"Why Meredith Whitney thinks a “bad bank” is a bad idea
Meredith Whitney and her team at Oppenheimer remain steadfast in their opposition to the creation of a “bad bank” that would buy so-called “toxic assets” from Wall Street’s flailing institutions (and so, save the world).
Whitney argues that the real problem is that banks are disinclined to lend - and that simply removing these assets from their balance sheets will not change that fact:
Lending standards have tightened dramatically, and there is an unavoidable restructuring of risk taking place. Such causes money to come out of the system and lending to contract, with or without this “bad bank” structure. Lower asset bases, higher credit losses, and bloated expense structures will continue to pressure banks’ earnings power and capital creation. We remain cautious on the group.
Cautious, and consistently unimpressed.
Other highlights from the note, emphasis FT Alphaville’s:
We do not believe a “bad bank” structure addresses the root problem of contracting system capital.
Writedowns from structured securities and illiquid assets is only one challenge related to the commercial banks. A challenge of equal importance is rising defaults from on balance sheet loans. Due to the pro-cyclical nature of loss reserving, banks are required to build reserves when their earnings power is weakest.
If a bank were to sell its “bad” assets into a “bad bank,” it would still be left with lower earnings power from higher losses on “good loans” and the requirement to build reserves, lower earnings power from lower assets and a higher legacy expense structure, or both.
The greatest unknown regarding the “bad bank” is at what price the gov’t would pay for “toxic assets.” If the government elects to pay fair market value, the banks will likely not elect to participate as capital hits would be too dear; however, if the gov’t pays above market, the burden on an increasingly “taxed” taxpayer grows.
We would be most encouraged by banks selling “crown jewel” assets to cover their own losses. We believe private capital will readily invest in businesses that make money and grow. However, the banks do not fit this description. We remain cautious on the group.
Moreover, Whitney believes a handful of lenders would “dominate the lion’s share of the ‘bad bank’”. Those lenders, she argues, should monetize their “good” assets to cover their “bad” assets.”
And who might the lenders be? Well, by Whitney’s reckoning (and others), Merrill and Citi have the biggest exposure to residential mortgages, at $44.6bn and $26.7bn respectively. Citi also has a fairly significant exposure to US ABS CDOs, at $18.9bn gross and $6.9bn net. So does Bank of America, with $11.9bn gross and $5.3bn net. (Gross means after writedowns but before hedges, in Oppenheimer parlance).
Oppenheimer also points out that in addition to the question of how these assets will be priced, it is not clear what will be held to constitute a bad loan: “will it be by loan product, loan quality, or geography?”
This is an important consideration, not least because, as Oppenheimer notes,
A large percentage of banks’ exposures are to areas with the greatest home price declines and the most vulnerable negative equity positions. Will these too become “bad loans,” and if so, what will be left of banks’ “good loan” earnings bases?
Take Bank of America, which partly through its Countrywide acquisition has $94bn in exposure to Californian mortgages - or five per cent of the company’s total assets.
And as the table below makes clear, these kinds of exposures are no less significant for Citi, JP Morgan, Wells Fargo and Wachovia:
Whitney is right to contend that a bad bank would only treat some of the existing ills - and that is unlikely to be enough.
Related links:
The 20 worst housing markets in the US - FT Alphaville
Citi’s Parsons calls for ‘bad bank’ - FT
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