The markets are abuzz with speculation that the Obama Treasury Department may use a scheme known as a “bad bank” as a new gambit in trying to resolve the widening financial crisis. Despite its name, the concept does not involve pillorying corrupt and reckless financial CEOs for their sins—as President Obama in effect did Thursday in expressing outrage over Wall Street bonuses. On the contrary, it is a way of absolving banks for their misguided lending and investment practices by having the government acquire their tainted assets and place them in a separate entity.
If this sounds familiar, it’s because it is essentially what former Treasury Secretary Henry Paulson insisted back in September was essential to the survival of capitalism. Yet after he steamrolled Congress into giving him authority to spend $700 billion on such purchases, he turned around and pursued an entirely different strategy of injecting massive amounts of capital into the banks. Since that approach failed to restore normalcy to the system, Paulson’s successor Timothy Geithner apparently wants to turn the clock back five months.
The mystique surrounding the bad bank idea comes from the fact that Sweden employed the technique to resolve a similar financial crisis 15 years ago. As the New York Times gushed recently: “With Sweden’s banks effectively bankrupt in the early 1990s, a center-right government pulled off a rapid recovery that led to taxpayers making money in the long run.”
Creating a bad bank is being depicted as an alternative to nationalization of major financial institutions. In fact, stock markets shot up on Wednesday after Geithner said the Administration would “do our best to preserve” the system of private ownership of banks.
What bad bank proponents tend to overlook is that the plan would probably involve nationalization as well. This is what happened in Sweden, where the government did not just relieve banks of non-performing loans and then leave them alone. Gota Bank, one of the weakest institutions, was nationalized and was compelled to merge with Nordbanken, which had been owned partly by the government but was then taken over completely (and privatized years later).
There are some other details about the Swedish experience worth noting. First, the government did not acquire the problem assets of all banks, though it did guarantee their obligations. The main bad banks were the ones spun off from Gota Bank and Nordbanken. Second, the troubled assets the government took over via entities called Securum and Retriva were mostly loans to commercial property owners and shares in industrial companies. Securum and Retriva took control of those properties, and when the commercial real estate market rebounded, they were able to sell off those holdings easily.
The financial world has gotten more complicated since the early 1990s. The toxic assets polluting the balance sheets of major U.S. financial institutions today are complex instruments such as mortgage-backed securities and collateralized debt obligations. These represent packages of large numbers of loans that cannot easily be disentangled. It is one thing to resell discrete office buildings and shopping malls but quite another to seize and resell thousands of bundled home mortgages. Does the federal government want to become a gargantuan version of those amoral people on late-night infomercials bragging about buying up and then reselling foreclosed homes?
Rather than wasting vast additional sums in a bad-bank bailout, why doesn’t the federal government direct its resources toward the creation of a “good” bank? The Federal Reserve is already acting not just as the lender of last resort to banks but has also provided loans to non-financial corporations by purchasing their commercial paper. Why stop there? If the for-profit banking system really is dysfunctional, then the solution may be to have the federal government step in to replace or supplement it in a major way. That’s the kind of intervention that may actually do us some good.