In a move not noticed much three weeks ago, Bank of America announced that it was segregating its crappy mortgages into a “bad bank”. It got more attention today by virtue of being discussed long form in an investor conference call (see related stories at Bloomberg and Housing Wire).
The use of a “bad bank” is strongly associatied with failed institutions. Some of the big Texas banks that went bust in the 1980s (Texas Commerce Bank and First Interstate) used “good bank/bad bank” structures to hive off the dud assets to investors at the best attainable price, and preserve the value of the performing assets. The Resolution Trust Corporation, the workout vehicle in the savings and loan crisis, was effectively a really big bad bank. The FDIC is (and I presume was) able to sell branches and deposits pretty readily; the remaining bad loans and unsellable branch operations reached such a level that the FDIC was forced to go hat in hand to Congress and get funding while it worked out the dreck. A similar structure was used in in the wake of the banking crisis in Sweden in the early 1990s.
I am told by mortgage maven Rosner and others that this move is not meant as a legal separation, but a mere financial reporting measure, so that BofA can declare, “See, we do have this toxic waste over here, but we are chipping away at it and we’ll have that resolved in some not infinite time frame” (the current talk is 36 months) “and look at how the rest of the bank looks pretty good!.”
So I may be accused of being cynical, but I read more into it than that. One distinction I like to make is between “stated truth” and “operative truth”. If a woman of a certain age starts working out, she might truthfully say to her buddies (“stated truth”): “I used to do a lot of sports when I was young, I’ve gotten out of the habit. I started exercising over the holidays, and it made me feel SO good I’ve now decided to stick with it.” The operative truth instead is, “I notice my husband eyeing younger women way too much. I have gotten a little porky. If I don’t get some semblance of the beautiful body of my youth back, he could stray.”
As we all know, shareholder presentations are a realm where stated truths are used routinely to mask operative truths. So the question is: can we infer the operative truths behind the BofA move?
What is striking is the tension between Bank of America saying that this is a measure designed provide more transparency to investors and put dedicated resources on a festering problem to get it resolved versus the specific and loaded terminology they used to describe it, “good bank/bad bank”. Normally, you’d assume that an investor presentation by a big public would be a deliberate affairs. But as Chris Whalen said to me by phone, “I wouldn’t assume that the people at Bank of America are being any more logical than they have ever been. They are just making this up as they go along.”
It is important to stress that this is not a mere accounting separation, it’s an operational split. I encourage readers to look at the investor presentation (click here as an alternative to the embedded version). In particular, note page 6. It shows the creation of a dedicated management team for what was described to investors as a new division. Most of them were probably part of the old Countrywide servicing unit. But the head, Laughlin, is new, and I would assume that at least Ellison and Schloessmann were at BofA corporate but already working close to full time on Countrywide matters.
But the weird part is, per Whalen, this is NOT a legal separation. However (putting on my M&A hat, and Whalen did not disagree) normally the big obstacle to companies hiving off divisions is the lack of a stand-alone management team. Note that that does not impede a sale, but selling a legal vehicle with revenues, staff, but a less than full management structure means you are basically selling a bunch of assets (which includes some management people and maybe some systems) rather than a business. It can only go to buyers who can provide the missing operational parts. Stand alone entities are vastly more saleable and command higher prices. And my belief (readers welcome to correct me) is having achieved operational segregation (in particular a stand alone management team, good stand alone operational reporting and financial controls), making a legal separation would not be that hard.
Thus the use of “good bank/bad bank” lingo, given what Whalen and others see as serial improvisation on behalf of BoA, may amount to a Freudian slip. The bank is probably enough in denial to believe that their putback and other losses really are well under $10 billion (we agree with them on putbacks, we’ve written repeatedly that we think those cases are overblown, but we think there are other chain of title issues that they have not treated seriously that will add up to much more in the way of legal liability and operational costs).
Having a separate operational unit means in a worst case scenario, BofA might be able to amputate this business in classic “bad bank” form. So whether by design or accident, the coded message in the choice of “bad bank” is: “If those crazy hedgies who say our liability is $70 billion are right, so what? They can all go pound sand.”
But could it really hive off ugly legal liabilities? Even though that may be what the BofA people would like to tell those nasty hedgies, the Charlotte bank stopped running the old Countrywide as a separate, bankruptcy remote entity not long after the deal was closed. So it would now seem hard to limit the legal liability to what would amount to a reconstituted Countrywide (but as we discuss later, with some help from their friends, who knows what might be possible…)
But let’s say those crazy hedgies are right in the dollar amount of liability, even if for the wrong reasons. BofA would be in serious trouble.
I’ve been completely skeptical of the resolution provisions of Dodd Frank for a simple reason: I’ve assumed, as in the financial crisis just past, and the big recent ones (the LTCM meltdown of 1998, the 1994-5 derivatives wipeout, which produced more losses than the 1987 crash) that they would center on the dealing operations of the major dealer banks (you may not have realized it, but the US rescue of Mexico was really a bailout of US banks that had written a boatload of derivatives on various Mexican exposures).
In our modern world, where major dealers have globe-ringing trading operations, there are two insurmountable obstacles to a tidy resolution of a major dealer. Any “resolution” will be subject to the laws of the multiple nations in which it operates. Dodd Frank does not have any authority outside the US. In addition, no counterparty wants to have his positions frozen while the courts are sorting out who gets what. If any major dealer is believed to be in serious trouble, no sensible counterparty will want to be exposed. And an untested resolution regime is not very reassuring. The run on Bear Stearns took a mere ten days. The authorities will be forced to bail out a major dealer if it starts to founder. And the banks know that all too well.
However, there is one place Dodd Frank resolution procedures might work, and that is on a strictly domestic non-trading operation. As former White House counsel Boyden Gray discussed disapprovingly in the Washington Post last year:
The Treasury can petition federal district courts to seize not only banks that enjoy government support but any non-bank financial institution that the government thinks is in danger of default and could, in turn, pose a risk to U.S. financial stability. If the entity resists seizure, the petition proceedings go secret, with a federal district judge given 24 hours to decide “on a strictly confidential basis” whether to allow receivership.
There is no stay pending judicial review. That review is in any event limited to the question of the entity’s soundness – not whether a default would pose a risk to financial stability or otherwise violate the statute.
The court can eliminate all judicial review simply by doing nothing for 24 hours, after which the petition is granted automatically and liquidation proceeds. Anyone who “recklessly discloses” information about the government’s seizure or the pending court proceedings faces criminal fines and five years’ imprisonment. As for judicial review of the liquidation itself, the statute says that “no court shall have jurisdiction over” many rights with respect to the seized entity’s assets (thus apparently eliminating many actions that would otherwise be permitted to seek compensation in the federal Court of Claims).
Gray described the process as a “star chamber” and further warned:
This means the U.S. Treasury and Federal Deposit Insurance Corp. are acting as a sometimes secret legislative appropriator, executive and judiciary all in one. Although there is little direct precedent, it is hard to believe that the Supreme Court would not throw out parts of this scheme as violations of either the Article III judicial powers, due process or even the First Amendment, assuming the justices do not find all of it a violation of the basic constitutional structure….Dodd-Frank strips the courts of the right to make statutory and constitutional determinations in critical circumstances, a throwback to the very first draft of the Troubled Assets Relief Program from the Treasury Department, which would have permitted no judicial review at all.
The problem is that the idea of Supreme Court intervention would wind up being theoretical. As former federal district court clerk Hans Bider of the Washington Examiner noted, district courts are incapable of actin on anything in 24 hours, so the inaction means the seizure by the Star Chamber will be deemed to have been approved. And the odds that anyone will be fast footed enough to run to the Supreme Court and get an injunction is unlikely (and may be a jurisdictional non-starter, given that matter would still be in the hands of the district court, even though it is clear that it will not rule in time). Once the Star Chamber has made the bank seizure, that hoary old saying will apply: possession in nine-tenths of the law.
Boyen’s concern was a repeat and probable escalation of the controversial actions during the bailouts, in particular the sort of favoritism we saw in the the AIG rescue, with creditors like Goldman and Merrill being paid 100% on credit default swap exposures that were clearly worth a lot less.
But I see another way this could operate. Let’s say the Lilliputians really do continue winning against the banks, and in particular Bank of America, in the courts. Their litigation losses and projected litigation liabilities mount at a faster pace (and that could happen even more quickly if investors decide to sue).
The FSOC tells Bank of America to put the legacy assets in a separate legal entity. Using its Star Chamber powers, it seizes the bank (either the entire bank, immediately spinning out the rest, or just the bad bank, the niceties of how you’d execute this maneuver are above my pay grade).
The powers that be then by fiat treat all the mortgage-related claims as liabilities of the bad bank. That bank has very little in the way of assets, so those creditors get paid a fraction of the value of their claims. Since this mechanism is beyond legal review, the creditors would be stuck with a fait accompli. They’d have no way of getting recoveries from other bank assets (the notion being that every penny paid in dividends and bonuses since the Countrywide acquisition really belonged to the bank’s creditors and claimants, so recoveries from the bank as a whole are fully warranted).
You can assume any scheme like this would be subject to Constitutional challenge. The creditors would no doubt argue that they had valid claims against the good bank, ergo the regulations surrounding the resolution would not apply (this risk might argue for resolving the whole bank and spinning the good bank assets, and probably the publicly traded liabilities out).
Is this way of screwing those who win in court as a result of foreclosure fraud possible? This scenario no doubt sounds like a stretch. But if you had told anyone in June of 2007 the events of the next two years, particularly the extent and ad-hoc-ness of the bailouts, they would have said you were nuts. And I would not underestimate the creativity of the powers that be in preserving the privileges of the banking classes at the expense of the rest of us.