What's old is new again: Just weeks after the Bush Administration scrapped plans to buy up some of the toxic securities weighing down financial institutions, newly minted Treasury Secretary Timothy Geithner acknowledged the agency is considering, among other proposals, a "bad bank" arrangement to do just that. The biggest challenges would include how to price the assets and whether the bad bank would buy from any institution or just a select few. Also open: Who would run the bank? Options range from the Federal Deposit Insurance Corp. to private contractors. Here's one way the approach could be structured.
1. The Treasury Dept. establishes the bad bank, capitalizing it with some of the remaining funds from TARP.
2. The bank raises additional funds, either by borrowing from the Fed or selling shares to private investors.
3. The bad bank uses funds to buy toxic assets from Bank A. It holds the assets to maturity, or sells them as markets revive. Losses are split among the bad bank's investors and taxpayers.
4. Treasury and/or investors commit additional capital to Bank A, compensating for losses realized from selling toxic assets.
A bad bank might revive trading of mortgage-related securities by establishing valuations for these assets. As the market recovers, or if housing prices begin to rise, the bad bank could break even or even turn a profit.
If the bad bank overpays, the selling banks get a windfall at taxpayers' expense. If the government underpays, banks won't have an incentive to sell. But if banks are compelled to accept lowball bids, their balance sheets could suffer.