Good Bank Bad BankBad bank sparks optimism in US equities.
Last night's decision by the US Federal Reserve's Federal Open Markets Committee to leave interest rates unchanged at virtually zero was a no-brainer. How can it do otherwise when the deepening financial and economic situation forced its back against the wall last December when it effectively cashed in all its chips and took the fed funds rate to nil.
All the Fed could do now is proceed with what it stated in the accompanying statement -- that is, to continue expanding its balance sheet. ‘The Committee also is prepared to purchase longer-term Treasury securities if evolving circumstances indicate that such transactions would be particularly effective in improving conditions in private credit markets.' And hope for the best. ‘The Committee anticipates that a gradual recovery in economic activity will begin later this year.' But even this statement has to be qualified with, '…but the downside risks to that outlook are significant.'
Indeed they are. At the same time the Fed announced its decision and its statement, the International Monetary Fund (IMF) released its latest projections. The IMF slashed its global economic growth projection down to 0.5 per cent this year - the weakest rate since the second world war - from its previous estimate of 2.2 per cent. It expects growth to rebound to 3 per cent in 2010.
Also, the IMF now expects global bank losses to reach US$2.2 trillion due to toxic assets. This exceeds the previous estimate of US$1.4 trillion stated in October and just US$600-800 billion before that. Is this latest projection now set in stone? Or will it be revised even higher in three months time, and higher still in six months? Remember that many of the assets have no market value as buyers have long vanished.
This is perhaps why US equities took as positive rumours that President Barack Obama's latest stimulus package could include the creation of a bad bank - an ‘Aggregator Bank' -- that will buy and stock illiquid and toxic assets of financial institutions. This plan is expected to be announced next week.
If the rumours are true, the Obama administration maybe hoping that this bad bank will succeed the same way that the Resolution and Trust Corporation (RTC) -- established in 1989 to dispose of bad assets of failed US savings and loans institutions - did in resuscitating trust and confidence in US financial institutions.
The concept is good. Take away all the bad assets from banks and financial institutions and they will be healthy enough to resume lending. Credit will again start flowing and grease the wheels of recovery.
But this maybe better said than done. After all the RTC of 1989 bought assets from institutions that were already dead. They no longer have any bargaining power as to the RTC's price offer.
Under the current environment, it is not that the financial institutions have any bargaining power either. But they are still alive, albeit barely. The disappearance of buy/sell transactions in toxic assets means that no one knows exactly what the market value of these assets are - or whether they are still worth something.
Herein lies the rub. If the bad bank bids too low for these assets, investors and shareholders of these still-operating institutions may dump their holdings and thereby, ultimately expanding the liquidity problem of these financial companies. Should the bad bank pay too high a price for toxic assets, it pays too high a price. It risks holding them in its vault for a very long time or it may have to write them off eventually -- wasting taxpayers' money in the process.
But surely the geniuses on Capitol Hill would have a Plan B for the bad bank to work. And for equity markets, at least for today, it may be enough to see their government working stridently towards a solution.