In an oped in today’s Washington Post, Peter Ackerman and John Vogelstein argue for a large good bank/bad bank approach to toxic assets:
In 1988, we participated in a fundamental restructuring of the Mellon Bank that holds many lessons for today. At the time, the market had no confidence regarding the size of Mellon’s asset problem. Instead of trying to convince investors that Mellon’s assets were valued accurately, chief executive Frank Cahouet asked that an entity be designed to hold all of Mellon’s nonperforming loans.
The Grant Street National Bank (In Liquidation) was formed, capitalized with Mellon’s troubled assets and financed as much as possible through debt secured against those loans. Over the next several years, loans were sold expeditiously to private buyers. Substantially all of the proceeds from the financing and the remaining liquid assets after debt repayment went back to Mellon.
Once Mellon no longer had nonperforming loans on its books, the write-downs taken by the bank from asset transfers into Grant Street could be quickly replenished through equity offerings. Mellon did not go through the trauma that other major American banks (including Citi) experienced in the early 1990s. Despite the dilution from the sale of new equity, its stock went up more than tenfold when it merged with the Bank of New York.
This “bad bank” model has been repeated many times since. The concept was used in the savings and loan bailout and in Korea in the 1990s.
They go on to explain in more detail how this might work — I won’t repeat the whole thing. I would like to highlight their conclusion:
In the early 1990s, the Japanese government encouraged banks to keep nonperforming loans on their balance sheets and value these loans as if they were not impaired. The loss of transparency (as well as the failure to put these loans into the hands of those who would restructure them) contributed to over a decade of slow growth and an underperforming stock market.
The Obama administration should not make the same mistake. If its economic team uses TARP to enhance price and value discovery of mortgages held in the banking system, we will be a lot closer to the end of the financial crisis.