Investors should not read too much into the Dow's nearly 400-point drop Tuesday. What they should concentrate on, in the view of a pair of economists, is the mechanism the U.S. Treasury uses to price toxic assets. The above is the most important 'unknown' in the U.S. Treasury's financial stability plan, so says economist David H. Wang -- how toxic assets that are clogging banks' balancing sheets and restricting credit -- will be priced.
"Will the United States government set-up a clearinghouse? Or will they design some type of open outcry, or managed open outcry? These are the key unknowns," Wang said. "Treasury Secretary Geithner and his staff cannot rush this decision, but on the other hand they cannot take two quarters to developed it. They have to announce the structure of the pricing program within a couple of weeks. I cannot underscore enough the importance of this pricing methodology. It will be the biggest factor in whether the credit system recovers, or something much worse occurs."
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.
Reader Comments (Page 1 of 1)
2-11-2009 @ 2:53PM
David said...
No doubt Geithner plans to give the toxic assets free of charge to Goldman Sachs, who will resell the assets to other banks and insurance companies. Goldman will win big, everyone else including the government will lose their shorts. It's just the way things work.
2-11-2009 @ 4:25PM
Andre Haeff said...
The elimination of Mark to Market is a solution that could restore confidence in
Treasury Secretary Geithner and his recovery plan.
All future planning of asset valuation and risk is based on certain assumptions of future value.
What was the Empire State Building worth when it was constructed in the midst of the depression?
Was our defense budget just before World War II thought to be excessive by many?
Replacing Mark to Market by a valuation system that includes
current, past and future prices creating a sort of moving
average upon which to plan US economic surival and growth seems to me to be the solution.
I hope the Treasury Secretary Geithner will seriously consider eliminating the Mark to Market accounting rule.
Other examples: the value of open land is low until it is developed; the value of an idea is
low until it is implemented; the prime historical example is when the Manhattan Indians marked the value of their island to the current market of $24 worth of shiny beads back in the 17 th century.
Andre Haeff 2/10/09 /2/11/09
2-12-2009 @ 3:14AM
John Bass said...
It appears the Mo Mod platform addresses both valuation of illiquid assets and mortgage modifications. Pricing is key, and the need for un-biased valuation is critical. If this can be done properly the "floor" of real estate can be determined very quickly. Stabilization of markets can occur since the "true underlying value" is transparent
3-06-2009 @ 4:08PM
scott safford said...
The initial valuation of the toxic assets becomes less important if safeguards are put in place which protect taxpayers.
For example, if a "Bad Bank" were formed with public and private capital and the and long term value of the toxic assets was thought to be between say 20 and 70% of face value, then the Bad Bank could acquire the assets and receive both the assets and stock warrants, depending on the price paid. That is, the higher the amount paid for the assets the more warrants received. If a bank sold its toxic portfolio to the Bad Bank at 20 cents on the dollar it would not give any common stock warrants. If 30% then warrants representing 5% of its O/S stock, if 40 cents on the dollar then warrants given representing 10% etc.
That way if the taxpayer and private investor in the bad bank were to overpay for the toxic assets the benefit would show up ultimately in the seller bank's common stock valuation, since the bad bank received warrants for that common stock it would participate in the upward movement of the common stock price and therefore have protection from the initial overpayment.