The Final Bank Plan is Emerging

From the WSJ:

The administration's plans have evolved over the past several weeks as it has considered and discarded a host of ideas, with financial markets anxiously awaiting details. Mr. Geithner had planned an announcement Monday but delayed it a day to allow the focus to remain on the stimulus bill in Congress.

The aggregator bank, which some refer to as a "bad bank," would be designed to solve a fundamental challenge: How can banks purge themselves of their bad bets without worsening their weakened condition?

The entity would be seeded with funds from the $700 billion financial-sector bailout fund, but the idea is that most financing would come from the private sector. Some critical elements remained unclear, including exactly how the government would entice investors to participate in the private bank, given that they can already buy soured assets on the open market if they want to. The government will likely offer some type of incentive, such as limiting the risk associated with buying the assets.

Let's start with the basic problem: banks have a ton of assets on their books that are dropping (and have dropped) in value. As these assets have dropped in value, banks have had to write them down, or increase their loan loss reserves. When they do this they hurt their balance sheet, thereby preventing them from making loans. It's also important to point out that in a recession loan demand drops as well. However, the current structure of bank's balance sheets is certainly not helping matters.

So -- how can we get these assets off the banks' books in a way that costs the minimal amount of pain? There aren't a lot of options here. Either:

1.) We keep the assets on the books: The problem with this option is we haven't done anything to cure the problem. The assets that are dropping in value and pulling capital away from a bank's capital base are still dropping in value and pulling capital away from the bank's capital base. The only way to cure the problem this way is to pour enough capital into a financial institution to account for the loss in value from bad assets and give the bank enough money to increase its reserves and thereby start making loans (if the demand is there). The fact that this hasn't happened yet indicates one of two things (and probably a combination thereof). We don't know the extent of the losses from bad assets and the cost is a lot bigger than we want to admit. Several commentators have mentioned the cost would be in the multiple trillions. While I personally dismissed these appraisals at first, they are starting to make more and more sense.

2.) We buy the assets and take them off the banks' respective books. This solution runs into a basic problem: valuing the assets properly. The first bad bank idea failed because there was no way to value the assets without leaving somebody holding the bag. If the bad bank paid market value they would force the selling bank to take too large a hit to its balance sheet. If the bad bank paid too much the taxpayer would be stick with the bill.

A trend is emerging in both of these options: no one is coming out and saying the current value of a large swath of bank assets is a lot lower than anyone involved in the process wants to admit. That's the real central issue here. And until we deal with that no plan will be 100% effective.

Let's continue:

The aggregator bank, which some refer to as a "bad bank," would be designed to solve a fundamental challenge: How can banks purge themselves of their bad bets without worsening their weakened condition?

The entity would be seeded with funds from the $700 billion financial-sector bailout fund, but the idea is that most financing would come from the private sector. Some critical elements remained unclear, including exactly how the government would entice investors to participate in the private bank, given that they can already buy soured assets on the open market if they want to. The government will likely offer some type of incentive, such as limiting the risk associated with buying the assets.

.....

The Treasury's working theory for the government/private-sector partnership is that investors wouldn't overpay, because if they did, they'd stand to lose money; but they also wouldn't underpay, since the selling banks wouldn't be willing to part with their assets too cheaply.

Here's a really big problem with the above idea: there is no guarantee any bank will sell the bad assets to the institution. While the investor (the government/business bank) may be thrilled at the possibility of buying really cheap asses, there is no guarantee banks will actually sell highly devalued assets to the bank. In other words, we're back at square one.