"Bad Bank"? A Bad Idea

The country already has enough bad banks -- Bank of America ( BAC - Analyst Report ) and Citigroup ( C - Analyst Report ) , for starters.

OK, that's just snarky, but we do have an existing mechanism for a bad bank -- it is called the FDIC. If a bank makes too many bad bets and becomes insolvent, the FDIC comes in. The insured depositors get paid off, or transferred to a healthy bank. The branches and other physical assets get sold to other banks. The shareholders of the insolvent bank are wiped out and the uninsured depositors and other creditors take a haircut.

If that is the plan, I have no problem with it. If, given the scale of the problem, some new entity (let's call it "RTC2") needs to be set up to hold these assets until they either run off or can be sold back to the private sector, so be it.

However, as I read it, that does not seem to be the plan. The new "bad bank" that is being proposed seems like a replay of Hank Paulson's misbegotten 3-page plan of last fall. The government would buy up the existing "toxic assets" from the existing banks and hold them.

The problem is: how much do you pay for these assets? If you pay market price, then the bank is insolvent, and you are back to square one. If you pay more than market price, it is simply an inefficient way to give a gift to the bankers who got us in to this mess in the first place.

If you bought 100 shares of XYZ Corp. six months ago at $100, and they are currently trading at $50, and then I come in and buy that stock at $75, I am giving you a gift of $2,500. This is true even if my cost of capital is lower, or if I have a computer model that says that XYZ Corp is undervalued at $50 and is "really worth" $80. It is a lot easier to see with openly traded and straight forward assets like common stock, than it is with thinly traded, obtuse, opaque and complex assets like some of the toxic assets, but the principal is the same.

The second approach that was done with the first half of the TARP was conceptually much better than overpaying for lousy assets, it was just very poorly implemented. The problem is that the banking system is almost insolvent system wide. Some banks are very deeply insolvent, and others are in better shape. But the scale of the losses that are hidden on the books of the banks exceeds their equity, even with the money already injected.

The answer, then, is to provide more equity to the banking system. With a leveraged balance sheet, a decline in the value of assets reduces equity much faster than it reduces assets, which further increases leverage, until equity reaches zero, leverage becomes infinite and the entity is insolvent. If a balance sheet is levered 30:1 and you want to spend 1 to reduce leverage, you don't subtract the 1 from the 30 (to get to 29:1), you add it to the 1 (to get to 15:1). It's called getting the most bang for your buck -- or billions of bucks, as the case may be.

However, the Treasury should get a market price for the investment. Last fall, Warren Buffett invested $5 billion in Goldman Sachs ( GS - Analyst Report ) ; two weeks later the TARP program also invested $10 billion. However, Buffett got a bigger percentage of Goldman, and the same number of dollars in dividend payments for his $5 billion investment than the Treasury did for its $10 billion investment.

So far, both investments have proved to be turkeys as the value of GS has slid significantly since then, making the warrants very far out of the money. However, any way you slice it, we got a far worse deal than Buffett did. The next tranche of the TARP could easily, at current prices, be sufficient for the taxpayers to become 50% owners of all the major banks in the country. The existing shareholders would be severely diluted, but the banks would be better capitalized and in the position to lend again.

The government would also then be in a position to stop the obscenely high salaries and bonuses that are paid out up and down Wall Street. This would also help firm up the capital position of the banks. Common dividends would also be eliminated for several years. A few years from now when the economy has recovered, the Treasury could sell off the bank stock and use the proceeds to pay down some of the ballooning federal debt.