Lenihan on Insurance and Bad Bank Proposals

Here are the latest comments from the Minister for Finance on the “bad bank” idea.  (And just to be clear, commenters, the bad bank proposal as currently understood in policy circles means governments overpaying for bad assets – a bad idea – and not the process of maximizing the sales value of these assets after banks have been nationalized – a good idea if nationalisation is indeed required.)

The headline “Lenihan says Government will consider setting up ‘bad bank’” confirms what anyone who watches RTE will already know (and what anyone who reads this blog will know I’m not very happy about).  However, the piece starts out promisingly.    “We can’t be jump-led by markets and market expectations into solutions that suit the banks rather than the people,” said Minister for finance Brian Lenihan last night, who noted banks were using the media to try to force politicians to adopt these types of state rescue plans.   Well said Minister!  Couldn’t have put it better myself.

And then some more good stuff: “Some of the proposals that have been advanced today such as risk insurance seem to involve a payment of a definite premium to the taxpayer in return for the assumption of an indefinite risk. And that is not something that any government could commit itself to,” said Mr Lenihan.   That’s the spirit!

But then things get a bit murky:  He said one of the difficulties with creating a scheme to deal with toxic assets was that it would add to the exposure of the state in relation to its sovereign debt. But he said it could be argued that if the Government had enough information on toxic assets – and Ireland was a small enough country to do this – and it could eliminate the risk then it would improve the risk posed by the existing Government bank guarantee scheme.  “We are at a great advantage that many of the larger (European) states have very extensive loan books and it is very difficult for them to do the type of comprehensive trawl through their banking system that we have been able to do,” said Mr Lenihan, who noted that a lot of the toxic assets held by European banks related to commercial paper, which was much harder to value than the property-based debts held by Irish banks.

This sounds a bit like grasping defeat from the jaws of victory, the minister bending over backwards to figure out why the current-vintage bad bank proposal — while generally a bad idea — might actually be a good idea here.  

I’m not exactly sure what the Minister is driving at here.  But I will point out that the most coherent argument put forward in comments yesterday in favour of bad banks rather than just re-capitalisation (from Mick Costigan) involved the Knightian uncertainty provoked by toxic assets.  Because people don’t know the distribution of losses, even a big re-capitalisation could still leave uncertainty about the potential for even bigger losses and thus doesn’t deliver confidence in the banking system. 

This is an interesting argument though I don’t think it’s relevant to the Irish case.   Firstly, there has to some figure for a large enough re-capitalisation (for instance, the full value of the bad assets) that gets rid of any Knightian uncertainty concerns.  Secondly, our toxic assets aren’t rocket science CDO-squareds built by physicists which can’t be valued because nobody understands them.  They’re bad loans to builders and we can go about making a reasonable guess at what they’re worth today.   Indeed, the minister seems to be making exactly this point.  So, as far as I can see, the Minister’s arguments seem to further point against the need for a bad bank scheme.

13 thoughts on “Lenihan on Insurance and Bad Bank Proposals”

  1. What he’s driving at is taking one position while also taking the polar opposite position just in case it turns out that his first position has to be changed later, in which case he can refer back and say that the new position was the position he intended to take all along.

  2. The one thing I’ve wondered about in this process is this – how are some of the proposals to buy up stupid loans by banks (“toxic debt” my ass) not State Aid under EU competition rules? Or has the bureaucracy been so pulverised by its vain attempts to rein in situations like Alitalia that it has stopped caring?

  3. Karl, here is a question that I have been wondering about the last day or two. I will insert (?) at every stage where I might be making a silly mistake.

    Say the bad loan is €100, and it is only worth €40. If the banks were to be recapitalised to fill the hole, you might want to give the bank €60. (?)

    On the other hand, if you nationalise and create a good bank, which seems to me like a good idea I have to say, then if you leave all the bad assets in the old bad bank, is it the case that the government would have to put €100 into the new good bank to fill the hole left by the complete departure of the bad loan from the books?

    So, given that you might not want to sell the asset now, since €40 might become €20 if you dumped everything on the market at once, and might indeed become €45 or €50 in a few years if we are lucky, is it the case that the good bank scheme would involve a bigger upfront injection of capital, and thus a greater initial level of borrowing, than in the ‘chuck the money into the existing rotten institutions’ scenario which is what is currently being contemplated? That is, €100 rather than €60? Of course, you borrow €100 but retain the €40 in the bad bank, so net it is equivalent, but I have a feeling that gross might also matter in the short run (?). And the €40 might, eventually, become a little more.

    Is that right, or have I made some fundamental error?

    (And why isn’t banking a madatory subject for all economics undergrads?)

  4. OK. First thing is that just because we have a lot of talk about building debt, we shouldn’t think that’s all we have. As the recession deepens, we are (in all likelihood, there are no figures) developing a commercial bad debt problem, i.e. commercial loans to companies that are in trouble. It is essentially impossible to value a problematic commercial loan, or even to say definitively whether it is problematic or not. There are generally few or no tangible assets underlying it (or if they are, they’ve been undermined by the property crash).

    Re good banks and bad banks: I think the point that Kevin is making is that it is easier to prop up something old than to start afresh. The problem is that sometimes the old thing is rotten through, and it becomes a stumbling block rather than a platform from which to move forward. (This is a general observation about life, rather than anything in particular to do with Irish banks.)

    It probably isn’t a matter of one solution or the other, it’s a mix of both. In real life, you don’t build a business out of money. A good business is one that does enough business, and makes a profit on that business. A ‘good’ bank isn’t characterised simply or even mostly by the state of its balance sheet, but principally by the capability of the management.

  5. Hi Kevin,

    A couple of points on your questions.

    1. I suspect the Buiter proposals of carving new banks out of old banks would, in practice, be very difficult to achieve effectively. My own thoughts on this had been to encourage the slightly more radical idea of using at least some of the re-cap money to create completely new banks. In the Irish case, with enormous guarantees for liabilities of existing banks in place, this still leaves a major issue of how best to deal with these potential liabilities but new banks are certainly one way to use government money to get lending going again without the problems caused by loan losses at existing banks.

    2. “Say the bad loan is €100, and it is only worth €40. If the banks were to be recapitalised to fill the hole, you might want to give the bank €60. “ — Yep, €60 exactly.

    3. “if you nationalise and create a good bank, then if you leave all the bad assets in the old bad bank, is it the case that the government would have to put €100 into the new good bank to fill the hole left by the complete departure of the bad loan from the books?” No. This bad loan would just be left in the bad bank. The good bank would have good loans on the asset side of the balance sheet with the source of funds being the guaranteed deposits on the other side. The equity capital for the good bank (the gap between assets and liabilities) would then be provided by the state. The bad bank would be left with the same amount of equity capital as it had beforehand and with a balance sheet that has some bad assets on the left-hand-side and non-deposit liabilities on the right-hand-side. In the Irish case, though, it should be stressed that we have guaranteed most non-deposit liabilities at least up to September 2010 and this complicates things greatly. Otherwise, the idea would be that the bad bank is left to get as much from the bad assets as possible and then distribute the proceeds to debtors according to the seniority of their claims. I would like to see a simple table outlining the liabilities of the six covered banks, organised by which are guaranteed and which are not, and by which expire before September 2010 and which expire afterwards. However, I haven’t seen such a table.

    4. “So, given that you might not want to sell the asset now, since €40 might become €20 if you dumped everything on the market at once, and might indeed become €45 or €50 in a few years if we are lucky, is it the case that the good bank scheme would involve a bigger upfront injection of capital” This isn’t really an issue. If the managers of the old bank decide they can achieve the best returns by holding on to their assets, then they could do so. What exactly the governance structure of such institutions would be is unclear. Buiter suggests debt for equity swaps so that these institutions would be managed to return the best possible cents-on-the-dollar for debtors. So they wouldn’t just dump everything on the market at once.

    5. Unlike our Minister for Finance, I’m not a lawyer, but I suspect our constitution’s reverence for property rights may make enforcing this idea rather difficult (going into banks and grabbing assets and offsetting liabilities from them at the same time may not be as trivially simple as it sounds). On the other hand, it does appear that we can nationalise banks if we want to ……

    And indeed, totally agreed on the need for mandatory courses in banking. Something like this perhaps —
    http://www.karlwhelan.com/Teaching/international_monetary.htm

  6. “Say the bad loan is €100, and it is only worth €40. If the banks were to be recapitalised to fill the hole, you might want to give the bank €60. “

    What about performing loans? They are also overvalued on balance sheets because they are secured by (tangible) assets that have been radically overpriced, and this is just as much of a problem.

    If you just treat the bad loans, you are in effect rewarding the most irresponsible lending, and leaving the (bad but still relatively responsible) lending still in the hands of the commercial banks.

    Then, next year, we will have a new batch of bad loans that constrict the flow of liquidity and more ‘bad banking’/recapitalisation will be called for. This will continue until nobody is prepared to lend to the Irish government anymore.

    Hence, a root-and-branch revaluation of the entire balance sheet, after complete nationalisation, is the only sensible approach. AIB, BoI etc are dead men walking.

  7. Karl: many thanks for this. And I wish I’d taken that class of yours.

    You say

    “The good bank would have good loans on the asset side of the balance sheet with the source of funds being the guaranteed deposits on the other side. The equity capital for the good bank (the gap between assets and liabilities) would then be provided by the state.”

    My question/confusion is: why isn’t that gap that has to be filled by equity capital equal to €100? If A=L initially, and L is transferred to the new bank, and we have left the bad €100 in the old bad bank, then why isn’t the hole €100?

    Is it because you have only transferred the deposit liabilities to the new bank, which are a fraction x of the original L? And so the equity infusion is only x times €100?

    OK, and then I understand your point about how the fact that we have also guaranteed some of the non-deposit liabilities complicates the picture as regards this strategy.

  8. Kevin,

    The flaw in your latest is the assumption that A=L. But, correctly valued, A is truly less than L. So the steps are:

    (i) recognize the true loss (in other words write A down from 100 to 40)

    (ii) transfer the bad loan of 40 to the asset management company, receive bond worth 40 in return.

    (iii) fill the hole in the balance sheet of the surviving bank (costs 60).

    By the way, you don’t have to treck all the way out to Belfield for a top notch course in banking. See http://www.tcd.ie/Economics/staff/batistac/mb_syllabus_08_09.pdf

  9. Thanks Patrick.

    So that I am sure that I understand. You say:

    (ii) (the new bank:?) transfers the bad loan of 40 to the asset management company, receive bond worth 40 in return.

    This bond comes from whom? The government? In that case the total up front cost to the government is 40 + 60= €100, as I suggested. (?)

    Or, does the bond come from the bad bank/AMC? In which case some of the assets of the new bank are claims on the bad bank and therefore, ultimately, its dodgy assets, which I thought we wanted to avoid. (?)

  10. Kevin — just to clarify. I was describing the Buiter proposal (carve out and capitalise new banks from the deposits and good assets and then leave the existing share-holders and bond-holders to fend for themselves — a great idea in theory but perhaps not workable in practice) whereas I see now that I should have been describing nationalise-and-put-the-toxic assets-in-a-bad-bank (which is what Patrick is doing).

    And for the last question, the government may be issuing a bond for €40 but it’s also getting back an asset supposedly worth €40 that it can put into its asset management company. It costs €60 to the government and produces a clean bank.

    And good to see that undergraduate money-and-banking is alive and well at both ends of the bus route.

  11. Kevin, Yes about upfront cost, but maybe that is not something to worry about too much. That bond is just an IOU, doesn’t have to be financed anywhere. Could be issued by the Asset Management Company with a government guarantee. And of course, as Karl implies, equity in the AMC could be sold to a third party.

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