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The theory, and potential pitfalls, of 'bad banks'

February 06, 2009|Michael Muskal

As President Obama's administration considers its next step to help a troubled economy, one of the ideas being considered is the creation of a "bad bank" to help the financial sector. Here are answers to some of the key questions that surround the proposal.

What is a bank?

A bank is a place where people put their money and, in exchange for the bank's use of the money, earn interest. Banks use their customers' deposits and invest them in the economy in the form of loans. People pay back those loans with interest that goes to the bank to fund its costs and produce a profit for bank stock- holders.

So what is a bad bank?

A bad bank is created -- usually by the government or an agency -- to store assets that are worth less than their face value in the hope that over time they will be worth more than they are now. The bank acquires the bad debts then holds them until they can be sold at a higher price. If there is a profit, it goes to the government or taxpayers.

Where do these bad assets come from?

A poor economy can create bad assets in many ways. For example, the number of jobs falls and unemployed people can't repay their loans. Or, the value of a house drops so much it is worth less than the mortgage. In general, when a bank loan or investment cannot be recouped by foreclosure, it is considered a bad asset.

Why would we want to put all of the bad assets in a single bank?

Putting all of the bad assets in one place frees up all the other banks, which are reborn with a clean balance sheet. With a good bottom line, banks can again lend money and re-energize the economy. If all goes well, the banking sector gets stronger, the economy gets a jump start and taxpayers stand to make some profit in exchange for risking government money.

What are some of the potential drawbacks?

The biggest issue is how to value the bad debts. The bank wants the value to be as high as possible so it can recoup as much money as is available. But a high price means that the bad bank, or government, could earn less from the sale of the debt and, depending on the future market, might even mean that taxpayers lose money on the bad assets.

So bad debts should be valued at a lower price. Is there a problem with that?

A low valuation means that similar debts, still on the good banks' balance sheets, are also worth less. Too low a price means that the bank won't have enough capital to make loans, which was the reason for creating the bad bank in the first place.

Has a bad bank ever been tried before?

Yes, both in the United States and abroad. The Resolution Trust Corp. formed in the wake of the savings and loan crisis of the 1980s was a form of bad bank.

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michael.muskal@latimes.com

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