One Step Closer to a Bad Bank Plan

Today’s Irish Independent reports that Peter Bacon has delivered his report on bad bank and risk insurance proposals to the Minister for Finance:

The Government has been advised to set up a ‘toxic debt’ company to take over billions of euro worth of bad property loans from the banks.

I’ve written quite a few times about the bad bank proposal and don’t want to repeat myself.    Still, it’s worth clarifying a couple of the nuances in the article because it likely illustrates the spin that the government would use to justify such a plan should it be adopted.

First, the article tells us that

Critical to any deal would be that the banks sufficiently write down existing bad loans before transferring them to a new state-operated company. It will be necessary to establish correct valuations for such assets to avoid perceptions of taxpayers having to foot the bill for rescuing the banking system.

The “correct valuation” stuff sounds sensible but, in reality, it’s a red herring. Think about this for a minute. What is the “correct valuation” for these assets if it’s not the value that a private-sector investor would pay?  And is there any reason to think that the inherent value of these bad loans would be different to the government than to private investors? 

Do not be fooled: The raison d’etre of these plans is for the government to pay more for these assets (perhaps a lot more) than private investors are currently willing to pay, i.e. to pay a lot more than they are worth.  This could avoid the banks having to be re-capitalised again.  With only the taxpayer available to re-capitalise and the market value of the banks being tiny, any further rounds of re-capitalisation would be taking the banks close to or into nationalisation. 

Second, we are told that

Most commentators agree that the Government would find it virtually impossible to raise the necessary funding in the international market to buy the banks’ toxic assets. However, one solution being mooted involves the proposed new company issuing government-backed debt to the banks in exchange for these assets.

This sounds almost too easy.  Print off some bonds, stick them in the banks and we’re done. Hey presto.  It is indeed the case that the government can re-capitalise the banks by printing off some bonds and giving them to the banks in return for impaired assets.  It can then set up the ‘toxic debt company’ to sell off the bad assets over time to attempt to come up with as much money as possible to pay off the bonds when they mature.  

It should be clear, however, that this scheme will still have implications for the government’s ability to raise funding in international markets in the future.  To the extent that the government overpays for these assets, the toxic debt company will come up short of covering the proceeds of the newly-issued bank bonds.  This leaves the Irish taxpayer with a (potentially huge) contingent liability.

11 thoughts on “One Step Closer to a Bad Bank Plan”

  1. What about the use of warrants to ensure the banks pay any difference between the value of government bonds used to ‘purchase’ these bad assets and the value of those assets once they are fully realised? This way the banks can decide to value the bad assets above market value now and and the taxpayer would get recompensed for this over time. It would also be easier to issue a bond to finance this as the government has a guaranteed return from these ‘bad’ assets.

  2. Karl,

    There seem to be two sets of problems with ‘bad bank’ and ‘insurance’ proposals.

    1. The structure. How should the thing be structured?

    This is the question that this paper seems to deal with. How do you value this stuff? What do you do with it when you’ve figured out just how toxic it actually is?

    But you are correct, it presupposes the answer to the second question.

    2. Should this debt be dealt with at all?

    I may be paraphrasing you correctly, but I think you believe that it is just wrong for banks to be ‘bailed out’ or ‘helped’ or ‘have their debts purchased.

    But if this is not done, surely these banks will collapse, causing massive damage to the economy and leaving depositors out-of-pocket. Depositors and bondholders would have to be compensated anyway if this happens, as a result of the guarantee. This would be an immediate liability and would almost certainly arise. To avoid this certain disaster, is it not better to guarantee the whole lot?

    Would it really be any different if the State were to just nationalize the bank (after which it would eventually have to sell the bank on for a pittance, and guarantee all its loans).

    None of these scenarios are pretty. Which one do you think is the least ugly?

  3. The Irish government setting up one bad bank has the (perhaps fatal) flaw that the transfer of each asset into it is a monopoly/monopsony transaction between the good bank selling th asset and the one bad bank. The valuation of each of these dodgy loans is very difficult. The measurement and control on over-payment by the state (financing the bad bank) is near-impossible. Perhaps the EU could enable several (say five) privately-owned bad banks to bid against each other to purchase assets from EU banks. There would still have to be some government subsidies; each state paying for the subsidy applied to the transfered assets of its domestic banks. The five bad banks could compete to purchase the assets at best price, using the fixed subsidy premium, and then compete on collecting on the loan assets over time.

    Doing this on an EU-wide basis has other advantages in terms of showing solidarity, without any need for cross-border cash assistance. It would only be in the setting up of the system not the funding of it that would have an EU dimension.

  4. What assets are attached to these bad debts? The Irish case seems different to the US case where the toxic assets are (simplifying) derivatives ‘backed up’ by subprime mortgages. In Ireland the bulk of the debts are linked to property developers. Presumably these debts are linked to schemes to develop land and these schemes are at different states of completion. The kinds of assets the debtors hold in Ireland appear to be more easily put to public use than the derivative/ sub prime assets. Do we know much about this? It seems to me to open up the possibility of making some use of the ‘real assets’ rather than just paying down the debt for the banks/creditors and leaving all the potentially valuable assets in the (apparently) ‘good banks’. I believe this is somewhat consistent with Karl’s previous points on the drawbacks of the ‘bad bank’ solution.

  5. The valuation is not the problem everyone makes it out to be. I will value the loans for you here and now.

    As of today, my valuation is a big fat zero, or if we are to be optimistic, slightly more than zero. As a portfolio, if you want to liquidate those loans today, they are basically worthless.

    Maybe if you were just selling one of them, then it would be worth something. (Say for a loan on development property in Dublin 4, it might be worth 30 or 40 percent of what was loaned). But the problem is that it isn’t just one loan we are talking about selling. There are thousands of these things out there, with a face value of hundreds of billions of euros, maybe more. There just aren’t enough riskophiles out there to buy all this super-junk at anything but the most minimal price.

    Again, this is an aspect of this being an international crisis. If it was just Ireland, the Germans, British and the Americans would undoubtedly pitch in and buy some cheap assets at the fire sale. But in this situation, there are very few parties in a position to buy from us, no matter what good value we are offering.

    What’s worse, by dumping all this paper (and effectively, the underlying property) or even establishing a low value on it, you are just going to undermine the whole property market all over again.

    So you say, let’s not value them en-masse, let’s value them as if we were selling them individually, and as if there were buyers. This is a ridiculous premise on which to value anything, but not an unheard-of one, so let’s proceed cautiously with this fiction.

    We put a notional value on the property, which is fairly low, but not zero, and not near zero. However, as a result of the valuation, someone (i.e. the government) is going to have to recognise a massive loss in one go. News of the scale of that loss will in itself cause a major upset and loss of confidence.

    Our valuation is also unhelpful if we were to sell the debt into the market that Gregory suggests. We will just find out that our low valuation was hopelessly bullish and that the new institutions are only willing to pay us a little more than zero for our ‘assets’.

    That’s why (I assume) governments think it’s better to hang on to the paper, and wait for things to maybe get better.

    The value of our super-junk is going to be further undermined by bad economic performance (and bad economic performance will create new bad loans in the non-property commercial sector). Goverments’ best chance to get maximum value for these loans is to get the economy back on its feet again. To do this, it needs to find a way to park these loans in a safe way, and gradually deal with them over a number of years.

    I still think the biggest issue we face is not a shortage of financial capital in our banks, but a shortage of ‘human capital’. We can always write a cheque to cover past mistakes (in fact we will have to) but who are we going to trust to build banks to finance orderly growth into the future?

  6. The question for me is – how can the government rig the market legally such that after the risk transfers to government, the value of bad assets rise because of regulatory or taxation or market changes within government power. Could the government for instance take ownership of foreclosed properties as bad assets and transfer them to local authority ownership as social housing using the property as a de facto capital grant, or in the case of industrial lands to the IDA or Shannon Development?

    Also – does the BABank being proposed preclude the purchase of bad assets owned by Irish banks but located outside the jurisdiction? Would EU law prevent such a decision?

  7. Ultimately the banks will have to be freed of the burden of unrecoverable debts if they are to stand on their own two feet again and not be wholly dependent on the Government’s guarantee. There will have to be new equity injections. Losses will have to be allocated between existing providers of risk capital and the taxpayer.

    The most important questions are not answered in the Indo leak. Where will the current providers of risk capital stand in the new structures? Will they have a claim on the bad bank? Will they retain a claim on the good bank (if not all of this valuation stuff becomes secondary). Looks like it’s all still to play for.

    We may expect to see this topic coming alive again post budget. Curious it should have been leaked now.

  8. William Buiter’s solution seems perfect. Almost too good to be true, but just glimpse at his CV and you can see he has to be taken seriously.

    http://blogs.ft.com/maverecon/2009/03/dont-touch-the-unsecured-creditors-clobber-the-tax-payer-instead/#more-804

    He points out that we could restructure the bank’s balance sheets without needing any taxpayer funding or insurance of any kind, and end up with some working banks that have sound balance sheets.

    The question is whether such a scheme could work for Irish banks. In theory, I don’t see why some sort of ‘new good bank’ couldn’t be ripped out of Anglo to get on with normal banking.

    Essentially, when a bank is effectively insolvent, the government simply hives off all the easy-to-value assets and liabilities and the branch network (taking slighty more assets than liabilities) to create new banks. The old banks are left with all the difficult-to-value stuff. And the ‘old bank’ owns all the equity in the ‘new bank’. This is what’s so nice about the plan – we just split each bank in two and rearrange their balance sheets. See his article to see a clear example of what he’d do with RBS. The ‘new bank’ will then be much more stable and will be given new senior management and can then easily get on with doing what banks are meant to do. The ‘old bank’ and its creditors cannot complain as they are given equity (but no control over) the ‘new bank’.

    There is much to recommend this plan, but I couldn’t put it any better than Buiter.

    Buiter has fantastic pieces, including a convincing argument to let the ‘old banks’ take the natural course, even if that is bankruptcy.

  9. As I have pointed out several times before, Buiter’s solution is exactly the standard US method of dealing with bust banks and not invented by him.

    His numerical solution for RBS works by hitting bondholders. Most (though not all) of the corresponding bondholders in Irish banks are currently guaranteed.

  10. Patrick, the Good Bank solution seems very different from a typical bankruptcy procedure. When split in two, in theory the Bad Bank could survive and all the bondholders are fine. It will, justifiably, have to fend for itself. Then we don’t care if the Bad Bank, with the incompentent management of old, goes bust; the branches and everyday customers were already transferred to the Good Bank. And crucially, the Good Bank needn’t be sold to a third party; the Bad Bank would continue to own (but not to control) it. I think the standard FDIC system involves selling the better assets in an auction to third parties.

    Bad bank, nationalization and insurance schemes are all worst case scenarios. But this Good Bank solution is something sensible that should be done immediately; we can then decide later what to do with the Bad Bank.

    Cheers Patrick for clarifying that this isn’t a new idea. Just after I posted it I asked myself “did I first hear of Buiter through this very blog?”. (Although I think I may have found him via the Financial Times). Buiter himself is always at pains to attribute the ideas to others. I didn’t intend to imply it was his invention. Thanks for clearing that up for me. I got a little carried away because I loved it so much!

  11. Blowing Bank Bubbles got Ireland into this mess so giving them more “money” “credit” to play with is really going to help…..

    I suggest you try the Iceland test: what would happen if Iceland got a new bank with billions in whatever passes for a currency there now. Who in their right mind is going to borrow into a depression?

    But this won’t apply to Ireland we are different. New paradigm. Fractioanal (sic) reserve lending…insane people!

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