The Winning Idea Of The "Bad Bank"

Now that Bank of America (BAC) has been given $20 billion more capital from the government in addition to about $118 billion in guarantees against toxic asset losses, the subject of whether the government will end up owning big banks is back in the headlines.

The government set up a loss sharing of $301 billion for Citigroup as it announced over $8 billion in losses today. It will also give the firm a series of loans, if Citi needs them. And, it will.

Bank of America has a market value of $42 billion. Why shouldn’t the taxpayers end up owing at least a third of the company for their $20 billion? In Citi’s case, the Fed may end up with the equivalent of a 50% share.

The government has avoided answering the question of ownership by putting cash into preferred shares which can convert to common stock or be bought back by the banks. This creates the illusion that the "ownership" issue has somehow been deferred, perhaps to the day when banks can redeem the Fed’s investment.

If the assets of banks continue to lose value due to failing consumer credit, corporate bankruptcies, and dropping real estate values, the idea of guaranteeing toxic assets really begs the question of government ownership of these banks. In the UK, the government is considering buying the worst assets from financial firms and putting them into a so-called "bad bank", a cesspool of loans and derivatives which may continue to lose value and drain bank reserves.

The trouble with the bad bank idea is that the government would fairly expect something in return for taking worthless paper from the financial companies. This brings the program of the government providing capital to saving banks back around to the idea that the Fed will own more equity in the nation’s banks. All of the roads to saving the banks lead to the same place. Taxpayers will own the core of the banking system–the largest banks in the country.

Nationalization of banks has been discussed for months now. The government is reluctant to take over banks and control the course of private enterprise. It does not matter. That is where the road ends. Money from the TARP will inevitably increase the government’s skin in the bank game.

Taxpayers can only hope that the banks reclaim their value in the next two or three years and that private capital will want to buy the government’s stakes.That would be part of a normal economic recovery cycle. Companies which have lost most of their value become attractive as the rising tide lifts all boats.

The country’s banks will be owned by the government in one form or another. The only question is when can these banks become private enterprises again.

Douglas A. McIntyre