Eve, please let me warn you beforehand.

I am at the moment not so overly interested in discussing the global economy, since I have actually to sort out other things, plus I am not an expert. On the other hand – given the circumstances – it seems everybody is somewhat forced to think about what’s happening there. So let’s make some procastrinating comments to the situation.

But as Mr. Ackermann of Deutsche Bank outlined here the best economic analyses seem to come from people who earn – due to their capabilities – more than 18 times than me. Means if you multiply the factor 18 by an unknown Nad-procastrination/non-expert factor than this gives you a measure of how useful my comment on bad banks is:

The term “bad bank” is a bit ambiguous. Bad banks are thought to be banks who would buy – as we call it in Germany – “poisened papers” (Giftpapiere) that is value certificates/papers/assets whose real value is probably much less then their actual value. The bad banks are intended to be fueled (with money) by governments:

Officials from the Obama administration are holding around the clock meetings with senior Wall Street executives on how to create a new government bank to buy bad assets from major financial firms.

However other people, like Niall Ferguson claim that they already exist:

Wir haben doch schon eine Bad Bank – die US-Notenbank Fed. Sie kauft den Banken seit geraumer Zeit Giftpapiere in einem gigantischen Ausmaß ab: Ihre Bilanz ist seit August 2007 um 150 Prozent gewachsen, auf mehr als zwei Billionen Dollar. Natürlich sagt Ben Bernanke nicht, was er da genau kauft – er kann praktisch derzeit tun, was er will. Was wir erleben ist eine Revolution in der Geldpolitik.

Translation without guarantee: But we already have a bad bank – the US bank Fed. It is buying poisened papers to a gigantic extend since quite some time: Its balance has been growing since August 2007 by 150 percent, up to 2 billion/trillion (a one with 12 zeros, the german word is unambiguous) dollars. Of course Ben Bernanke doesn’t say, what he is actually buying there – he can currently, practically do what he he likes to do. What we experience here is a revolution in money politics.

The ambiguity in the concept of a bad bank lies in the different interpretation on how (or if at all) the governments should get something in exchange for the to be expected losses which are involved with a bad bank:

according to financialweek.com:

Goldman Sachs economist Jan Hatzius has estimated that total credit losses may exceed \$2 trillion globally, and banks have so far recognized less than half that much.

In other words: if the governements would plainly buy the bad assets then this could mean that they may loose more than 1 Trillion dollars, that is the global tax payer looses these 1 Trillion dollars. Not so nice. And there could be more.

What would happen if governments wouldn’t buy the bad assets or do something else?

There seem to be 2 major problems:

1. If governments wouldn’t buy these assets then the above indicated possible losses may be on the side of the banks. This may lead as I understood to multiple bank-bankruptsies. If a bank dies then often saving accounts are rather safe due to a national deposit insurance. However if banks are dying in grand style than even this insurance may be in danger. People would panic and the rest is left to the readers phantasy.

2. Banks have not enough trust to lend out money anymore. This phenomen is called credit crunch and a major reason for the upcoming/ongoing economic crisis. In particular banks don’t trust themselves anymore – which is in turn again mainly due to their “poisened papers”. In short – if one doesnt find a solution to the credit crunch then the economy will be even more impaired.

What are these poisened papers about?

There seem to be various kinds, but a lot seem to be related to the US house market. Some of them could may be be called “overvalued credits”. That is house owners in the US got loans from banks, often with a non-fixed interest rate. These credits were chopped into pieces – partially together with “assurances for the credit loss” – and made into certificates/bonds. Due to the chopping, the trading and the changes in the market the actual value of these certificates got somewhat detached from their original value. In particular due to the variable interest rates and a declining economy a lot of house owners couldnt/cant pay their loans anymore, which makes the losses of these assets even bigger and so on. So this seems to be somewhat a vicious circle.

Is there a “something else” what governments could do?

In my point of view one way to mitigate the problems would be that the US government converts the house-owner (and/or car and consumer good) loans. That is the government hands out safe steady interest loans (may be if necessary at a smaller value) and exchanges them for the “poisonous” bank loans. Since the government now “bought” the loans from the house owners there is no reason anymore for a high interest rate on the side of the banks (since there is no risk of credit loss anymore) and thus one should fix the interest of these bank loans at a very low level e.g. per decree. One of the advantages of this approach would be that one major obstacle in assessing the actual value of the “poisonous papers” would have been eliminated, i.e. these papers would have a “floor price”.

again from financialweek.com:

Until the bad assets are repriced, it makes little sense to pump more money into the banks, said Alex Pollock, a resident fellow at the American Enterprise Institute in Washington.

If the bad assets are repriced then it’ll be clear who would be bankrupt and who not and the state could be prepared to jump in for e.g. saving saving accounts.

Why shouldn’t governments buy the assets?

Given the fact that the governments are already in demand for supporting the economy (which is mainly due to the credit crunch) the financial crisis appears to be more than ever a – what one calls in Germany – “Fass ohne Boden” (barrel without bottom) and thus supporting the financial system in certain ways, like e.g. buying bad assets with a possible loss of 1 trillion dollar would make a global economic crash even more likely.

I.e. It seems to be unrealistic that the taxpayer -even if he/she wanted to- could accomodate for such a loss.

Hence one has to make decisions about which losses could be justified and who should pay for them. As already said the saving accounts (at least up to a certain sum) shouldn’t be lost, so here the government should be prepared for support. However high risk investments, which apparently brought huge returns (25%?) and which are now failing are not the business of the taxpayer.

Concluding: bad banks of the above described kind (which are as I understood, a solution e.g. Mr. Ackermann is in favor of) are – in my cheap opinion – rather bad. I think they are even bad, if one would buy bad assets at a low guarantee price.

Prof. Rogoff of Harvard suggested to use the “swedish standard playbook” (again from the financialweek.com article):

“In essence, the government takes over the troubled banks, separates the good and bad assets, and later resells the cleaned up bank to the private sector.

Meanwhile, the bad assets sit in a publicly-funded “bad bank,” and are eventually sold off, often at a substantial loss to taxpayers.”

So in his approach at least a rather “neutral” body would sort the bad from the good assets, which at least would make the banks trustworthy again.

However I think I would prefer to let the banks go bankrupt and take them over then when the bad assets are set to a floor value, where losses are almost excluded. Maybe I miss some major point here, or may be this is what was meant here by Prof. Rogoff ? Why should the taxpayer pay for a troubled bank at all?
(It actually seems that the german government has this approach in mind?)

Another point is the credit crunch. Even if the bad assets would be bought up there is still some likelihood that this may not enhance the trust very much. So bad banks may be even no big help in the credit crunch! For fighting the credit crunch it seems to be much more helpful to further and support banks who are lending out money (at least for a certain amount of time) and/or to convert bought-up banks into banks which hand out loans (especially to companies) than to hope and wait that banks regain their trust again.

Even better: try to find the reason, why people need loans and try to reduce their need for them.

The above measures seem to me to be more valuable in order to avoid a really big crash than bad banks.

1. Hein V. Kleist Says:

I find it a little dangerous that you suggest to let problematic banks go bankrupt! Don’t you know that the collapse of Lehman Brothers almost destroyed the world financial system? There could be a chain reaktion of an unknown size!

comments in german, french and russian will be translated into english.
you can use LaTeX in your math comments, by using the $shortcode: [latex] E = m c^2$