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Wednesday, January 28, 2009

Bad Bank! Bad!

The banking sector has continued to deteriorate.  Thus far, plans like TARP, intended to shore up balance sheets, have had almost an opposite effect on confidence due to excessive flip-flopping by policy makers.

The latest bailout direction appears to be in the form of a “bad bank” structure.  The FDIC would purchase the worst parts of bank portfolios.  How much the FDIC would pay for these troubled assets is unclear.  Sheila Bair, the chairwoman of the FDIC, has been pushing to let the FDIC renegotiate mortgages and this would likely be key to getting out of the portfolio over time.  This is basically the original TARP plan which was rejected in favor of temporarily nationalization through large capital investment by the Treasury and Fed in ailing banks.

In the hedge fund industry, when a manager undertakes an unproven strategy with money taken from investors under a different operating pretense, its called “style drift”.  It’s a no-no.  Savvy investors will quickly pull capital when they see a manager do it as its an unknown variable – the story is changing – its not the strategy in which they had originally invested.  While the FDIC is no hedge fund, and there really is no yard stick by which to measure a successful strategy for dealing with the plague of credit derivatives, this is clearly major drift from the FDIC’s mandate of protecting consumer deposits. Buying up bad paper and renegotiating mortgages is not really what they're historically known to do successfully.

The FDIC is an undercapitalized regulatory body that has infinitely insured deposit accounts.  Frankly, they are the most bleeding heart of financial organizations, offering to bail out any and everyone.  While they may effectively reduce the bad loan problem, the aggregate effect of reducing the value of the bad mortgages will likely hurt values of home owners everywhere.  Should your neighbor get more favorable terms than you when you’re paying your bill and he isn’t because he bit off more than he could chew?  How long before timely mortgage payers are demanding that they get 40 year fixed rate loans, too?

A new bad bank.  Like we didn’t have enough of those already?

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