America's BadAsset Bank

There was an announcement yesterday that Sheila Bair (who will stay on as head of the FDIC) and Henry "Hammerin Hank" Paulson have floated the idea of a BadAsset Bank (I made up that name, they said "Bad Bank").

I the surface I think this plan has some merit. With the TED Spread still twice its normal level, and with more housing related losses surely to come, we absolutely need some bold action.

Now, the exact details were not released, but my best guess is that this new entity would work like the trading desk at the FED or at some nameless bank. They would prime the liquidity pump for various frozen markets, and continuously buy and sell toxic assets.

There are surely few positive attributes and opportunities in this plan. One, these assets are probably wildly undervalued, and even if held until maturity the government would end up making a little bit of coin. Two, that the buying and selling of assets or churning (as my former economics professor called it - and which is also illegal for lay people) may make the government money as it does for the Federal Reserve in their buying and selling of Treasuries. Three, most of all banks will be in a be more solvent, and markets more generally will gain confidence. After the Lehman default fear of counterparty default was like a cold chill felt down the spines of all market participants. This phenomenon almost surely gets overblown because not everyone can default, but that's not what credit markets were saying during the throws of the crisis. My guess is this risk would be greatly reduced by this BadAsset Bank, and maybe the progress in credit spreads would continued at an even faster rate.

There are also surely a few negative attributes and opportunities in this plan. First, there is the Krugman concern that the government would waste the money through such a mechanism, and may well pay too much for the toxic assets. Second, there is the size concern, can these markets be affected by such a small amount of money relative to their size. Third, it is possibly that all firms may decide that the creation of the BadAsset Bank would signal a great time to run to the exits, which may further push down asset prices (that said I do not know the likelihood and it may have just the opposite effect).

Now, all of this must be taken in context. I have not seen any draft of this plan, so the details may be operational different than my assumptions and the negatives and risks may be mitigated by the details. My hope is that this idea or something that looks like it, such authority for Treasury or the FED to take on the same responsibilities, are taken seriously. Obviously, the merit in an independent (perhaps emergency) vehicle would be preferable because it would have a more concise, well-defined set of goals and responsibilities than a similar plan in the hands of Treasury or the FED would have.

That is a lot to take in. I surely do not have a comprehensive understanding of the entire idea, but I will try to learn more and synthesize it here in the days to come.