What Should A “Bad Bank” Pay?

The following post highlights these stocks: Goldman Sachs (GS), Berkshire Hathaway (BRK-A), Wells Fargo (WFC), KeyCorp (KEY) and Comerica (CMA).

The central problem to the “bad bank” solution is highlighted in this morning’s New York Times http://www.nytimes.com/2009/02/02/business/economy/02value.html?_r=1. Consider the following situation:

“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 bond that is trading at 38 cents provides a vivid illustration of the dilemma in valuing these assets. The bond is backed by 9,000 second mortgages used by borrowers who put down little or no money to buy homes. Nearly a quarter of the loans are delinquent, and losses on defaulted mortgages are averaging 40 percent. The security once had a top rating, triple-A.”

The idea of the “bad bank” is that this new government backed entity will buy up all these bad assets from the financial system and hold them for a long time, possibly until maturity. This would then free the bank that currently holds it to make new loans and get the economy moving again.

This example shows that despite all the write-downs so far, there are many, many more to come. The current owner is clearly being delusional, perhaps almost to the point of morally (perhaps not legally) committing securities fraud in telling its investors its book value, if its book value is in part based on a valuation of $0.97 for this asset.

These are close to “zero-down” second mortgages we are talking about here. When a second mortgage goes bad, it really goes bad — most of the time resulting in a total loss. For the bond to be trading at $0.38 probably indicates that it is a senior tranche of this securitization.

Anyone who thinks that the “kitchen sink” has been thrown in is forgetting about the counter tops, the bathroom sink and the toilets that also have to be thrown in. There are many more write downs that the banks will have to take.

But what is the “bad bank” supposed to pay for this? The “true value” of this security is unknown, but it strikes me that it is probably much closer to the $0.38 that a willing buyer and a willing seller are able to agree on than the S&P model based on current default rates. Depending on how representative this security is of what is on the banks books, the bank would be insolvent if the “bad bank” paid $0.38, and would have to post a big loss even if the bad bank paid $0.53 or even $0.87.

Remember that the trend in foreclosures is still up, despite many state level efforts to postpone them. If, on the other hand, the bad bank were to pay the $0.97, it is simply a gift to the bank that holds it, and will reward its fantasy. This is exactly the same problem that we saw in the very early stages of TARP 1.0 and is the reason that the Treasury moved to injecting equity directly into the banks rather than buying up bad assets.

Injecting equity is still conceptually the right way to go; the problem with TARP 1.0 was the execution. The Treasury was so concerned with making sure that the terms were “not punitive” that it gave away the store.

For example, the net present value of the preferred that the Treasury got in Goldman Sachs (GS) was only worth only $0.50 on the dollar relative to what Berkshire Hathaway (BRK.A) was able to get two weeks earlier.

Also, the oversight provisions that Congress put into the original TARP legislation was geared towards firms that sold toxic assets to the TARP, and said nothing about firms that receive equity injections from the TARP. Since buying toxic assets was the stated aim of the TARP when it was passed, it is understandable, if unfortunate, that the law was written that way.

As a result, we saw the financial firms paying out an outrageous $18 billion of bonuses in 2008, using taxpayer TARP money to do so. There is little that can legally be done now to recover those funds. There will most likely be stronger laws in place to prevent it happening again in 2009 or 2010.

Unless you think that the Obama Administration is going to be substantially more generous to the banking system than the Bush administration was, do not get too excited about the financials even if the bad bank plan moves forward. The TARP will force banks to take huge hits on any assets it acquires.

The fact remains that most of the banking system is close to insolvency. Any government rescue going forward is going to result in far more dilution to existing shareholders than occurred in TARP 1.0. Avoid the banks like Wells Fargo (WFC), KeyCorp (KEY) and Comerica (CMA).

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