Archive for June 4th, 2009

Bank Detox Halted

Thursday, June 4th, 2009

“The Federal Deposit Insurance Corporation indefinitely postponed a central element of the Obama administration’s bank rescue plan on Wednesday, acknowledging that it could not persuade enough banks to sell off their bad assets,” according to The New York Times. The Times reports that the cancellation confirmed many oberservers’ suspicions that the program may not work.

Among those skeptical of the plan at the outset was Smeal’s Jean Helwege, who wrote for Business Casual in March that the plan’s success depended on how well the Obama administration pressured the banks into writedowns.

From Helwege’s March 26 entry:

A critical part of the Treasury plan to remove the toxic assets is participation by the banks.  One has to wonder why these assets, which have been weighing them down for well over a year, have not yet been sold. One potential problem is a lack of liquidity: Few financial institutions have the funds available to buy them. Thus the Treasury has moved to provide financing in its auction. However, another possibility is that banks are reluctant to sell the assets. Bank regulations provide perverse incentives to troubled banks: Even when the banks and the market know the true value of a bad loan, banks resist writing down their assets to avoid having to raise more capital to secure deposits.

As long as few toxic assets are trading, bank regulators cannot easily prove that banks are operating with faulty balance sheets. Suppose a bank makes a $100 loan that subsequently goes bad. If the bank reappraises the loan at $60, it must find an additional $40 in capital to maintain its regulatory net worth. As bad as that sounds, a Treasury-sponsored auction that reveals a value of only $30 would be even worse, as it might indicate insolvency and thus lead regulators to take over the bank. Some banks would rather not participate in any plan to clean up toxic assets if the asset values they record in their books are still far from the true market values.  Instead, they will prefer to wait for recovery, no matter how slow.

Whether the plan works or not depends crucially on banks’ incentives to participate, and this in turn depends crucially on how well bank regulators have succeeded in pressuring banks to write down assets to reflect the true losses. Treasury efforts to entice buyers with subsidies and loan guarantees will help bring them to the auctions, but their profits from buying cheap toxic loans will not materialize if the banks stay away. As infuriating as these subsidies are to American taxpayers, things could be worse if banks refused to cough up the assets on which Wall Street vultures hope to profit.

Tags: Banking, Economic Crisis, Finance, Helwege
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