Friday, January 30, 2009

The "Bad Bank" Plan

The aggregator "Bad Bank" plan is a horrible idea for most banks, especially those who are still hiding their bad assets in level 3 instead of those that have marked to market. The problem is simple: Bad banks have not written down their bad assets to market levels for fear of insolvency. If they were to mark their debt down to market, they would be well underwater and would have to be taken over by the FDIC and liquidated into the market (which is what would happen ideally). But these banks are most politically connected banks with the most toxic unsecured derivatives out there (Goldman, Bank of America, Citi, JPMorgan, etc.) If one of them were to fail, all of them would go under because they are all counterparties to each other in their credit default swap charade. Therefore, they are threatening the government with financial system meltdown if the government will not support them.

Back to the problem. The bad bank plan requires the banks to sell assets at some "value" probably determined through some auction process. Unfortunately, the "assets" are really only worth a few cents on the dollar which will require the banks to realize huge losses that they didn't want to take in the first place and are hiding at inflated values in level 3 (marked to whatever you pull out of your ass vs. marked to market). An auction is a problem if you are in a free, highly competitive market. It would force you to sell assets at meltdown prices (the real market value) because people just want to get the junk out of their hands at any cost if they are solvent so they can go on with life. Selling the assets at meltdown prices into a highly competitive market is a bad idea for a bank that wants to continue operations. So what would you do if you were in this situation?

The good thing for these banks is they have political connections and they basically control the policy of the Federal Reserve. If I were a banker, I would want to continue the policy of "treasury for trash" swaps into infinity and inflate the hell out of the money supply so eventually I could cover the cost of the losses over a long period of time by just inflating the problem away.

Or, I would use my political connections to create an auction process where all participants are colluding to maintain high values (70 cents on the dollar) on worthless assets (0-10 cents on the dollar) in order to dump losses on taxpayers. The auction process would involve only the largest participants (Citi, JPM, BofA, Wells, etc.) and would have a facade of a real auction to project to the dumb public the idea that there really is a value for the worthless paper that I was holding, it just wasn't reflected in the market because of "illiquidity". We would all collude and set a price that was the best we could all get given a certain amount of funds. Then I would ask the government to recapitalize my bank (and the others) to ensure that I was able to continue my bad lending habits. All of this would be agreed upon in private prior to the actual auction.

An auction process with limited participants and lots of collusion creates inflated prices (remember economics, game theory, market structure?) This would be an easy sell because it looks at least a little like a free market type of gambit and my humongous bank has a lot of politicians on the bankroll. Unfortunately for the little guy, it probably means a really high inflation tax bill, all to pay off assets that were worthless that my local congressman deemed appropriate to spend trillions of dollars on.

I fully expect a plan like this to come out very soon because it is the best option for the big banks to dump their pile of shit with the least amount of damage to their balance sheets.

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