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Don’t touch the unsecured creditors! Clobber the tax payer instead.

The above title is obviously sarcastic.  Buiter makes a lengthy case to create a good bank rather than bad banks.  The argument centres on the treatment of toxic assets – assets that are not only bad but which are worse, impossible to value.  The Irish bank’s problem is mostly about honest, decent bad assets rather than toxic, but his argument gives much for us to think about.

Willem Buiter, 13 March 2009

Good Bank vs Bad Bank

The Good Bank solution differs significantly from the Bad Bank solution as regards its distributional implications, its medium-term and long-term incentive effects and its immediate financial stability impact.

Under the Bad Bank approach, the authorities either purchase toxic assets from the banks that made the toxic investments/loans, or they guarantee (insure) these toxic assets.  Toxic assets are assets whose fair value cannot be determined with any degree of accuracy.  Clean assets are assets whose fair value can easily be determined.  Clean assets can be good assets (assets whose fair value equals their notional or face value) or bad assets (assets whose fair value is below their notional or face value).   When the authorities acquire the toxic assets outright, they establish a legal entity to manage these assets – the Bad Bank.  The publicly-owned Bad Bank either sells these toxic assets as and when they cease to be toxic and a liquid market for them re-emerges, or holds them to maturity.

Under the Bad Bank approach, the legacy banks, either sans the toxic assets or with the toxic assets guaranteed by the state, live to fight another day.  The presumption is that the state overpays for the toxic assets.  The price it pays is certainly greater than the immediate liquidation value of the assets by their owners.  It is also likely to exceed the present discounted value of the future cash flows of the assets, or their hold-to-maturity value.  Similarly, the cost of any guarantees provided by the state in the case where the toxic assets continue to be held by the banks, is likely to be less than the fair value of these guarantees.  Link to full article

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