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Bad bank can bring back good money

As the banking crisis rolls on, calls for a UK bad bank to buy up and hold toxic assets from the balance sheets of troubled lenders are becoming louder.

The Government launched its five-point plan last month in an attempt to salvage the banking sector, including an asset buy-up scheme and an asset guarantee scheme.

But some experts say this is a halfway house and the only way to save the banks is to remove the bad assets completely, putting them into a bad bank, allowing the newly cleaned-up banks to begin lending once again.

In the US, a bad bank is still very much on the cards, with US Treasury secretary Timothy Geithner last week tentatively announcing a plan to buy up assets as part of the troubled asset relief programme.

Federal Deposit Insurance Corporation chair Sheila Bair told CNBC last month this possible aggregated or bad bank would be the best way to allow US banks to start lending.

She said: “The aggregated bank might have an advantage in the sense that it actually moves the assets off the balance sheets, freeing up better lending capacity, which is really the whole public purpose of all these initiatives.”

Allianz Global Investors European chief investment officer Neil Dwane says a UK bad bank is inevitable because politicians have overlooked the scale and size of the balance-sheet problems of many of the world’s major banks.

He says: “For example, Barclays and Deutsche Bank both have balance-sheet assets considerably larger than the US Federal Reserve itself. Indeed, the hardest rescues of banks so far have been those where the banks are so much larger than the underlying national economy in which they started their life, like the three large Icelandic banks, most of the UK and Swiss banks.”

Dwane says, given the sheer scale of the challenge and the pace at which banks have grown their balance sheets over the last decade, no one is certain as to what they own and what they owe.

“Banks are, in effect, paralysed from lending because they have no capital to lend out,” he says. “They have been in denial about the valuation of many assets held on their balance sheets as marked-to-market or level-three assets, marked to directors’ myth valuations. These assets are now seen to be toxic and are in the process of killing the banks. If these assets are written off or down to their appropriate real value then the banks are bust, pure and simple.

“History shows that almost every banking crisis has had a bad bank as part of the solution. This solution works because the toxic assets are placed in a vehicle that can cope with the toxicity over time and importantly allows the clean bank to do what the body politic wants its banks to do.”

Exact Mortgages managing director Alan Cleary agrees that there are few alternatives left and says the maths makes sense for taxpayers to underwrite a bad bank. He says: “Politically, this is a big decision but there are only two eventual outcomes – either create a bad bank and take these toxic assets off the balance sheets or nationalise the struggling banks.”

Cleary says mathematically a bad bank is the most prudent choice. He surmises that of the £1.2 trillion UK mortgage book, a very worst case scenario would be that 30 per cent were toxic, meaning £350bn would need to be bought. He then calculates that even if there were only returns of 50 per cent, this would cost the Government £150bn.

Realistically, Cleary says only between 5 per cent and 10 per cent of all UK mortgages could be toxic and, of them, losses could be expected of 20 per cent. That means if the Government were to buy up the toxic assets, it would stand to lose maybe £15bn, which he says is small in the context of the recent financial packages.

Cleary says a bad bank could be beneficial to taxpayers. “If these toxic assets were held for the long term, they would give a rate of return,” he says. “As soon as house prices begin to bottom, and they will, the assets could rise in value by as much as 50 per cent.

“This has to happen. The plans so far are just a halfway house. We are at Defcom 4 now, whether the Government takes its time and the banks suffer more damage or it acts now, a bad bank will be a reality.”

Business Lending managing director Stuart Parfitt thinks the ringfencing of assets, whether they are good or bad, is the only way to guarantee lending in the UK. Parfitt worked on the Swedish good/bad bank model in the mid-1990s, so has first-hand experience of the solution.

He says: “Unless you can get bad assets off the balance sheet, management will struggle to find the time to create good loans. We need to free up resources within the banks because right now they are filled with highly unmotivated staff members who are getting a daily kicking in the press. If the bad assets are removed, you can get on with some good quality lending.”

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