The key to making the bad bank work is the gap between private interest rates and government interest rates, Sheila Bair argues in a revealing interview with the The Washington Post today.
Bair says the “bad bank” would buy troubled assets at levels above what the market could pay because the costs of financing by the government are much lower than those by private investors. This is undoubtedly true. The question is whether or not this will be as effective as Bair hopes.
First, let’s clear away all the confusing nomenclature. Bair likes to call it an “aggregator bank.” Others prefer the term “public-private partnership” because they think they will be able to get private investors to invest alongside the government in the troubled assets purchased from financial institutions. Whatever you want to call it, and however it is actually managed, the idea is the same: have a government entity buy up assets from banks at prices above what they could get on the market. The banks would take some losses because they still have the assets marked at unrealistically high levels, but not as much as they would if forced to sell them privately.
Bair thinks the cost of financing purchases is at the heart of the difference between what banks think their assets are worth and what investors are willing to pay. She said the government can eliminate that portion of the difference by providing low-cost financing.
“One of the reasons that prices are distressed right now is because of the lack of financing to make purchases,” Bair tells the Washington Post. “The government, by providing low-cost funding, it will help to tease out that liquidity premium from the pricing and hopefully get the pricing a little higher.”
The biggest potential stumbling block is whether or not the difference in borrowing costs is enough to bridge the gap. There are plenty of warning signs it won’t be. If a bank holds on its books a mortgage backed security at 89 cents on the dollar that the market prices at 60 cents on the dollar, the gap is far too broad to be bridged by this kind of borrowing cost arbitrage. Even if the government paid the full borrowing cost difference to a bank, and let’s say that was as high as 1500 basis points, the bank would have to huge losses on the sale. Many banks may be in such poor financial health that taking such losses could render them insolvent or below regulatory capital requirements.
Why doesn’t Bair see this as a problem for her bad bank plan? On the one hand, she doesn’t understand the severity of the problem at banks (which is frightening for someone in her position). On the other, it seems that Bair, like so many top officials in the Washington, is operating under the conviction that toxic assets are really worth much more than anyone is actually willing to pay for them. But since many bankers believe the very same thing, they’ll be unwilling to part with the assets except at highly elevated prices. So we have a kind of dangerous contest where the bad assets will wind up in the hands of whoever is most confident the market is mispricing the assets.