Bring On The Bad Bank

To those of us that were around in the late 1980’s and can actually still remember what the acronym RTC stands for (Resolution Trust Corporation), this week’s talk of creating a so-called “bad bank” to help solve the credit/banking crisis sounded like a pretty good idea. After all, the plan has historical precedence and it seemed to work for both the good ‘ol USofA and Sweden during previous banking crises caused by real estate.

To be sure, the current problems we are facing are not exactly the same as what we saw here in the U.S. during the S&L crisis or those in Sweden during the early 1990’s. However, as the saying goes, while history may not repeat itself exactly, it often rhymes.

Wall Street certainly seemed to like the idea as the fortunes of the stock indices appeared to rise and fell with the status of the “bad bank” plan last week. For example, after Tuesday’s close, CNBC’s “old professor” Steve Liesman reported that the Obama Administration was close to deciding on a plan to create a “bad bank.” Then on Wednesday, the Washington Post said that Obama’s advisers were in the final stages of debating options including the “bad bank” approach. And then early Thursday, Reuters reported that the administration would roll out a plan nearly next week.

The talk of a “bad bank” was good for gains of about 3% - 5% on the major indices as the bulls argued that the plan represented a light at the end of the credit crisis tunnel.”

However, once reporters began digging into the story, it became clear that the “bad bank” idea may have been in the trial balloon stage last week. Stocks tanked in response to being toyed with and the Dow finished with the worst January on record, falling by -8.83% for the month.

So, is the “bad bank” a good idea, or simply another attempt by the administration to gain the confidence of the public?

Historical Perspective

Perhaps the best thing the BadBank USA idea has going for it is the fact that the plan has worked in the past, both here and abroad. Thus, it would stand to reason that the announcement of such a plan could be a confidence booster.

In 1989, the Resolution Trust Corporation (RTC) was set up by the US Government. The company was charged with the task of liquidating real estate-related assets and mortgage loans that had been on the books of S&L’s declared insolvent by the Office of Thrift Supervision as a result of the S&L crisis.

According to Wikipedia, the Resolution Trust Corporation pioneered the use of so-called “equity partnerships” to help liquidate real estate and financial assets which it inherited from insolvent thrift institutions. These equity partnerships involved a private sector partner acquiring a partial interest in a pool of the “bad” assets, controlling the management and sale of the assets in the pool, and then making distributions to the RTC reflective of the RTC’s retained interest.

From 1989 through mid-1995, the RTC “handled” nearly 750 S&L’s with assets totaling almost $400 billion (which was a pretty big number at the time). And in short, the S&L Crisis eventually went away and the stock market, as well as the economy flourished.

The Current Plan

This time around, the plan would be similar as the “bad bank” would essentially buy up the toxic assets that have been weighing down bank balance sheets and then sell them off over time – hopefully making a tidy little profit in the process (perhaps this explains Bill Gross’s giddiness every time he talks about his firm “shaking hands with the government”). The idea is if worry over capital requirements can be eliminated, then banks might be able to return to the task of lending money.

Another benefit of the plan is said to go straight to the heart of the current economic difficulty – the housing market. By putting mortgages that are in default in the hands of the folks able to print money, BadBank USA could more easily rework the terms of mortgages and put an end to the downward spiral of mortgage delinquencies leading to home foreclosures, which leads to lower prices. And maybe, just maybe, if the foreclosures were to stop pushing prices down, we might see a bottom begin to form in housing prices.

At What Price?

To be sure, this is not a simple undertaking and on Friday it was reported that the plan might be stalled because no one can figure out how to “get ‘er done.” There are two questions at the crux of the dilemma. First, what price would BadBank USA pay for the toxic assets? And second, what’s this grand plan going to cost the government?

Since everyone knows that the current pricing for the alphabet soup of bad assets including CMO’s, CDO’s, and MBS’s is based on fire sales and forced liquidations, one idea is for the government to “pay up” a bit for the assets. This would help the banks by adding capital, which in theory anyway, would help them get back to lending.

However, as in any transaction, if BadBank USA pays too much for the assets, the return on the taxpayer’s “investment” will be negatively impacted. Thus, the dilemma becomes one of whether to focus more on getting the banking system healthy or the taxpayer making a buck. (Insert political opinion here.)

Then there’s the issue of the total dollars needed in order to fund this puppy. Estimates are all over the map, but given that the first Citigroup rescue cost more than $300 billion, you can rest assured that we are talking about trillions of dollars here. Most estimates are in the $1 trillion to $2 trillion range; however in a research report to clients last week, Goldman Sachs put the number as high as $4 trillion.

Bring It!

Although the administration probably doesn’t spend much time looking at the charts of the stock market, given that the Dow now finds itself sitting near the “line in the sand” that has been established over the past two weeks, one could argue that if a plan is not presented in the next few days, the line will break and a full-fledged retest of the November 20th lows will be the order of the day.

Remember, one of the things the stock market hates most is uncertainty. And with the stimulus package considered questionable at best in terms of its ultimate effectiveness , the last thing the market needs right now is uncertainty over whether the government is going to take the right course of action with the banks.

Thus, it will suffice to say that the focus of the market in the near-term will be the status of BadBank USA and/or any other plan that the economic dream team comes up with. So, stay tuned, this ought to be interesting.

Wishing you all the best for a profitable week ahead,

David D. Moenning
Founder TopStockPortfolios.com

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