So I saw a link to this article, explaining what a "bad bank" was. Only, I initially read the headline as "bad idea" bank, which I thought was actually much more indicative, descriptive, and factual (so I was somewhat disappointed with the actual piece, which was fluffy, misleading, and not particularly interesting). So, here's my revision. :)
Obama's 'bad idea' bank: What it is, how it would work and its potential drawbacks
February 6, 2009
As President Obama's administration considers its next step to help a troubled economy, one of the ideas being considered is the creation of a "bad bank" to help the financial sector. Here are answers to some of the key questions that surround the proposal.
What is a bank?
A bank is a place where people put their money and, in exchange for the bank's use of the money, earn interest. Banks use their customers' deposits to make loans, usually to big corporations, and as collateral for borrowing more money, which they can then invest. Banks also use that money to buy and sell leveraged investments, sell derivatives, and essentially gamble on borrowed money to try to maximize the returns for their executives in the form of fat salaries and bonuses. Sometimes these bets don't work out well, in which case the government pays them off instead with taxpayer money.
So what is a bad bank?
A bad bank is created -- usually by the government or an agency -- to store assets that are worth less than their face value in the hope that over time they will be worth more than they are now. In this case it's not really a hope: the assets are largely already worthless, and everybody knows it. Their face value is whatever the bank says it is, in order to appear to be less insolvent than everybody knows it is.
Where do these bad assets come from?
A poor economy can create bad assets in many ways. For example, banks could give loans for million dollar homes to people who didn't have jobs, because they didn't care since they were securitizing the loans and selling them as highly-rated securities to investors who relied on the fraudulent colluded ratings. Or, the value of a house, which was bought during the peak of the enormous housing bubble at over 5x historical average valuation, corrects enough that it is worth far less than the mortgage. Or, the bank could have purchased a derivative with borrowed money secured by its deposits which is now worthless because the entity they would collect from (eg: another bank) is effectively bankrupt, and only still in business because of fraudulent accounting allowed by the government. In general, when a bank loan or investment cannot be recouped by foreclosure (or otherwise collecting on the asset securing the loan, if any), it is considered a bad asset.
Why would we want to put all of the bad assets in a single bank?
Putting all of the bad assets in one place frees up all the other banks, which are reborn with a clean balance sheet. With a good bottom line, banks can again pay their executives their enormous salaries and bonuses, and get back to leveraged gambling to maximize their returns. If all goes well, the banking sector gets stronger, there's no effect on the economy, and taxpayers get raped in the ass repeatedly with the largest telephone pole in financial corrupt insider payoff history.
What are some of the potential drawbacks?
The biggest issue is how to value the bad debts. The bank wants the value to be as high as possible so it can get funneled as much taxpayer money as possible. But a high price means that the bad bank, or government, pays more money for the worthless assets; and, depending on the future market, might mean that there's less money available to waste on other massive pork spending programs. Then again, since the government is printing new money in both cases (not to mention the Trillion+ deficit this year alone), that problem is already being dealt with at the expense of the longevity of the US currency.
So bad debts should be valued at a lower price. Is there a problem with that?
A low valuation means that similar debts, still on the good banks' balance sheets, are also worth less. Too low a price means that the bank won't have enough capital to make loans, which was the reason for creating the bad bank in the first place if you're a total moron, don't understand how anything in the lending market is working, and/or are a sociopathic liar. Too low a price really means that you risk the banks being revealed as insolvent, forcing you to print more money and manipulate the accouting standards further to keep them afloat long enough to pay for the next round of executive bonuses and retreats.
Has a bad bank ever been tried before?
Yes, both in the United States and abroad. The Resolution Trust Corp. formed in the wake of the savings and loan crisis of the 1980s was a form of bad bank. In that case, however, the low asset valuation was caused by a lack of confidence in the system, rather than a complete loss of value of the underlying assets which caused the current problem. However, massive government bailouts to prop up bubbles have certainly been tried before: see Japan in the 1990's through today, and the US in the 1930's.