Creating Bad Banks … On Purpose!

We Americans know that we need not look very far to find a bad bank. 140 of them, in fact, failed in 2009, and another 41 recently failed during the first quarter of 2010.

There are also a wide variety of ailing banks that would have failed if not for bailouts by the federal government. Citigroup, for instance, owns many failing subsidiaries that are dragging down a purportedly healthy commercial banking core; that’s why CEO Vikram Pandit is striving mightily to shed those weak divisions. Bank of America also asserts that it manages a relatively healthy core banking operation, but that it has been weakened by a government induced shotgun wedding with Merrill Lynch.

Then there are the tiny Special Purpose Entity banks acquired by investment institutions like The Hartford. These banks are tiny specks of commerce that barely conduct any business activities at all; they exist for the sole purpose of positioning their financially unstable corporate parents to qualify for federal bailout funds. And investment houses like Goldman Sachs and Morgan Stanley may be strong financial institutions, but they are undeniably bad banks because they take no consumer deposits and make no consumer loans; they also chose to become bank holding companies for the sole purpose of qualifying for federal bailouts.

None of these banks, though, were intentionally created to be bad in nature; their descent into “badness” was a regrettable outcome of the Great Recession of 2008. So why would any one decide to create a bank that is intentionally bad?

Ask the Irish!

To whom shall we turn for an answer to this question? Let’s ask the Irish government! This past week, they decided to create a government owned bank that will purchase 16 billion euros of terribly risky assets for a discounted price of 8.5 billion euros from five domestic financial institutions that are desperate to be rid of them. The official name for this intentionally weak bank is the National Asset Management Agency, but the Irish have dubbed it Bad Bank to reflect the nature of its asset base.

Why would the Irish government make such a startling decision? Apparently, they believe that they’ve run out of alternatives. They’ve already invested a huge amount of capital in two giant insolvent Irish banks, the Anglo Irish Bank and the Bank of Ireland, but have failed to resuscitate them because of the poisonous impact of these toxic securities on their asset portfolios.

So the Irish have decided to create a new government entity that will purchase these securities from the Irish banks, thereby removing a fiscal cancer from their books and providing them with fresh capital with which to repair their operations. The hope, of course, is that these banks will continue making loans and stimulating the Irish economy.

Only in America

Before we Americans start to criticize this strategy, though, we might want to take a closer look at our own government’s decisions. Indeed, Washington has also opted to create intentionally bad organizations, albeit with uniquely American flavors.

For instance, were you aware that only one General Motors fell into bankruptcy, but two GMs actually emerged from it? The good GM is now manufacturing automobiles, but a bad GM is now functioning as well, liquidating the suffocating obligations that dragged the original GM into bankruptcy.

The American federal authorities arranged for the creation of Bad GM for the same reason that the Irish government created NAMA: to allow an organization that was deemed too big to fail to shed itself of toxic assets and/or overwhelming obligations. Such accounts are customarily written off in bankruptcy court, but creditors of the bankrupt organizations are traditionally required to write off their investments as well.

In the case of GM and the Irish banks, governmental authorities clearly believed that they couldn’t ask GM retirees and Irish passbook savings account holders to write off their entire retirement pensions and cash account balances. Thus, they stepped in and allowed these obligations to live on, secure in the hands of government sanctioned entities.

A Road Not Taken

Interestingly, during the early days of the 2008 banking crisis, the American government did indeed authorize Treasury Secretary Hank Paulson to spend hundreds of billions of dollars to establish a federal bank that would purchase troubled assets from failing banks. In fact, that’s why the controversial TARP bail out program was called the Troubled Asset Relief Program; it was designed to adhere to the same model that the Irish government implemented last week.

Paulson created quite a ruckus when he used those TARP funds to inject capital directly into bad American banks instead of purchasing their bad assets from them. He explained, at the time, that direct injections could be processed more “quickly and forcefully.”

The Irish government itself caused a minor ruckus last week when it established purchase prices that were significantly less than the levels originally forecasted by banks. Because Paulson opted to take a different road to bailing out American banks, we may ultimately be able to assess the relative wisdom of these alternative approaches by comparing the long term health of American banks to Irish banks, and of the American economy to the Irish economy.