Pricing system for toxic assets deemed key to U.S. Treasury bank rescue plan

Currently, most toxic assets are illiquid and don't trade. Further, along with constraining credit, the unknown price and quality of the toxic assets has radically lowered bank sector confidence, which has discouraged private capital from investing in banks.

Banks taking 'survivalist stance'?

If the assets are largely toxic, that would imply that banks wouldn't mind ridding themselves of the bad debt in a sale to the government, but Wang says that may not be the banks' stance. "After the sale of toxic assets, some banks may be revealed to be insolvent, with their operations taken over by the government, or dissolved. For these banks that means they will be out of the game and no longer have a seat at the table," Wang said. "As zany and as irresponsible as that may seem, some banks may be holding off, may be concealing the quality of these toxic assets, because it keeps them in the game, even though U.S. credit markets and the economy continue to worsen as they do so. They may view this stance as 'holding out in hope of a better scenario,' one where they survive. It could be a survivalist stance."

A secondary and related question concerns the federal government's stress test for the nation's largest 18-20 banks, so says economist Peter Dawson. "Which banks full of toxic assets will be allowed to fail? And if that occurs, what will be the form of the intervention that fills each bank's role?"

If Wang is correct regarding a potential "survivalist stance" by certain banks -- and those banks are insolvent -- Dawson says federal government nationalization is possible, as is an option outlined by my colleague Peter Cohan: creating new banks.

"The problem with each of those is, first, there is nothing in the U.S. experience that suggests that nationalization of the banking sector would be acceptable. The political system and culture of the United States just doesn't support it. This isn't France. Look at the resistance to the government's intervention in the U.S. auto sector. To give you an idea of the magnitude of change implied by nationalization, it would be like France suddenly going from a 5-week national vacation system to a 2-week vacation system. See what happens if you do that."

"Second, creating new banks suggests that current stakeholders, the existing banks, won't be major players in the new banking system. Again, there's nothing in the American experience, historically, that suggests that the federal government will shut out existing stakeholders in a new system," Dawson said. "It would be completely foreign to the American experience."

Fiscal Policy / Economic Analysis: For investors, Wang and Dawson agree that they shouldn't worry about short-term Dow fluctuations: these days, a hedge fund manager sneezes and the Dow drops 200 points. Investors should concentrate, they said, on Geithner's upcoming system for pricing toxic assets and his mechanism to remove them, and, by extension to get assets trading, and credit flowing, again.