"bad bank"

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"Bad bank" is a term used to describe a solution proposed in early 2009 to address the U.S. banking crisis that began in 2007. It is the offspring of an earlier version of the Troubled Asset Relief Program (TARP) in which the government would buy up the toxic assets (many of them mortgage-backed securities) that are causing meltdowns at the nation's big banks, preventing them from issuing new loans. The earlier version of the TARP was unpopular, however, and then-Treasury Secretary Henry Paulson instead decided to invest the first $350 billion of the bailout money directly into the banks. But in 2009 the financial sector was still in bad shape, and the asset purchase idea was proposed with a new name. The "bad bank" would be a financial institution operating under federal control that would buy the "toxic" assets of financial institutions. Treasury would then replace these assets with cash and thus free up the banks to begin lending again. The toxic assets would then be sold off over time.[1]

The idea was suggested as an alternative to nationalizing the major banks, which many people considered contrary to the free-market system.[2]

A somewhat similar plan was established in the late 1980s as the Resolution Trust Corp., which was set up to sell off assets from defunct Savings and Loan organizations. In that case, however, the government entirely took over the banks. The "bad bank" is designed to cut out only the parts of the banks that are causing problems.[3]

One obstacle facing this proposal is the difficulty in putting a price on those toxic assets. [4] It is difficult to determine how much the government should pay for them, since there is currently no market for them. Paying too much would waste taxpayer dollars, but paying too little would mean few banks will want to participate. Also, accounting rules state that all asset prices must set at the current market value. Without rule changes, any lowball prices the government offers could be applied to assets the banks choose not to sell — forcing them to take massive write-downs that would reduce their overall worth, and threaten their survival.[5]

U.S. Treasury Secretary Timothy Geithner eventually proposed a Public-Private Investment Fund in lieu of the "bad bank" idea, which would take on older ("legacy") toxic assets. This would allow financial institutions to clean their balance sheets while letting the private sector determine a price for the previously illiquid assets. Geithner said the new fund would start with $500 billion with a goal of eventually buying up to $1 trillion in assets.[6]

The Public-Private Investment Fund was part of the Obama administration's Financial Stability Plan, which Geithner revealed on February 10, 2009. [7]

In May of 2009, the German government adopted a “bad bank” scheme to rid that country’s institutions of their toxic assets. It would led any bank that chooses to park its least liquid assets in the "bad banks" for up to 20 years. In exchange, these special-purpose vehicles would issue the bank with a bond whose value would be guaranteed by Soffin, the federal authority that manages the German government’s bank rescue fund.[8]