Baddest Banks May See Fix-It Plan Revealed Next Week
January 27, 2009 by Tisa Silver
Filed under Finance
This afternoon CNBC’s Steve Leisman reported that a ”Bad Bank” plan is under construction. The Treasury Department refused to comment on the plan and said that nothing would be announced this week.
So, what is the need for a bad bank plan?
There are several answers, but the core is pretty simple. The word bad is probably the best word to describe assets held by many banks these days.
Many banks purchased illiquid, risky assets. Illiquid assets may be unique in nature (meaning that it is difficult for the market to find an appropriate price) or unpopular (meaning nobody wants them). Risky assets may be attractive because of the higher returns they offer, but what they offer and what they actually pay can be two different rates.
Typically, when you buy an asset and later decide you don’t want it, you can throw it away or sell it to someone else. Let’s examine the options:
1. Toss it – No one wants to throw away assets, especially not ones that cost a substantial amount of money to acquire.
2. Sell it – This is the preferred method of unloading undesirable assets. But what happens when you buy something and nobody else wants it? The overpriced asset weighs down the books and drives down the value of your equity.
Many banks have purchased assets that are worth much less than their purchase price. To make matters worse, some of the assets are difficult to price, so there is no real way of knowing what their market value should be. The declining value of assets eats away at the value of the bank’s equity. This is where the “Bad Bank” plan would come in.
The Bad Bank plan would involve the establishment of a “bad bank,” which would purchase bad assets and assess their value. Steve Leisman said there are murmurs about the use of common stock to close the gap between the government’s assessed value of the assets and the purchase price.
Here’s an example of how this might work: Let’s suppose the government buys an asset from a bank for $5 million. If the government’s pricing model determines the asset is only worth $4 million, the bank would then issue $1 million worth of common stock to the government.
Today, news of the plan worked wonders for the banking sector. Bank of America (Ticker: BAC) closed up 9.33 percent, Citigroup (Ticker: C) rose 9.61 percent and JPMorgan’s (Ticker: JPM) shares rose 3.43 percent.
I guess we can look at those increases and see which bank is believed to be the baddest. No surprise there.
Interesting. Thanks for the explanation. So let me get this straight – the government takes the asset plus stock in the bank for the difference ? Doesn’t that devalue the bank stock overall? Does this mean another hit to my 401k?
Thanks Lela. You got it. The buzz surrounding the plan says that if the government buys an asset for more than market value (as determined by the government’s pricing model), then common stock will be used to fill the gap. More common shares will cause dilution and government ownership usually doesn’t help existing shareholders. Right now stocks in the baddest banks are heading up on rumors of the plan because it is some form of assistance.
I hope there will not be another hit to your 401k! If you aren’t withdrawing in the near future, perhaps appropriate values will be restored by the time you do withdraw. Valuation is extremely trick right now. If the banks can’t value their assets and the government buys then guesses the value of the assets, how can anyone accurately value the bank’s equity?