Bad Bank Snag, Nationalization, Nothing But Questions

Everyone waited last week for the government to set up a "bad bank" last week where banks and major financial institutions would get to sell their toxic debt and credit instruments. So, it won’t shock many of you that there have been problems with this idea.

The prices to be paid for these assets were seen as too high.  The "N WORD" for "nationalization" is unfortunately becoming a growing risk for investors. Here is what seers like Julian Robertson, Meredith Whitney, Bill Seidman, Jamie Dimon, Bill Gross, and others have to say about it.

There was a very mixed bag of reactions from the start.  Wall Streetwants a bad bank.  Main Street wants a bad bank.  The Obamaadministration wants a bad bank.  Yet the obvious hurdles are creatingan untenable situation. 

Yesterday, there was a rather sobering interview on CNBC with financialsage Julian Robertson.  He wants a "good bank, bad bank" system andwants it fast.  He warns that the US is in a "Japan of 1989" situation,only worse and with more fallout that could tip us over the edge.Robertson actually tones down the net impact of what would happen undera nationalization plan.  Bill Gross argued that the cost of borrowing by Uncle Sam that could be much higher down the road.

Jamie Dimon of JPMorgan Chase was not very gung-ho on the notion of a badbank, but did note some merits.  He was also hinted that "other unhealthy" bankscould use it. He said JPMorgan didnot want capital and that the Bear Stearns buyout was not justsuggested.  We talked a year ago about financial mergers being mandatedrather than preferred.  We admit that a few of those that were deemedhealthy at the time ended up being among the rubble.

Bill Seidman is a former FDIC Chairman who dealt with many troubledassets after the S&L crisis of the 1980’s pans the notion of a bad bank  He points out that "price" will get in the way and thatmany banks will not participate because the losses will come at toogreat of a cost.  His idea is for a bridge bank where the governmentseizes insolvent banks and then sells them back to the private sector.

Seidman’s idea is the most logical in free market capitalism wheresystematic risk is kept at bay, but there is one real problemhere.  First off, the government would be seize too many banks and the attempt to avoid systematic risk would probably toppleupon itself. There are very few buyers out there in today’s climate.Those instant losses will create waves of bankruptcies and will likelyhave counterparty ripple effects all through the system.  The solutioncreates the same problem.  Lastly, even with all the money that is onthe sidelines there are many who think there is not enoughcapital to buy all of the distressed assets at fire-sale prices.  Intheory, would the healthy banks open credit to the creditworthy to buydistressed assets?

Star banking analyst Meredith Whitney of Oppenheimer joined the ranksof those who are against the "bad bank."  She had a note thisweek that has some actual praise for the plan, but it isobvious she thinks the situation gets worse either way.  She argues that the bad bank program will not address thecontraction of capital in the financial system.  Whitney believes thatthe banks will still be left with much lower earnings power from higherloses on what they consider as the good loans or from a lower assetbase.  Whitney would rather see thebanks sell of valuable assets to cover their losses.  CNBC’s DavidFaber noted that Meredith Whitney is now referring to the "bad bank" asthe Bank Asset Repository Fund.  Yep, the acronym would be the "BARF."

The pundits all worry how thegovernment will value the bad assets.  In short, ifthe assets were priced at what they are really worth, banks will refuseto participate or will realize actual losses that would be too great toparticipate.  And if the assets are priced too high, then Uncle Sam isscrewing over the taxpayer base by overpaying for bad assets.  It isalmost a financial "kobayashi maru" for financial Trekkies. Lendingstandards are also now significantly tighter.  The money is coming out ofthe system and lending will contract whether a bad bank exists or not.

Nationalization of the banks may be an inevitable outcome.  One notionwe want to stress is that while everyone is scared of nationalization, there is not even a real consensus of what it would end up looking like.

Banks and lenders acted irresponsibly.  This goes from credit cardofferings, to mortgages, to credit lines.  Borrowers are equally atfault.  They lined up for unlimited free money and took on too muchleverage for assets that were artificially priced higher.  And thegovernment mandate through the end of the 1990’s and into the firstpart of the 2000’s was encourage home buying.

Somehow that notion of universal ownership wound up getting people living paycheck to paycheckto make up income to get a mortgage. Young school teachers got interest only loans to buy $400,000 homes. People turned their houses into piggy banks with home equity loans on the foolish theory that prices would continue rising.

Bring the bad bank.  Don’t bring the bad bank.  What is obvious is thatthere has to be a lot of pain in the system and there has to be awashing-out process.  This is called the hangover phase.  And thishangover will be worse than other hangoverphases because the party went on much longer, and everyone at the partyused more substances besides booze.

A bad bank in some form or fashion is likely to come.  But the banksare not eager to participate because the pricing will likely show thatmany are suddenly insolvent or are on the verge of insolvency.  Obamadoesn’t want a systematic ripple.  Wall Street doesn’t want anythingbut a child’s notion of "Do-Over!" 

More and more on Main Street wantthe institutions to pay and there is a growing lynch-mob attitude thatseems like a reality TV show where everyone gets voted off the islandwith no real consequences.  This can’t work the same way.  Someone hasto ultimately blink here.

It seems now that all parties are getting caught up over executive pay, bonuses, and office decoration expenses.  These are majorproblems, but they are obscuring the end problem.  Smart investors whohave been patient and financially conservative so that they could takeadvantage of the mayhem need to start figuring out what a "bad bank" oreven a nationalization scenario will mean for asset prices.  And the"asset prices" need to ultimately be determined by the free markets.That is nowhere near the case today.

Jon C. Ogg
January 31, 2009