Self Management of Bad Assets and Bank Nationalization

January 28, 2009

Sankarshan Acharya
Pro-Prosperity.Com and Citizens for Development

January 27, 2009

Honorable President Barack Obama

Honorable Vice President Joe Biden

Honorable Speaker Nancy Pelosi

Honorable Senator Harry Reid

Honorable Senator John McCain

Sub:     Self Management of Bad Assets, and Bank Nationalization.  

Pooled Bad Bank versus Self Management of bad assets by Each Bank

Forming a Bad Bank under the FDIC by buying assets of troubled banks is sub-optimal for taxpayers: 

1.      Under the Bad Bank plan, the FDIC will pay for the bad assets of a troubled bank a price determined by fairness/market/judgment/model. Pricing of bad assets may not be perfect.  But this imperfectness is not the basis of the claim that the Bad Bank plan is costlier and riskier to taxpayers than Self Management of bad assets by each troubled bank.

2.      Under my Self Management proposal, a troubled bank will be allowed (i) to peg its bad assets at the same price that the FDIC/Treasury will deem appropriate and (ii) to continue owning and managing these assets. 

3.      After the prices of bad assets are pegged by the FDIC, the troubled bank will no longer be required to mark the prices of these bad assets to the market. 

4.      The troubled bank will receive no money from taxpayers for the bad assets because the assets will remain with the bank, not transferred to FDIC’s Bad Bank. 

5.      Under the Self Management policy proposal, taxpayers will not pay anything to the bank and face no risk due to FDIC’s potential inefficient management of the pooled bad assets as compared to the efficient management possible by banks that are intimately familiar with their own bad assets.

6.      The Self Management plan thus dominates the Bad Bank plan. 

Is the ulterior purpose of Bad Bank to infuse fresh capital to troubled banks?  If so, optimality of infusing fresh cash to troubled banks should be independently assessed, not through the Bad Bank subterfuge.  If the ulterior purpose of the Bad Bank plan is to infuse fresh cash to troubled banks, then this should be weighed against (i) inefficiency of central management of bad assets pooled into the Bad Bank, (ii) forfeiting efficient Self Management of the bad assets by the banks that are intimately familiar with such assets, and (iii) greater risk and cost to taxpayers due to upfront infusion of cash to troubled banks and potential bungling by the Bad Bank.  In other words, the Bad Bank plan should not be an indirect route to infuse fresh capital to troubled banks.  We should optimally adopt the policy of Self Management of bad assets at the troubled banks and independently consider optimality of fresh infusion of taxpayer funds to these banks.

The Bad Bank seems very different from the RTC.  The RTC was essentially based on nationalization of troubled thrifts entirely.  The Bad Bank will pool only a part of the assets (bad assets) of each troubled bank. 

The fear about nationalization of big banks like Citigroup or Bank of America has given rise to the Bad Bank plan.  Pooling troubled big banks under the FDIC appears to be an impossible task.  It will be unlike the smaller troubled thrifts that were pooled into the RTC. 

But the ailing big banks are already de facto nationalized. 

The relevant issue now is formal nationalization via a mechanism that will enhance credit flow and boost the trust in the American financial system.  We should compare formal nationalization with fresh infusion of taxpayer funds into the troubled mega banks.  We should not obfuscate this relevant issue with a Bad Bank plan.

Nationalization and Safe Banking

As argued in earlier memos, all indebted households should optimally receive lower mortgage interest rates (like one year Fed funds rate plus 2.5%) and troubled households should get debt relief to avoid foreclosures.  Otherwise, more and more prime debtors will become subprime, creating further panic among creditors.  If not done fast, widespread depression may ensue to erase the credits to a level equal to repayable debt. 

The fastest way to attain lower mortgage interest rate is to nationalize the tottering banks like Citigroup and Bank of America.  The Congress should decree to buy 51% of the common equity at a fixed price per share equal to the average closing stock price prevailing over the seven trading days preceding such promulgation, and appoint a professionally qualified BOD and CEO to run the nationalized bank. 

Payment of a fair price to current shareholders will obviate the current mistrust of investors towards inconsistent government policies like issuing warrants to purchase common stock of Fannie and Freddie at $1 per share.  The government has given Citigroup $45 billion in equity and $300 billion in debt guarantee, but has not issued such warrants to buy common stock at $1 per share.  Why did the government decree $1 warrants for Fannie Mae before infusing any cash to this company?  The government issued such warrants to artificially drop the Fannie Mae share value to $1.  Why?  Investors have lost total faith in government because of such inconsistent policies.  The investors, detecting inconsistent government policies, have basically lost their trust in the U.S., causing irreparable damage to the flow of credits which is bedeviling the economy.

Inevitability of Safe Banking and Nationalization

Nationalization of banks and their reorganization into “safe banks” and “universal banks” is optimal for taxpayers and perhaps inevitable because the crisis is quite deep.[1] 

1.      The vast majority of households seem to be financially eviscerated and heavily indebted.

2.      The banks, serving as intermediaries between creditors and debtors, have become bankrupt because of defaults by many debtors.

3.      The banks have asked a bankrupt government to create more money by borrowing or by printing (quantitative easing) on the back of the same eviscerated producers to pay the creditors who have created the problem through lopsided rules. The government has obliged via TARP, credit guarantees and Federal Reserve lending (quantitative easing). But the crisis has not gone away because the vast majority of effective producers are virtually bankrupt with many losing jobs as the creditors pull back out of escalating fear. 

4.      Banks are under immense pressure from creditors. But the idea of creating more and more new money on the back of the same eviscerated effective producers is not an optimal long-term strategy. It is like beating a dead horse to let the king continue his ride for the jaunt.  Creditors’ incomes and tax payments are dependent on interests earned from credits lent to the effective producers. The effective producers are thus the economic backbones of a country.  Bankrupting them and then creating money on their back will not resolve the crisis.  Any apparent resolution will likely be fleeting. 

5.      I believe that the above factors will eventually force the government to nationalize banks in order to lend directly at lower rates of interest.

Forcing China to Revalue Yuan is sub-optimal

Did China create the crisis for the U.S. by fixing its currency, Yuan, at a much lower value than possible under free trade?  It appears so.  But it is not true. 

The crisis is due to the lopsided rules of governance that allow a few Americans to cannibalize the incomes and savings of the vast majority and to move the massive capitals so garnered to manufacture goods in China or to obtain services from India and then to sell the imported produce to the cannibalized Americans to enhance the riches further, while touting in a controlled media about the goodness of cheap foreign goods for the consumers.  The lopsided rules of governance thus undercut the financial roots of the vast majority of American producers while enhancing the wealth of a few.  Now the wealthy creditors have eroded their wealth because the cannibalized society can no longer prop their credits.

So, what is the optimal policy to stop cannibalization and to build financial strength of the American households?  Households have responded by adopting own policies to cut down consumption. 

The Congress can adopt a simple optimal rule on compensation: to not let any executive in a company get more than about ten times of the average wages of the other employees in the company.  The number “ten” is inspired by the U.S. president’s wage being about ten times of the average household income.  People and the Congress have a right to set such policy because the source of profit of a company is less pay to employees and higher prices to consumers as well as other lopsided rules that facilitate financial cannibalization of the vast majority.  In the best interest of the nation, the Congress can and should set optimal policies for wages of executives of all companies, not just those that receive direct government aid.[2] 

Only a trust-worthy and efficient corporate and financial system can attract international investors to lend their savings.  This will restore stability of the international monetary system.  A non-cannibalized American producing class can grow savings to feel confident of investing in risky ventures as the trust and efficiency of the system of governance rises.  The alternative is to force China to revalue its exchange rate, but this route will solve very little if not cause global trade wars and instability of the international monetary system.     

With profound regards,

Sankarshan Acharya

Note:The following news clips show that the idea of Bad Bank, floated before the dispatch of this letter, will perhaps be abandoned.



Bank Stocks Lead Wall Street Rally

Published: January 28, 2009

Speculation and news reports that the government was considering a deal to set up a “bad bank” run by the Federal Deposit Insurance Corporation ignited a rally on Wednesday that lifted stock markets to their highest point in two weeks, injecting a note of optimism into markets that have been stricken by new fears about the scope of the economic downturn.

Although the Obama administration announced no plans to absorb billions of dollars in toxic assets still lingering on banks’ balance sheets, but Treasury Secretary Timothy F. Geithner has confirmed that officials were considering the “bad bank” idea. And on Wednesday, speculation alone was fuel enough for a broad rally that lifted the Dow 200 points and financial stocks nearly 13 percent.

“Investors are concluding that if the F.D.I.C. is going to run the bad bank and take on all the bad assets of the commercial banking system, then they will suddenly be transformed overnight into good banks,” said Ed Yardeni, the investment strategist, who added, “which is a bit of a stretch.”

The Dow Jones industrial average closed up 2.5 percent or 200.72 points at 8,375.45 while the broader Standard & Poor’s 500-stock index ended 3.3 percent higher at 874.09. The technology-heavy Nasdaq index rose 3.5 percent to 1,558.34.

It was Wall Street’s third consecutive day of gains, coming at the end of a rocky January. Even with Wednesday’s gains, the major indexes are still down 3 to 4.5 percent since the start of the year.

In addition to the bad bank idea, the House is also expected to vote late Wednesday on a $825 billion stimulus plan that contains a combination of tax cuts and new spending.

Financial companies including Citigroup, Bank of America, Barclays and HSBC rose by double digits, while Goldman Sachs, Morgan Stanley and JPMorgan Chase also posted gains.

Shares of Wells Fargo jumped more than 20 percent after the company posted a fourth-quarter loss of $2.55 billion, its profit hurt by mortgage assets that it assumed after it took over Wachovia. The results, however, were better than some analysts had expected.

Wednesday was a day of rare gains in the financial sector. Bank and investment stocks were pummeled in 2008 as the credit crisis unfolded and bad bets on mortgage-backed assets hobbled some of the country’s strongest financial institutions, forcing them to turn to the federal government for pieces of the $700 billion bailout.

Financial stocks have fallen even farther so far this year, with shares of Citigroup and Bank of America tumbling 50 percent in January on fears of growing instability in the financial system.

“A lot of these bank stocks are getting awfully close to zero,” Mr. Yardeni said. “I don’t think you’re seeing buyers. I think you’re seeing short-covering.”

European markets also got a lift in afternoon trading from a sense of renewed confidence in beaten-down banks. A Citigroup analyst recommended that investors buy the Lloyds Banking Group, and they did so in droves, sending shares of the British financial-services company 40 percent higher, a surge that lifted a range of other European banks stocks.

“These stocks have been so beaten up over the last year and a half that people will be attempting to bottom-fish occasionally when the news abates somewhat,” said Mark Cliffe, chief economist of the ING Group.

The FTSE 100 in London rose more than 2 percent in afternoon trading in Europe, and the DAX in Frankfurt was up nearly 4 percent. The CAC index in Paris was more than 3 percent higher.

Crude oil prices settled at $42.03 a barrel, up 45 cents.

Geithner Says ‘Range of Options’ Considered for Banks (Update2)

By Robert Schmidt and Rebecca Christie

Jan. 28 (Bloomberg) -- U.S. Treasury Secretary Timothy Geithner said the department is considering a “range of options” for its financial rescue plan, with the goal of preserving the private banking system.

“We have a financial system that is run by private shareholders, managed by private institutions, and we’d like to do our best to preserve that system,” he told reporters today in Washington.

Geithner was asked about the prospects of bank nationalization before a meeting with several officials charged with providing oversight for the $700 billion financial rescue effort. He said the administration would move “relatively soon” to announce its strategy.

“We are putting together what we hope will be a comprehensive plan for helping repair the financial system and bring recovery as a critical component to the president’s commitment to get growth going again and bring the economy back on track,” Geithner said.

Under pressure from lawmakers and taxpayers, upset that the rescue plan shows few signs of lifting the economy, the Obama administration plans to overhaul the effort. Geithner fielded questions from reporters for the first time as Treasury chief.

Without commenting on whether the administration would create a so-called bad bank to absorb troubled assets, Geithner said: “We’re looking at a range of options in that context and we hope to be in a position relatively soon to lay out what we believe is a viable program.”

TARP Oversight

The officials at the meeting included Neil Barofsky, the special inspector general for the Troubled Asset Relief Program, and members of the Congressional Oversight Panel headed by Harvard law professor Elizabeth Warren.

Under Geithner’s predecessor, Henry Paulson, the Treasury allocated about half of the $700 billion program to inject capital into banks, help automakers, and guarantee assets for Citigroup Inc. and Bank of America Corp.

In its rescue efforts so far, the Treasury has taken ownership stakes in more than 300 banks as a condition of receiving aid. The government usually receives preferred shares and warrants, which can be converted into common stock and cashed out at the government’s request.

The Treasury, under the TARP, has not sought voting rights or control over day-to-day business.

Geithner, who took office two days ago, has pledged to make the bailout more transparent and yesterday offered plans to shield the program from political influence. Today Geithner said the Treasury will post contracts with TARP participants on the department’s Web site within days after deals are done.

“That’ll give the American public a chance to see those, to look at the detailed terms and conditions, in a relatively short time period after they’re concluded,” Geithner said.

To contact the reporters on this story: Rebecca Christie in Washington at; Robert Schmidt in Washington at

Last Updated: January 28, 2009 15:24 EST

FDIC May Run ‘Bad Bank’ in U.S. Plan to Remove Toxic Assets

By Robert Schmidt and Alison Vekshin

Jan. 27 (Bloomberg) -- The Federal Deposit Insurance Corp. may manage the so-called bad bank that the Obama administration is likely to set up as it tries to break the back of the credit crisis, two people familiar with the matter said.

FDIC Chairman Sheila Bair is pushing to run the operation, which would buy the toxic assets clogging banks’ balance sheets, one of the people said. Bair is arguing that her agency has expertise and could help finance the effort by issuing bonds guaranteed by the FDIC, a second person said. President Barack Obama’s team may announce the outlines of its financial-rescue plan as early as next week, an administration official said.

“It doesn’t make sense to give the authority to anybody else but the FDIC,” said John Douglas, a former general counsel at the agency who now is a partner at Paul, Hastings, Janofsky & Walker, a law firm in Atlanta. “That’s what the FDIC does, it takes bad assets out of banks and manages and sells them.”

The bad-bank initiative may allow the government to rewrite some of the mortgages that underpin banks’ bad debt, in the hopes of stemming a crisis that has stripped more than 1.3 million Americans of their homes. Some lenders may be taken over by regulators as the government seeks to provide a shield to taxpayers.

Bank seizures are “going to happen,” Senator Bob Corker, a Tennessee Republican, said in an interview after a meeting between Obama and Republican lawmakers in Washington today. “I know it. They know it. The banks know it.”

Nationalization Question

Still, nationalization of a swath of the banking industry is unlikely. House Financial Services Chairman Barney Frank said today “the government should not take over all the banks.” Bair said earlier this month she would be “very surprised if that happened.”

Obama is under increasing pressure to drastically revamp the $700 billion Troubled Asset Relief Program for the ailing industry. While setting up a bank to buy underwater assets is emerging as a favored approach, it could drive up the cost of the rescue in excess of $1 trillion.

Frank told reporters today that he would be open to expanding the size of the bailout if the Obama administration “can demonstrate the need for it.”

Senate Banking Committee Chairman Christopher Dodd said today he wants to hear more about the bad-bank idea when he meets in coming days with newly installed Treasury Secretary Timothy Geithner.

‘Comprehensive Plan’

Geithner, who was sworn in earlier this week, has pledged to unveil a “comprehensive plan” for responding to the crisis that will aid financial companies as well as small businesses, cities unable to borrow money and families facing home foreclosure.

The new administration is also pressing Congress to pass an $825 billion economic stimulus, which could complicate any effort to get additional bailout funds from lawmakers. Obama will tomorrow meet with chief executive officers at the White House on the stimulus. The White House declined to release the names of the CEOs.

A key question for the bad bank would be how to value the toxic assets it would buy. Geithner, in a Jan. 21 hearing before the Senate Finance Committee, outlined three possible alternatives: look at how the market is pricing similar assets; use computer model-based estimates from independent firms; and seek the judgment of bank supervisors.

Pricing Assets

“They all have limitations,” he said. “I think you need to look at a mix of those types of measures.”

Federal Reserve Chairman Ben S. Bernanke suggested on Sept. 23, when then Treasury Secretary Henry Paulson was initially considering buying bad assets, that the government should purchase them at values above the near fire-sale prices prevailing in the market.

Bair has said that cash from the TARP may help capitalize the bad bank and that commercial lenders may kick in some money of their own. One possibility that’s been discussed is issuing firms some kind of stock in the new organization as partial payment for their impaired assets.

FDIC spokesman Andrew Gray declined to comment.

In any new rescue efforts, the Treasury is likely to continue to require banks to hand over ownership stakes to the government as a condition of receiving aid. Programs so far have sought preferred shares and warrants, which can be converted into common stock and cashed out on the government’s request.

Fed Meeting

Bernanke, who has endorsed the idea of a bad bank, is discussing fresh strategies for combating the financial crisis with his central bank colleagues this week. The Fed’s Open Market Committee tomorrow will release a statement about 2:15 p.m. in Washington.

The Fed has participated in Treasury-led initiatives that insured toxic assets remaining on the balance sheets of Citigroup Inc. and Bank of America Corp., and analysts said such measures could be used to complement the bad bank.

The government will likely use its ownership of toxic assets to rework soured mortgages and prevent foreclosures.

The FDIC is already modifying troubled mortgages held by IndyMac Federal Bank FSB, the successor to the failed lender managed by the agency since July. Bair, a longtime advocate of foreclosure relief, said the initiative was meant to serve as a model for the mortgage industry.

The Fed also said in a policy paper released today by the House Financial Services Committee that it will ease terms on residential mortgages acquired in the rescues of Bear Stearns Cos. and insurer American International Group Inc.

To contact the reporter on this story: Robert Schmidt in Washington at; Alison Vekshin in Washington at;

Last Updated: January 27, 2009 19:54 EST

Frank Is ‘Open’ to Increasing U.S. Bailout’s Size (Update1)

By Alison Vekshin

Jan. 27 (Bloomberg) -- House Financial Services Committee Chairman Barney Frank said he would consider expanding the $700 billion financial-rescue fund, and expects the Obama administration will soon address banks’ toxic assets.

“I am open to that if they can demonstrate the need for it,” Frank told reporters in Washington today when asked if he’d approve a request to enlarge the Troubled Asset Relief Program. “I do think they will be addressing fairly soon the question of what you do about the bad assets” on banks’ balance sheets, he said.

Frank’s remarks indicate a growing recognition among lawmakers that President Barack Obama’s economy team will need more than the $350 billion of TARP that has yet to be committed. House Majority Leader Steny Hoyer said last week he “would not be surprised” at a request for an increase.

Frank said he expects to begin working with Treasury Secretary Timothy Geithner “immediately” on rules to stabilize the banking system, including a plan to buy soured mortgages.

Congress this month released the remaining $350 billion of TARP funds to the Obama administration. Frank and other congressional leaders have faulted former President George W. Bush and his Treasury Secretary Henry Paulson for not using the initial $350 billion released in October to stem foreclosures and spur lending.

Frank said he’d consider releasing more funds if the Obama administration showed “that there is a problem, that what they’re doing is helping alleviate the problem and that they’re doing it in a way that is supportable.”

Administration officials and banking regulators are considering ideas including setting up a “bad bank” to remove the toxic assets curbing banks’ ability to make new loans. Geithner, who was sworn in yesterday as Treasury secretary, last week pledged “much more substantial action” on a “very dramatic scale” to repair the financial system.

To contact the reporter on this story: Alison Vekshin in Washington at;

Last Updated: January 27, 2009 12:50 EST