Constructing a Bad Bank to solve the Credit Crunch problem is too difficult in the current volatile situation. It would be quite wrong to force independent banks into one if they are not in receipt of taxpayer share capital.The main banks headquartered in the UK are too big to be taken on by the taxpayer. The taxpayer should not be expected to carry the burden of their potential losses on lending all round the world.
Some people think it is a relatively simple matter. They argue that too many bad loans are holding back the banks from lending more money. So why not, they argue, shunt all the bad loans off into a Bad bank which the government can own and work its way through, allowing the banks to start again with cleaned up balance sheets and loan books?
There are all too many obstacles in the way.
The first problem is that bad loans do not have a bad loan label on them, allowing easy identification. Some bad loans will be obvious – they are debts owed to the bank by companies or individuals who have already gone bust. The other bad loans are to people and companies who may go bust in the future or who may have trouble meeting the interest and capital payments.
The second problem is that there is not a given stock of bad loans, which once dealt with sorts the problem out. In this kind of fast developing recession the number of bad loans expands as the economy lurches downwards. Companies that can meet their payments today may be unable to next month. Individuals who can meet their mortage payments at the moment, may lose their jobs next month and then be unable to pay the interest.
The third problem is that the main UK banks are also big global banks. How would the UK authorities offer to take bad debts related to the UK in a way which did not leak out into other countries banked by the UK banks? If they could just buy up UK bad loans, how could they stop the benefits of doing this leaching abroad, making the whole task so expensive for UK taxpayers?
The fourth problem is how to value the assets or bad loans. Everyone involved now seems to understand valuing them is very problematic. If you cannot value them accurately then either the government pays too little, leaving the banks in a very weak position, or pays too much for the loans,leading to huge losses for taxpayers.
Let us look at some examples of these problems.
Loan One: to a man who has a drink problem and is a gambler. He fails to make his regular interest payments. The bank has to call in the loan. The bank manages to sell the house for more than the mortgage, so gets all the money back. (Ultimate value of loan £1 in the £)
Loan Two: to a steady well paid civil servant who has always made his payments and apparently has a secure job. He then gets involved in an acrimonious divorce, loses his job through bad conduct, fails to make the payments. The bank reposseses and sells the house for 75% of the mortgage. (Ultimate value of loan 75p in the £)
Loan Three: Loan to a company which is trading successfully in autosales. Demand halves, profit margins disappear as customers demand keener prices. The company fails to meet repayment schedule. The bank puts the company into receivership, and discovers it only gets back 20 p in the £
Loan Four Loan to a financial company which has bought financial futures. The bank believes it has full security and is told the future position is to reduce risk in the underlying financial business. The futures go horribly wrong, losing the company more than its capital. (Final value of loan zero)
Loan Five:Loan to another company that has geared positions in futures contracts 5 times the size of its balance sheets. Bank makes the company close them down over six months. Company does so and makes a profit. (Value of loan £1 in £1)
It is not easy spotting in advance which loan falls into which value band. Loan Two looked like a high quality one and Loan 5 looked very risky. Of course bankers spend their lives trying to evaluate these things. They look at the cash flow of a businesses or the income of individuals to see how likely it is they can pay the interest. They look at the value of the home or the business to see how they could get their money back if the client stopped paying the interest. In normal times their rules of thumb and their mathematical models work. In these extreme conditions they do not. Unlikely people and businesses go bust. Asset values collapse so quickly that banks are left without proper cover for their loans. That is why it it so difficult to sort out the true values of these loans and to make proper provision for them.
I was very critical of the government blundering in to buy shares in banks where it was obvious a lot more needed to be written off their loan books. The government should have tried to come to better views of the value of the loans before putting money in. This process is now happening because the banks need to produce end year figures and are having to be more realistic about how many loans will go wrong and how much they might get back.
The government needs to make the banks do this exercise for the year end. It needs to tell the banks they have to cut their costs and get themselves back into profitability quickly, as they need retained profit to strengthen their balance sheets. The government should be ready to lend against security, and offer sensibly priced guarantees both on deposits and lending, but they should not buy more shares, and should not yet buy bad loans. The situation is still too unstable, and we have no idea how many more bad loans will emerge in the hostile trading conditions of the first half of 2009