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Tuesday, March 24, 2009

Some More Thoughts on Geithner's Toxic Asset Plan

I have had a chance to read several pieces analyzing Geithner's plan to deal with the toxic assets. Before I go on, as I have said, there is no magic bullet and so while I will find plenty to criticize, there is likely plenty there for any plan. The plan is an attempt to thread several sharp needles and thus it is loaded with potential dangers.

As I have said before, the real problem with all of these toxic assets is that in order to sell them at approximately what people will pay they would sell at 30 cents on the Dollar, however in order to keeps banks solvent they would need to be bought at 60 cents on the Dollar. As such, it's important to understand that the problem isn't merely that banks have "toxic assets". If merely removing them from their books was the problem, they would just give them away for free. The problem is that they can't sell them at a price that will keep them solvent.

In order to close this gap, the plan attempts to provide so many incentives that it will drive more buyers into the market. It's simple economics really. The more buyers show up, the higher the ultimate price. It's of course impossible to know if the incentives are big enough, however the incentives are massive. That presents its own problems. These private firms would be required to only come up with one twelfth of the money it takes to buy these assets. Five sixth will be loaned out by the FDIC and the other sixth will be paid by the treasury. As such, the tax payers are on the hook for the other eleven twelfth. Yet, these private firms decide entirely which assets to buy and how much to buy them for. Furthermore, it is also up to their discretion when to sell and for how much. Finally, if these private firms take a loss, they are not responsible for paying back the loan to the FDIC.

As you can see, in an attempt to create a vibrant market, this plan also puts all sorts of tax payer money at risk with almost no control. Furthermore, by limiting the down side risk to the investor, this plan also encourages the investor to dump the investment in a manner they wouldn't if they were on the hook for more.

As such, this plan could very well work in removing these toxic assets at a price that will allow the banks to stay solvent, but that plan will then likely cost the tax payers somewhere near another trillion Dollars. Remember, while the incentive to buy these assets initially is made more enticing through these nice government terms, whoever these investors then sell them to won't get the same terms. As such, this plan will likely drive up the price well beyond what they are worth. By doing so, these investors will find it rather difficult to make money on said loans. As such, the tax payers will then ultimately be on the hook for most of the losses.

So, what we have is two issues and neither of which have anything near a guarantee of success. The first issue is that the plan needs to inflate the current market well beyond where it is now. The second issue is that these incentives might be so favorable that the taxpayer will then be on the hook for buying up most of these toxic assets. It's impossible now to tell if either will be resolved. This plan can succeed however a lot of things will have to go right in order for that to happen.

Here is my plan to deal with these toxic assets.


Anonymous said...

It still sounds kinda like fitting a square peg in a round hole. They need to create a market for this bad debt, but they have to promise the moon because the market is even more risk averse than market conditions now.

mike volpe said...

It is in my opinion as well.

I see this largely as an accounting issue and that can be resolved by changing accounting standards. That's why my idea involves changing mark to market and allowing these banks to value these assets at prices that will keep them solvent and then forcing them to hold these assets for years.

If you are going to value something as a long term asset, you have to hold it at long term.

Anonymous said...

Are there any restrictions on which "private investors" qualify to buy these toxic assets? Is there any reason why banks wouldn't buy their own assets at 1/12th the "solvency-break-even+1/12th" and then dump them, and write the loss off on their taxes?

I'm very skeptical that this only puts the taxpayers on the hook for a mere $1 Trillion. My understanding was that the toxic assets amounted to something a lot closer to $15 Trillion (at full value, though market value would only be 30% of that). Is this incorrect?

mike volpe said...

I don't know how much is the total value of "toxic assets" and I assume that is more than just bad mortgages.

I know that any potential private investor would need to apply with the government beforehand and I assume your scenario would be snuffed out at that point.