The Seoul Solution to the Banking Crisis: no need to sell off toxic assets immediately

The Seoul Solution to the Banking Crisis, by Weijian Shan
Geithner doesn't need to sell off toxic assets immediately.
WSJ, Feb 12, 2009

Let's face it: the American financial system is basically insolvent. To date, the U.S. government has committed, on behalf of taxpayers, more than $7 trillion of capital injections and guarantees to financial institutions. Treasury Secretary Timothy Geithner said Tuesday the government will pour up to $1 trillion more into a "Public-Private Investment Fund," which will be tasked to buy up banks' bad assets -- the real blockage in the credit pipeline. The trouble isn't, however, that banks don't want to sell loans. They just don't know what a fair price is in a now-illiquid loan market because there are no buyers.

How should the government price toxic assets? If the government overpays, current shareholders will be unjustly enriched at the expense of taxpayers. Rewarding reckless behavior would only encourage more of it. If the government underpays for assets, it will amount to an expropriation of private properties without just compensation, and make the banks' capital positions even weaker than they are now. There's another complicating factor, too: Since most bank deposits are government-guaranteed, the government has the ultimate responsibility to save failing banks. That means Washington must take over the failed bank before selling it off. The government will own the assets and sell them when private capital is brought in to recapitalize the bank.

How should the government price these assets? Mr. Geithner's plan suggests that the determination of the prices will be left to private investors. But what if the government is the seller? How does the government get it right? How do private investors get it right? It seems to be an impossible task, because currently there is simply no market for toxic assets, and if there is, the market will deeply discount them, either bankrupting the bank or costing taxpayers dearly. It is a major dilemma which needs to be resolved. But there is a proven way to solve the problem, and it should be used again.

During the latter part of 1998, the financial system of South Korea -- at that time, the 10th largest economy in the world -- was basically insolvent. Many banks failed as bad loans mounted. Capital flight reduced Korea's foreign exchange reserves so much that the country teetered on the verge of sovereign debt default. Korea had to request emergency funding from the International Monetary Fund, which, working closely with the U.S. Federal Reserve, eventually provided the country with a $58 billion rescue package.

The package came with strings attached, one of which was for the Korean government to sell off to foreign investors a clutch of failed and nationalized big banks including Korea First Bank. The Fund reasoned that the failure of Korea's banking system was due to a total lack of a "credit culture," as lending had typically been done on the basis of either government policies or collateral without much regard to the creditworthiness of the borrowers. Seoul thought foreign investors could help inculcate this culture into the banking system.

U.S.-based private equity firm Newbridge Capital was one of the only two bidders -- among more than 40 invited -- to attend the government-mandated auctions. I represented Newbridge at these meetings. After weeks of negotiations, we reached a preliminary agreement with the Korean government to give us the exclusive right to acquire Korea First Bank. The key part of the deal was that all the assets be priced at fair market value. The memorandum of understanding specifically called for all assets to be "marked to market" on a loan-by-loan basis, after which Newbridge and the government would jointly invest into the bank to recapitalize it.

"Mark to market" accounting, however, turned out to be completely inoperative in a financial crisis because then, as now, there was no market for bad loans. Sellers thought that assets would be worth more when the economy eventually recovered. Buyers worried they might be worth less if the economy continued to deteriorate. Both were right because there was a significant probability for either to happen, but their divergent expectations made it impossible for them to agree to the right price.

Then the parties discovered a simple methodology that resolved the dilemma -- and could resolve America's dilemma, too.

Since the market was illiquid, we realized that it was impossible to determine the "fair value" in the near term. We thus agreed to a so-called future "buy or sell" arrangement. Over the following three years, on the anniversary of our agreement, the bank would name the price for any existing loan on its books, and the government would have the option to "buy" or "sell" that loan at that price.

The goal was for the government to minimize the amount of money it would have to inject to make up the difference between the market and face values of bad loans, and for us not to have to bear the losses from the bad loans we had inherited when we bought the failed bank from the government. This arrangement gave us the time to work out or to improve the value of these loans, and perhaps for the loan value to recover over time. If it didn't fully recover, and on one of the anniversaries we valued a problem loan at 70 cents on the dollar and the government agreed, we would receive an injection of 30 cents to make us whole. But if the government thought we were lowballing it, the government could buy the loan from us at full face value -- $1 -- and sell it to other investors at a higher price, say 80 cents. This would leave taxpayers with a loss of only 20 cents, as opposed to 30.

The beauty of this methodology is severalfold. First, the government did not have to sell bank assets to private investors at deeply distressed value in the depth of a financial crisis -- a move which would have incurred huge losses for taxpayers. Over time, as the economy recovers, the loan value is likely to improve.

Second, the bank was no longer crippled by the burden of bad assets because it knew they were ultimately protected by the government. The new investors could concentrate on fixing the operations of the bank and making new loans.

Third, the plan removed any incentive for the privatized bank to cheat the government. To a bank, an interest-yielding asset is more valuable than cash. Therefore a bank would want to hold on to an asset, and more importantly to a customer, as long as the loan is safe. In our buy-sell arrangement, if the bank mistakenly underpriced a loan or tried to lowball its value, the government would buy it with cash and the bank would lose the loan and the customer. If the bank overpriced the asset, the bank would risk losses as it would get stuck with a loan for less than its book value. Therefore, the bank was incentivized to work out the loan to the best of its abilities and to price it as accurately as possible.

This methodology worked so well for the Korean government that, three years later, after the program ended, the government had spent a fraction of its original budget to rescue the bank. Under the new owners, many of the nonperforming loans were worked out and recovered, along with the recovery of the Korean economy.

In retrospect, the methodology was the best deal for taxpayers. It did not give investors as much gain as government-assisted bank deals elsewhere at that time, which allowed new investors to buy assets at substantially marked down values and capture significant windfall gains when the market and asset value recovered. We earned our upside from revitalizing and building up the bank, not from gains on legacy assets at taxpayer expense. Both the Korean government and Newbridge eventually realized many times their investments when the banks recovered and were sold off five years later.

Like Korea a decade ago, the U.S. government is left with little choice but to nationalize insolvent banks. Mr. Geithner now needs to flesh out the methodology through which he's going to relieve these banks of their bad loans. There is no lack of capital in America today, or in the world beyond it. Mr. Geithner can make it flow again, if he only looks to Seoul's example for how to do it.

Mr. Shan is a partner at TPG Capital. The views expressed in this article are strictly his own.