Cleveland Fed economist calls for toxic asset bad bank
James Thomson, vice president and financial economist for the Federal Reserve Bank of Cleveland, believes regulators can ease the pain of future financial meltdowns by creating a bad bank to acquire all toxic assets, including underperforming mortgages. He argues this would shorten the pain by quickly forcing one entity to pull in and manage all distressed assets with the explicit purpose of turning them back over to the private sector as soon as practicable. On Tuesday, Bank of America (BAC) announced a similar initiative to work through $1 trillion in legacy and delinquent mortgages in the next three years. While the Federal Deposit Insurance Corp. already assumes in hundreds of bad assets when financial institutions go into receivership, the regulator is not set up to quickly handle an influx of bad assets, Thomson contends. Instead, he recommends the creation of a resolution management corporation, or RMC, to take over distressed assets in future market meltdowns. "The RMC that I propose would be sponsored by and operated by the federal government," Thomson said. "It would become operational only in response to a financial crisis where the volume of troubled assets that needs to be managed and disposed of exceeds the capacity of the FDIC’s receivership operations." Thomson said troubled assets — such as toxic mortgage loans — are "like a carton of eggs in a supermarket. They might appear to be fine eggs, but if shoppers suspect they might be tainted on the inside, the eggs might not sell at any price." This is the dilemma that paralyzed financial institutions holding toxic mortgages during the 2008 crisis, he said. Thomson believes a quick cutting away of bad assets in times of market volatility will free up financial institutions, allowing them to move forward with lending and other business activity. "The logic of stripping away toxic assets from their current owners is the same as ripping off a bandage — it hurts, but it’s best to get it over with quickly," Thompson said. "Otherwise, you only prolong the pain." Thomson said such a program would need to be transparent enough for taxpayers to track losses and gains on all assets. "The bad bank must quickly return assets to the private sector at the highest possible recovery value. A fast realization of losses is the surest path to economic recovery, as financial market players can effectively take their lumps and move on," he said. As far as how to operate the bad bank, Thomson said the entity could receive a $100 billion line of credit from the Treasury Department. It would be a temporary bank created for one purpose with explicit authorization to disband once its no longer required. Write to Kerri Panchuk.