A number of comments on Kevin’s link to Buiter’s discussion of bank nationalisation have brought up the idea of a “bad bank” that can be used to take over non-performing assets. I think this issue is important enough to hoist out of the comments and onto the front page! It should be noted that Buiter is discussing this idea in the context of a fully nationalised British banking system. The “bad bank” idea has an “economies of scale” advantage in that case. so that all bad loans can be grouped together and dealt with by a team specialising in getting the best long-run return for the government from working out bad loans.
Outside the context of full nationalisation, I’m not sure I understand the “bad bank” idea or why it has caught on in the Irish media over the last day or two. I’ve been puzzling over this the last few days and then found a post by Paul Krugman that expressed my puzzlement far better than I could. In a post entitled bad bank bafflement (good post title!), Krugman says: “The idea of setting up a “bad bank” or “aggregator bank” to take over the financial system’s troubled assets seems to be gaining steam. So let me go on record as saying that I don’t understand the proposal. It comes back to the original questions about the TARP. Financial institutions that want to “get bad assets off their balance sheets” can do that any time they like, by writing those assets down to zero — or by selling them at whatever price they can. If we create a new institution to take over those assets, the $700 billion question is, at what price? And I still haven’t seen anything that explains how the price will be determined.”
In the Irish case, perhaps someone could explain to me how the bad bank proposal gets at this question. What price would the Irish government pay to struggling banks for their underperforming loan portfolios? Why should the government pay a price above current market value rather than, for instance, provide additional capital to cover the implicit losses and thus increase the government’s equity share?
As Krugman notes, in the US case, the answer to these questions appears to be that Bernanke believes the market is systematically underpricing a wide range of mortgage-backed securities and that the US government may break even (or perhaps profit) from buying them at above market rates and selling them later or holding to maturity. Whether Bernanke is right or not is open to question. But is there any reason to think a similar logic applies to Irish commercial property loans?