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Another term that has been thrown around recently is the “bad bank” term.  It’s an unfortunate term because it is Wall Street slang for something not quite what it sounds like, and this confusion seems to have caught at least a couple of commentators short.

Certainly within the thousands of US banks, some of them are “bad.”  Some are probably “really bad.”  This however, isn’t what the Wall Streeters mean when they desicribe a “bad bank strategy.”

What they really mean is taking a bank (which may be a “so so” bank) and splitting it into two companies, one of which looks mostly like a healthy bank, and one of which looks really bad.  Here’s how it works.  First, let’s describe our fictional bank.  Start with $11 billion in assets, consisting of $1 billion in cash, $9 billion in loans, and $1 billion in branches, buildings, computers, etc.  On the liability side, it has $10 billion in deposits, with a remaining $1 billion in shareholders equity (see Bank Capital post).

In theory, this bank could divide in two.  Simply carve off half of each asset class and half the deposits into another company, and you could create two banks out of one.   Each would look just like the other, and each would be as “safe” or “good” as the predecessor.

Now let’s assume that the original bank has a bunch of bad loans, so the loan portfolio is now worth $7.5 billion rather than $9 billion (after mark-to-market accounting has forced the bank to state these assets at their de-valued levels).  Our bank’s balance sheet now shows assets of $1 billion in cash, $1 billion in buildings and other equipment, and $7.5 billion in loans or $9.5 billion in total assets.  It still has $10 billion in deposits, so shareholders equity is now negative by $0.5 billion.  At this level, the shareholders are wiped out and the bank would fail to meet its legal capital requirements.

One way or another, our bank needs to go to the stock market and sell shares to replenish it’s capital.  The challenge is, the stock market hates uncertainty.  If our bank had $1.5 billion in loan losses, what’s to assure investors that there’s not more to come.  Investors, waiting for the other shoe to drop, balk at buying our bank’s stock.  To restore confidence and enable the new share sale, our bank needs to do a thorough housecleaning.  There’s an old Wall Street joke that if you’re going to release bad news, release a lot of it, and the joke goes, if you’re going to “take a bath”, “take a big bath.”  Our bank needs to do a once-and-for-all final writeoff of bad loans, so that no matter how bad it sounds, they can assure investors it won’t get worse.

Here’s where the “bad bank” strategy comes into play.  Our bank takes a critical look at all its loans.  Remember, if it had $1.5 billion in loan losses, this was probably a partial loss on more than $1.5 billion in loans, not a total loss on $1.5 billion.  So let’s say they find $3.0 billion (face value) of loans that are worth $1.5 billion now after accounting for late payments, devalued collateral, etc.  It packages these $3 billion face value loans up and sells them to a new “bad bank” created simply to absorb these loans.  Our bank’s Wall Street colleagues create a new company like BancoMalo, issue new shares in this bank, and in the old days, sold an enormous amount of junk bonds on behalf of BancoMalo so that this new entity could buy the $1.5 billion loan package from our bank.  The new BancoMalo entity is pretty speculative because it’s new and it will have a mountain of junk bonds to repay.  It is only a bank in the sense that it will own the original bank loans, but it won’t take new deposits.  The reason anybody would invest in BancoMalo is based on their belief that with patience and aggressive loan workout, the loans now worth $1.5 billion (but originally worth $3 billion) might eventually be worked out for more than $1.5 billion.

Let’s return to our original bank.  Now it’s assets look like $2.5 billion in cash (the original $1 billion, plus $1.5 billion from BancoMalo), $6 billion in loans (the original $9 billion less the whole portfolio that was $3 billion now at BancoMalo), and the $1 billion in branches and mainframes, for a total of $9.5 billion in assets.  They still have $10 billion in deposits.  They’re still short of capital.

However, now they can confidently say that their $6 billion loan portfolio is healthy.  They are also now cash rich, able to make some additional loans, which they’ll swear will be good because they’ve learned their lesson.  And they won’t be distracted working out all those bad loans–the new investors at BancoMalo will be doing that.  They can now sell shares at what they hope is a much better price to replenish the $1.5 billion originally lost. Finally, as a healthier bank, they’ll attract deposits at more favorable rates.

Mellon Bank did this successfully in the late 80’s (a little debrief is here). In their case, original shareholders got some shares in the bad bank.

There are aspects of the Federal rescue plan that have elements of “bad bank” strategy to it. Getting uncertain assets off the books allows the banks to recover, which has been the policy impetus behind the proposal from the start.