Meredith Whitney today punches a big hole in the notion that creating a bad bank to buy up troubled assets will rescue our financial system. And it certainly won’t prop up failing banks. The problems at banks are deeper and broader than just too many bad structured mortgage products on the balance sheets.
- Financials have lots of loans that are likely to default.
- They don’t new have a revenue model to replace the old, broken one.
- They won’t start lending just because you buy the bad assets.
Here’s the report from Meredith Whitney:
Talks of creating a “bad bank” are once again gaining momentum, and accordingly, we feel compelled to repeat and review our thoughts on the subject. In brief, simply removing “toxic” assets from bank balance sheets will not directly cause banks to increase lending. Lending standards have tightened dramatically, and there is an unavoidable restructuring of risk taking place. Such causes money to come out of the system and lending to contract, with or without this “bad bank” structure. Lower asset bases, higher credit losses, and bloated expense structures will continue to pressure banks’ earnings power and capital creation. We remain cautious on the group. KEY POINTS
- Capital contraction is accelerating throughout the U.S., and the economy is clearly showing the results of such. The economy will recover when the capital base or “denominator” reverses course. We do not believe a “bad bank” structure addresses the root problem of contracting system capital.
- Writedowns from structured securities and illiquid assets is only one challenge related to the commercial banks. A challenge of equal importance is rising defaults from on balance sheet loans. Due to the pro-cyclical nature of loss reserving, banks are required to build reserves when their earnings power is weakest.
- If a bank were to sell its “bad” assets into a “bad bank,” it would still be left with lower earnings power from higher losses on “good loans” and the requirement to build reserves, lower earnings power from lower assets and a higher legacy expense structure, or both.
- The greatest unknown regarding the “bad bank” is at what price the gov’t would pay for “toxic assets.” If the government elects to pay fair market value, the banks will likely not elect to participate as capital hits would be too dear; however, if the gov’t pays above market, the burden on an increasingly “taxed” taxpayer grows.
- We would be most encouraged by banks selling “crown jewel” assets to cover their own losses. We believe private capital will readily invest in businesses that make money and grow. However, the banks do not fit this description. We remain cautious on the group.