Bad Bank

Today it was leaked that the US Federal Government is seriously considering (up from whisper gossip) on creating a world class "Bad Bank". What does "Bad Bank" mean you may be thinking. Its pretty simple really. Lets consider the current problem with US Banks.

US banks and other financial institutions have "assets" (Really they are debts, that supposedly pay a return, which they don't) called Mortgage Backed Securities and other similar financial products, that have a specified paper value. This "estimated" or computer-model generated value was good enough to trust until companies and countries realized, that an artificial value placed on a financial asset may not translate into a true, actual value. Historically, since the Great Depression, value was assessed by how much similar "assets" where paid for. This is called Mark-to-Market. When the revelation that a made-up value isn't as reliable as Mark-to-Market, confidence caved among companies.

This seems rather absurd. As an example, if I told you my used car is worth 30K, but I tell you to not ask anyone else what they PAID for a similar car, just trust me on my value model, you would think I'm crazy.

So now banks have assets on their books, with paper values, that no one believes are real. Hence its impossible to "trust" each other to lend money. Whats the solution?

The TRUE solution is to mark-to-market all assets and let the weak fail. Of course this will not occur until all other options are tried, and the US stock market has fallen to S&P 500 or lower.

No one wants mass-failure of banks, least the banks that are insolvent, so the government and the industry has come up with a different solution. Take all the assets we don't want to know the true value and put it into one "Bad Bank". How do we get assets out of US institutions and put it into the "Bad Bank"?

Simple, have the US Taxpayer BUY the assets at what the government and the company agree (not mark to market) value and have the government put the asset into the "Bad Bank". Then the US Government and the taxpayer can enjoy their return on investment from this purchase for the next decade to come.

What happens if after the "Bad Bank" buys the asset, it is rudely discovered to have been over-valued? The government will be on the hook for the difference. The companies that sold the asset have the cash from the sale, and are safe from more losses.

This, my friends, is yet another step into the Great Depression II. If this event passes, I'll write another entry, and add it to my line up of "Financial Ground Zero" series of posts marking the epic decisions that may lead the US into financial ruin. If the US implodes, it will take many bad decisions, not one, to bring it to it's knees. It will take years. So, this story has not ended, and there can still be a script re-write to make it a happier ending. But this latest twist is not a turn for the better. See WSJ for similiar spin.

For trading, its GREAT news! The market, assuming it looks only skin deep, should SOAR. Banks, which have finished reporting its hellish earnings, now have no more bad news to report. This coupled with "the final solution" for the US problems should catipult the market upwards in the next days, if not weeks to come. It won't be a straight line, of course, but trend up not down. The Bad Bank has not been approved, but the "serious" nature of the intent, without details should scare the short-sellers of financials.

There is the possibility that people see this as yet, another ploy to avoid facing reality, and therefore prolong the pain and drag on the US government and therefore it's people. But I suspect the news media and politicians will be in full spin. This will be compared to the 80's Resolution Trust Corporation that helped clear problems with S&Ls, to the tune of 400 Billion dollars.

This event is in-line with why I changed from a 2+ year shorting the market to holding the market long, for now. An Obama save-the-world multi-month rally may occur, and I want to be on the correct side for that.

The worst case scenerio, and, lets hope it never happens, is at somepoint the US government after taking on all this debt has it's credit rating cut, eventually into junk status. At that time, the party is truely over, and why I still like "cheap" resources as a long term play. The risk of failure for all these efforts is too great to ignore.

As a warning, this may tank gold, hard core. And gold miners. The gold play is somewhat out of fear, and if the world reduces it's fear, so should gold. But gold could spike as people expect the USD to devalue or "cheapen" by being wreckless. It is pretty much impossible to say for the near future, a coin toss really.

There is NO CERTAINTY in any of this rant, and I reserve the right to change my view as things develop. Anything short of my previous rant of full disclosure of all bad debt, and returning to true accounting, will result in failure. Honest (accounting) IS the best policy.

For gambling plays, take a look on FAS, I was waaaay to early for it, and paid heavily for being wrong in my timing.

Update 1/29/09: Bad Bank estimated at 2 Trillion. When has ANY estimate to financials in USA been accurate? See 2 trillion expect 3-6.