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'Bad Bank' Plan Has Pitfalls, Analysts Say

Laurie Kulikowski

As support builds on Wall Street and Capitol Hill for a "bad bank" that would help financial institutions free their balance sheets of illiquid assets, two prominent analysts on Thursday noted significant stumbling blocks in the way of the plan's success.

Oppenheimer analyst Meredith Whitney and FBR Capital Markets analysts led by Paul Miller questioned the impact that the bad bank concept that helped buoy financial stocks on Wednesday may have on the earnings power of financial companies.

The Obama administration is formulating the next phase of the federal government's response to the banking crisis and have expressed a willingness to consider using the remaining $350 million of the $700 billion Troubled Asset Relief Program, or TARP -- and possibly much more -- to buy up bad assets weighing down the banks.

Such a move would be a return to TARP's original intention, before then Treasury Secretary Henry Paulson turned his attention to making preferred equity investments in banks as a means to deliver much-needed capital. But Whitney -- who won acclaim for her early calls on Citigroup's (C Quote) need to cut its dividend and the insufficient capital levels at many major banks - said the bad bank plan did not address the "root cause" of the problem.

"If a bank were to sell its 'bad' assets into a 'bad bank,' it would still be left with lower earnings power from higher losses on 'good loans' and the requirement to build reserves," Whitney wrote in a note Thursday.

She says the "greatest unknown" regarding the bad bank structure is at what price the government would pay for the assets.

"If the government elects to pay fair market value, the banks will likely not elect to participate as capital hits would be too dear; however, if the government pays above market, the burden on an increasingly 'taxed' taxpayer grows," she writes.

Whitney has several other concerns including -- how exactly will regulators determine what is a 'bad loan.'

"Will it be by loan product, loan quality, or geography? We believe creating a 'bad bank' is, at a minimum, more complicated than it seems," Whitney writes.

Echoing Whitney, the FBR analysts led by Miller say the potential plan, while helpful, ultimately will not "sufficiently address the common equity shortfall."

"The premise of allowing banks to clear their balance sheets of hard-to-value assets improves transparency, which makes them more investable; however, given our belief that the government is not going to substantially overpay for these assets, the plan does not sufficiently address the common equity shortfall," the analysts write in a note. "With a less opaque balance sheet, banks should have an easier time attracting private capital, but current shareholders still face dilution."

The FBR analysts say that institutions "trading at or below tangible book value" that also have "large amounts of level II and level III securities held-for-sale or trade as a percentage of capital," or banks that have recently purchased assets at significant discounts could stand to benefit the most

The list of possible beneficiaries includes Bank of America (BAC Quote), Capital One (COF Quote), Huntington Bancshares (HBAN Quote), Webster Financial (WBS Quote) and Zions Bancorp (ZION Quote), FBR says.

Still, the majority of the toxic assets -- at least related to risky securities -- have been written down, Whitney says, and that only a few larger lenders would dominate the bad bank structure.

Whitney would rather see banks sell their "crown jewel assets" to cover losses. "We believe private capital will readily invest in businesses that make money and grow," she writes.

Administration officials said they expect Treasury Secretary Timothy Geithner to unveil his plans for a new financial industry rescue next week. Geithner has said the administration is considering a range of options for how to change TARP, but has not yet offered specifics. He has said the bad bank idea is one of the options on the table.

Either way, banking industry executives are getting antsy.

Speaking to other participants at the World Economic Forum in Davos, Switzerland Thursday, JPMorgan Chase (JPM Quote) CEO Jamie Dimon said that the federal government needs to "just get on with" creating a workable program that would address the global banking crisis, according to the Financial Times.

"Politicians are playing catch as catch can," Dimon said, according to the FT. "I haven't yet seen people get all the right people into the room and close the door and put a solution up on the wall."