U.S. will need bad bank to take care of toxic assets, accounting giant says

Exclusive analysis for FinReg21 by Darrell Delamaide 

Amid reports that the government’s plan to remove toxic assets from U.S. banks is floundering, the world’s largest accounting firm came out with a report this week saying that a “bad bank” solution is probably inevitable. 

Treasury Secretary Timothy Geithner has sought to avoid a bad bank solution with his proposal for a Public-Private Investment Program that enlists private sector fund managers and private equity along with generous government credit guarantees to purchase the assets, effectively providing a government subsidy. 

But recent press reports have suggested that the program is running into delays because banks, having successfully passed the government’s stress test and raised new capital in the market, feel less incentive to sell these assets at a loss. Private investors, on the other hand, are leery of the program because they worry about a possible political backlash or even new restrictions from Congress after they have invested. 

Against this background, PricewaterhouseCoopers, the largest auditing firm in the world, argues that a bad bank – a separate entity that would sequester the toxic assets and allow the remaining good bank to resume active lending – would be the most effective way to get these assets off banks’ balance sheets. 

And, PwC warns, it is unlikely that economic recovery can begin until this problem is solved. 

“[B]ad banks have often been resisted at the outset in past crises initially for cost and political reasons, then ultimately adopted,” the accounting firm writes. “Delaying this decision in past crises has been costly, however, as our research indicates the longer troubled assets remain on bank balance sheets, the longer the crisis tends to last. In other words, history shows that troubled assets must be removed from bank balance sheets before economic recovery can begin.” 

John Garvey, head of PwC’s banking and capital markets activities, drove home this point in an interview with PBS’s Nightly Business Report. “I think ultimately the paper shows that until the banks are cleansed of these toxic assets, normal lending and banking functions cannot proceed at the level that's necessary to support the economy,” he said. “So we think there still needs to be more done to remove those troubled assets from bank balance sheets.” 

banks have been used in past banking crises. The most notable example in the U.S. was the Resolution Trust Corp. set up in 1989 to handle bad assets from the savings and loan crisis. More recently, Sweden and Japan have employed bad banks to resolve banking crises. In most cases, the bad bank was able to turn a profit selling the assets over a period of years, so that the end cost was lower than the initial outlay. In the current crisis, Swiss, Irish and German governments have adopted bad bank approaches. 

PwC lists a number of reasons why bad banks have been so successful:

• The management of the bad banks can focus solely on restructuring credits with borrowers and selling troubled assets;

• The management of the good banks is not preoccupied with managing troubled assets and dealing with negative public perception; and,

• Investors get a more transparent view of the potential earnings streams of the good bank and a better understanding of the capital requirements for managing the bad bank assets.

Moreover, when the government is sponsoring the bad bank to take over the toxic assets and leave a “good bank” for investors, there are additional advantages:

• Confidence can be quickly reestablished in the remaining good bank, allowing the institution to raise new capital; • Private investors generally begin to participate in those recapitalization efforts; and

• The government’s retained ownership in the good bank often rises in value, generating capital gains that can be used to offset the cost of the bad bank. 

The key issue in resolving the toxic asset problem – and the one that has stymied the government’s efforts since the Troubled Asset Relief Program was first launched last fall – is how to price these assets. 

In its PPIP proposal, the current administration has argued that prices for the “legacy” assets are temporarily depressed and banks should not have to take write-offs for the current market valuation, which is below their actual worth. 

So the government pressured the Financial Accounting Standards Board to relax “mark-to-market” rules so that banks could have some leeway in pricing these assets on their books. 

By the same token, PPIP, with its government subsidies and guarantees, is designed to encourage private sector investors to bid generously for the assets, so that banks will not have huge charges if they sell them. BREAK

But banks now appear unwilling to take any write-offs at all and would not be willing to sell the assets for anything less than current book value. In fact, some banks want to purchase more of the toxic assets through the PPIP program to benefit from the government subsidies and perhaps turn a profit – which seems to turn the government’s program on its head. 

The PwC report acknowledges that asset pricing is a problem in the bad bank solution, too. “In the current crisis, inconsistency of valuation models and methods across financial institutions has been cited as a significant barrier to the creation of a sovereign bad bank,” the report says. 

In some past crises, the report says, the governments first purchased the assets in bulk using a somewhat arbitrary but consistently applied pricing mechanism, such as audited book values or consistent discounts by, and then conducting sales with price discovery by third-party investors. 

A more recent government-sponsored bad bank adopted a variation of that mechanism, where the valuation of assets was made through a price arbitration process that leveraged third-party valuation experts to determine a “fair” price. “We believe this type of model can be applied in other situations as well,” PwC says. 

PwC is not a disinterested party – it would very much like to earn huge fees helping a government or private institution set up a bad bank. But as auditor to 44 of the world’s top 50 banks and with 34,000 professionals in 150 countries, it has some claim to expertise. There may well be a bad bank in our future.