What’s a Bad Bank?

Have you wondered what this bad bank thing is that Obama is looking at?  Let’s take a look at this letter from First Fictitious Bank that will help us understand what a bad bank is and how it works:

 

“I have an embarrassing question to ask you. It’s not something that I’m proud of but I need help.  I own a bank.  When I noticed that the housing market was going up fast, I invested in something called Mortgage Back Securities.  You may not know what these are so let me explain.  An MBS is similar to a bond where people make money off of the money that people are paying on their mortgages.  As long as people are paying, I’m making money. 

 

Here is the problem.  I didn’t think that the real estate market was going to plummet.  I didn’t expect that so many people were going to foreclose on their homes and I didn’t expect that companies like Fannie Mae and Freddie Mac would largely cease to exist.  Now, my MBS assets are worth a fraction of what they were.  What’s worse is that I invested too heavily in them and although officially my Mortgage Backed Securities are still worth $100 billion, they are probably only worth about $60 billion and maybe less.  Nobody will but them from me. 

 

The good news is that I still have another $100 billion in good assets.  These are loans that people are paying and they are making my bank money.  I have $180 billion in liabilities.  This is the money that people have deposited in my bank that I have to pay them if they make withdrawals.  People are seeing these MBSs on my balance sheet and don’t want to invest in my bank because they think that once I sell them, my bank is going to have more liabilities than asses and we won’t be solvent. 

 

We wouldn’t be able to pay back those that have deposited money with us.  For that reason, investors won’t buy our stock.  If they won’t buy our stock, we can’t lend to other banks, small businesses, or to you.  It stems from these Mortgage Backed Securities that are bringing my bank to a standstill.  If you can think of anything I can to get these off of my balance sheet without taking a huge loss, I would be most grateful.  I have heard of something called the bad bank idea?”

 

This is the real world scenario that many banks are facing.  If you understand the above account, you under the basics of why the banks are largely holding our economy back from recovery.  If they can’t lend to others, the economy grinds to a halt.  The government is looking at creating what is being called a “bad bank.”  This bad bank would buy up all of those bad assets from the banks leaving a much cleaner looking balance sheet which would hopefully entice investors to again invest money in these banks which would entice banks to get back to healthy lending.  Economists believe that this would be a powerful catalyst to economic recovery.

 

If you’re wondering how investing mistakes can simply disappear from the banks’ balance sheet, you aren’t alone.  It is believed that it may take more than $1 Trillion to buy these assets.  Additionally, many argue that if any company makes bad financial decisions, they should pay the price and if that means going out of business, so be it. 

 

That debate hasn’t been solved as of yet but many argue that if these banks fail, so does our financial system and until they are able to lend again and people will invest in them, the economy will continue to get worse. 

 

You now understand the most basic premise behind the bad bank idea.  What do you think?  Is the bad bank idea a good idea?  Let us know.

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