest on what you think is more difficult: starting banking organizations from scratch vs valuing assets.

1. “Fresh banks” certainly seems a seductive concept, but it will be difficult, expensive and take quite some time. In my world – the leveraged buyout world – I’ve watched two new lending entities arrive on the scene during past decade, Madison Capital Funding and the old Merrill Lynch Middle Market group, now a unit of GE/Antares.

In those instances finding people, bricks and mortar, setting up loan monitoring systems etc etc took over a year to get those outfits started, and they were single site entities. Creating major new institutions with national loan origination capabilities and so forth will be that much more difficult. Your first loan might occur in 2010, if you wanted to do this in anything better than a reckless fashion.

2. Dave S correctly points out that much of the current problem, even for healthy banks, is underwriting uncertainty because of general economic conditions. NewBank won’t solve that.

3. The Good Bank / Bad Bank concept is fine if, operationally, you want to get the bad loans out from the four walls of the lending institution so their people aren’t continually preoccupied with problems. Then you can get them back in the business of lending money. However, you just gave the old equity holders and (shareholding)employees a pass on the nickel of the taxpayers.

4. You can do the workout equivalent of Student Body right. You reprice the current portfolio, recapitalize the bank accordingly with fresh equity, and wipe the old equity out. To the new money go the spoils. To the old money: “you screwed up, tough.”

Valuing the portfolio would be difficult, but the actual mortgage loans have a logical floor price. The derivatives? I’d have to investigate that more.

Option 4 is effectively nationalizing troubled banks. But at least the taxpayer would own the equity in the banks they bailed out. The banks could be reprivatized in the future, if the political will was there.

Perhaps its because of the nature of what I do for a living that gives me a bias, but #4 seems the only fair alternative. And #1 a logistical nightmare.
Bernard Finel

February 6, 2009 at 12:16 pm

Steve: Well, we don’t really know what the portfolios looks like. And ultimately, I am not sure it is possible to disentangle the assets into actual houses that can be valued. It is my sense, and I could be wrong here, but that what some of the banks are holding are not deeds to houses, per se, but rather the rights to certain payments at a certain time. If you could just resolve it down to foreclosed properties, we’d be in better shape… but the slicing and dicing of loans into mortgage-backed securities may have made this impossible.

So many of these assets may be worth, literally zero… and some may be worth less than zero if the banks used them in credit-default swap transactions… in short, the banks may have commitments to pay to spread risk on assets that have no value at all.

As for your comments on pork and boondoggles… the biggest single item GOP Senators now want to cut is aid to local school districts — $39billion. Now, I have kids, and I get the newsletters from the school. I live in a very affluent area. But without some help my kid’s class size will likely increase by 10% next year, their budget for educational supplies will decrease by 25%, 1st year teachers may not be renewed (including my son’s wonderful 1st grade teacher), and forget about computers and such… now, since I live in a rich area, we parents will probably chip in and make up a lot of the difference… but in a lot of places, the kids are going to have worse schools and those regions are going to have more unemployed teachers. You want to call that pork… go ahead. I consider it a reasonable counter-cyclical investment in a crucial public good.
Dave Schuler

February 6, 2009 at 12:19 pm

Toxic is too strong a word for these assets. Behind every bad loan is a real house with real value.

I don’t think that most of the “toxic assets” are mortgages. I think that most are complex financial instruments that ultimately rely on the values of multiple real properties. As I understand it what makes them toxic are the rapid changes in the underlying values and the complexity of the instruments themselves.
Bernard Finel

February 6, 2009 at 12:28 pm

Drew:

but the actual mortgage loans have a logical floor price

No, not really. Go to Detroit. Hundreds of vacant properties abandoned. Why? Because their value is less than zero. You have transaction costs to buy them, maintenance costs to hold them, more transaction costs to sell them. And before the Steve’s jump in, it isn’t just taxes that make up the transaction costs. It is personnel costs to process the transactions, it is paperwork and other internal control mechanisms even aside from government reporting, it is liability concerns from holding the properties. Some properties are worth, in short, less than zero. In a declining market, many might be — not because the house itself is worthless, but because the process of taking possession, preparing for sale, and actually completing the transaction may be higher than the value of the house — or at least close enough that your best bet is to just sit on the loan and hope that somehow someone comes in and rescues you.
Steven Donegal

February 6, 2009 at 1:53 pm

Get the valuation problem solved and a market can be found to sell them. A simple relaxation or suspension of mark to market rules months ago could have headed off much of this problem by holding off panic.

It would have made the banks’ balance sheet and capital look better, but it wouldn’t have solved any other problems. The banks couldn’t sell the assets at the value on their balance sheets, so no one would really have any idea who is solvent and who isn’t. Given that circumstance, there is no reason to think that the interbank lending markets would be functioning any better than they were.
Drew

February 6, 2009 at 1:55 pm

Bernard –

I meant on a portfolio basis. Of course various mortgages will have various values, some zero.

Valuing a portfolio is an entirely different exercise than pegging individual assets.
sam

February 6, 2009 at 2:09 pm

[A]ny proposal for turning bad banks into good banks could lead to huge transfers of wealth between taxpayers and bank shareholders.

I’m surprised the Republicans haven’t jumped all over this idea.
Steve Plunk

February 6, 2009 at 3:02 pm

Bernard,

Thank you for the response.

I agree we have some complex financial instruments on our hands but each of those goes back to real assets that must be valued properly. There are a number of ways to do that whether it be appraising properties or analyzing cash flows. It’s a big job but it needs to be done and will help restore confidence in all of the paper.

While I understand the plight of public schools this reduction should not result in 10% larger class size. That is the rhetoric of school officials. Regardless that type of funding should be debated in a stand alone bill and part of the stimulus package.
fester

February 7, 2009 at 8:33 am

There are multiple banks with relatively healthy balance sheets and relatively health positive cash flow — pump the cash into them as they have the core of expertise to expand relatively quickly compared to start-ups….
Drew

February 7, 2009 at 3:37 pm

bernard –

Fester beat me to the punch. Its a halfway house, and those can be bad. But maybe that’s the way to thread the needle. The govt money goes to the “responsible” banks. They buy out the bad banks, wiping out the old equity/senior management (the traditional capital markets solution) but don’t have to start a new bank from scratch.

The criticism would be that the govt is picking winners.

But they aren’t now?

It would be a donnybrook, deciding what the “fair” price for a bad bank is.
Bernard Finel

February 7, 2009 at 4:10 pm

But Drew, your argument supports my position.

Old banks that are solvent continue to operate and benefit from existing relationships and expertise.

Old banks that are insolvent are liquidated.

New banks are supported by government money, but have limited resources and no pre-existing relationships. They will fill a gap, but not put old solvent banks out of business. After a while, you privatize them through a straight stock sale letting the market price the new banks.

You don’t need to find a way to price assets, you don’t get the government into a situation of buying a pig in a poke, and you avoid picking winners and losers.
Drew

February 8, 2009 at 8:27 pm

“But Drew, your argument supports my position.”
Say what? We appear to be ships passing in the night.

1. “Old banks that are solvent continue to operate and benefit from existing relationships and expertise.” Bernard, this was never an issue in the debate. Completely agreed.

2. “Old banks that are insolvent are liquidated.”

Apparently you are viewing liquidation as costless. As a crusty old German prof of mine used to admonish: “Dammit, Drew, think operationally.” Exactly what does “liquidated” mean? Who stays around to administer and liquidate the bad banks portfolios best as they can for the benefit of creditors? (After all, there are good assets in there.) The government? Well then that’s really a vote for a variant of the “bad bank,” RTC type approach. Create your RTC to do the liquidation job, but that will take lot’s of govt – that is, TARP – money. You are not in favor of that approach.

Management? Well forget that, they are gone; the company is in receivership… unless you do my capital infusion/capital markets workout scenario and wipe out equity but keep management in place to run the place. There goes your TARP money for the infusion.

And I can’t imagine you mean just the proverbial turning out the lights. In either event, its not your NewBank proposal.

3. “New banks are supported by government money, but have limited resources and no pre-existing relationships.”

Well, they have no bad loans to deal with, for sure. They also have no portfolio income. So yes, they will need lots of TARP money until they gain traction. This is now just circular, Bernard, back to the original debate. You want to create and fund de novo banks with all the operational issues, risks and costs I cited. But you’ve spent your TARP money winding down the bad banks portfolios through liquidation. This is tremendously (doubly?) expensive and operationally challenging. With the propensity for hyperbole I have. Pardon me. Its preposterous, and would make Rube Goldberg proud.

3. “After a while, you privatize them through a straight stock sale letting the market price the new banks.”

That’s fine. If you could pull off the Houdini act proposed in #2, yes, you could privatize the Newbanks at some point. Perhaps you could even eventually recover your investment to get the NewBanks going. (Although the risk adjusted return would, IMHO, be miserable.)

4. “You don’t need to find a way to price assets”.

Not really. If whoever is liquidating the bad banks portfolio is doing their job, that’s exactly what they will be doing.

5. You don’t get the government into a situation of buying a pig in a poke.”

Not so. The government cannot abandon the task (or at least the expense) of liquidating the bad banks portfolios, that takes money…..like an RTC. You are also starting up new banks, that takes money. You will effectively have had the government pay twice; the mother of all pigs in a poke.

6. “and you avoid picking winners and losers.”
If you say so. I don’t think Ma and Pa Kettle will be applying for banking licenses. People with huge political interests, with lobbyists……probably many execs from those former bad banks….will be vying for the bank charters and funding. Not picking winners? Really?

I guess we could chase our tails here all day.
It seems to me the decision turns on two issues:

1. Funding a liquidation of old banks plus funding the operational difficulties, risks, and govt costs of setting up entirely new banking enterprises…..vs

2. Valuing the portfolio and making an appropriate capital infusion, or selling off the bad bank portfolios to healthy banks.

I admit a bias. No. 2 seems infinitely wiser. As a private equity person (and former banker) who has been investing in and building enterprises for many years, and who understands portfolio management, I view starting up a new banking world of the magnitude required, and to be making loans sometime before the Cubs win a World Series – which could be quite a while – to be a monstrous task, indeed a fools errand.

Anyway, thanks for the give and take.
Drew

February 9, 2009 at 3:45 pm

Bernard –

A light bulb went off as I was showering this AM (sorry for the visual). Perhaps we have a language issue here. The term “liquidation” in the world of bankruptcy and restructuring has a very narrow meaning, and it is different from “forced sale.” So when you say my post on selling to healthy banks (“forced sale”)reinforces your point on liquidation, this may be the issue:

Liquidation (in an industrial setting) implies liquidation of assets, not an enterprise: collection of receivables, and auctioning off inventory and equipment. All can generally be accomplished in about 180 days. For a bank, which really just has receivables, the tenor of those receivables at 1 – 10 – 30 years means you can’t just liquidate. You have to administer and collect over the long haul. Hence the expense I referred to. Or you sell the portfolio to a healthy bank. A forced sale.

In any event, here is some commentary you may find interesting:

http://www.cumber.com/commentary.aspx?file=020609.asp&n=l_mc