Why a “Bad Bank” Could Be a Good Thing

The North American housing market needs more than a boost to rebuild itself. Can a big “bad bank” save us?

The United States Treasury has proposed establishing a “bad bank” – concentrating so-called “toxic” assets in a single institution. Why would this make sense – why would concentrating lousy financial instruments in one set of hands do anything but create a giant failure?

Start with one of the underlying causes of the financial crisis

The collapse of the market for mortgage-backed securities (MBSs) played a significant role in the meltdown. MBSs represent a very toxic asset. As a first step, some mortgage lenders were encouraged to lend to “sub-prime” customers – people who couldn’t otherwise get a loan. These borrowers were risky because they typically lacked the income to pay off the loan (plus interest), but they wanted to borrow so they could buy houses they couldn’t otherwise afford. Some undoubtedly expected their new home would rise in value fast enough they could always sell to get out from under their debt if they had to. Mortgage lenders compiled many of these loans into a single security. Think of the original loan as a claim, an IOU; by combining many into a single package, the lender creates a larger asset to sell to other investors. This package is the MBS. When investors bought an MBS, they were buying the right to a portion of many individual mortgage repayments. Unsurprisingly, some of these less than desirable borrowers failed to meet their repayments. When a few got in trouble, they sold their homes, driving down the market price. Any others who bought with the intention of reselling for a profit in the shorter run see (knowing they can’t keep up the payments), see the shift in pries, and decide to sell too, driving the price further down.

Perhaps as many as 30% of the sub-prime mortgagees defaulted. In a normal market, the owners of the MBS would face a loss of 30% on their investment. MBSs would drop in price to reflect the lower value. That didn’t happen. Instead, the price tanked. No one knew what the percentage of defaults in each particular package of mortgages was, or was likely to be. Since the chance of repayment was likely to be a 30% loss but could be much higher, no one would buy them – everyone wanted to sell. That’s no market at all. These securities became worthless (“toxic”).

De-tox

Since people are uncertain about the relative value of these mortgage-backed securities, the bottom dropped out of the market. With everyone trying to sell the same type of product, and too few buyers, the price fell close to zero. Concentrating these assets in a single actor’s hands serves two important purposes. By buying them for any price, the government turns the sure loss into a small gain, improving the books of the commercial financial actors who hold them.

By concentrating these assets in a single institution, the “bad bank” can return them to value because the underlying source of income in these mortgage-backed securities remains above zero. The market failed here because of uncertainty about the mix of mortgages bound together in each security. By putting them into one owner’s hands, the securities can be unraveled. The bad mortgages can be separated from the worthless ones, so the losses can be realized – leaving gains to be realized as well. Even if half the sub-prime mortgages go into default, the other half still generate income.

Takeaway Points

i) The longer the delay, the worse the underlying problem gets. The problems at the bottom with mortgages triggered a financial crisis. The financial crisis kills business activity. The drop off in business activity leads to unemployment, which leads to more mortgage defaults at the bottom. Stimulus spending may slow this chain reaction, but hasn’t yet broken it.

ii) MBSs were sold internationally. Will an American “bad bank” be able to unravel the mess if it doesn’t buy up “toxic” assets owned by foreigners, but originating in the U.S.? Will American taxpayers foot that bill?

iii) The U.S. is learning from the experience of Sweden in the 1990s, which used a “bad bank” to resolve similar financial problems. It’s a reassuring sign that this American administration really will listen to the advice of others.