One Way to Deal With Toxic Assets
For at least four months now, it has been recognized that “toxic assets”, mostly mortgage-backed securities for which there is currently no viable market, are clogging up our financial system like plaque clogs up coronary arteries. The actions taken thus far have been piecemeal, half-hearted, and ineffective. Our economy is still in danger of a financial heart attack.
Treasury Secretary Paulson was on to something when he pushed his $700 billion “Troubled Asset Relief Program” (TARP) through Congress last year. The advertized purpose of TARP was to buy up toxic assets, thus removing them from the banking system and restoring it to health.
Unfortunately, shortly after the TARP funds were voted, the Treasury Department decided that the money could not be used for its intended purpose because there was no way to determine appropriate prices to pay for the toxic assets.
By definition, toxic assets are those whose value is so uncertain that there is no functioning market for them. If TARP paid too little for the toxic assets it bought, the banks would not be restored to financial health. If it paid too much, the banks would get a windfall at taxpayer expense. The Treasury Department also realized that in any price negotiation, the banks would know more about the nature and value of the assets than would the people representing TARP.
Since abandoning the original concept of buying up toxic assets, TARP funds have been deployed to fight financial fires. Some of the money has even been used to bail out the U.S. auto industry. Meanwhile, the problem of toxic assets clogging up the nation’s financial arteries has remained.
Fortunately, there is a way to buy up toxic assets that does not require assessing their value today. It is based upon the indisputable fact that at some point between now and thirty years from now, the value of all of today’s toxic assets will be known with certainty.
The Treasury should create a “bad bank” to buy up toxic assets. Let’s call it The Bad Bank of the United States (BBUS).
BBUS would buy whatever assets a financial institution wanted to sell to it, paying whatever price the institution asked, up to (say) 80% of par value. The institution would get cash. BBUS would get the toxic assets plus a special contingent variable warrant (CVW), good for common stock in the institution.
BBUS would place all of the toxic assets obtained from each institution in a separate account. The cash generated by the assets would be retained in the account and invested in Treasury securities. Each account would be charged interest on the original purchase price of the assets at the Treasury’s cost of funds plus (say) 1% to cover the operating expenses of BBUS. The detailed status of each account would be posted on the Internet.
BBUS would wait until all of the toxic assets in a given account had resolved themselves, either by being paid off according to terms or via some default process. At that point, there would be some amount of cash in the account. If this amount was greater than what BBUS had paid for the assets, half of the excess would be returned to the financial institution and half retained by BBUS. If the amount in the account was less than what BBUS paid for the assets, BBUS would exercise the CVW.
Each CVW would give BBUS the right to demand that the financial institution that sold it the toxic assets hand over common shares equal in value to any deficit in its account at BBUS. For example, if on the date that the assets in an account were fully resolved the fund had a deficit of $1 billion, the institution would have the option of either paying BBUS $1 billion in cash or handing over common shares with a market value of $1 billion. BBUS would dispose of any shares received as soon as practical.
It is possible that there would be financial institutions whose entire market capitalization would be less than the deficit in their toxic asset account at BBUS. In these cases, BBUS and the taxpayers would take a loss. These losses would (potentially) be offset by BBUS’s 50% share of the gains on the accounts that returned more than BBUS paid for the assets.
It might seem strange to allow financial institutions to select the toxic assets they sell to the BBUS and to set the prices of those assets up to some maximum. However, financial institutions will have incentives to price these as accurately as they can. If they set prices too high, they forgo current tax deductions and set themselves up for involuntary equity dilution down the road. If they set them too low, they will lose money unnecessarily.
Given that the government played a major role in creating the toxic asset crisis in the first place (via an unstable dollar and various laws promoting mortgage lending to sub-prime borrowers), it is not unreasonable that the government assume some financial risk. Under the BBUS plan, participating financial institutions will bear as much of the risk they can bear without impairing their ability to perform their economic function.
Because the detailed status of each account at BBUS will be published on the internet, the markets will take into account the projected gains or losses in these accounts in valuing each financial institution. This will feed back into the market price of the institution’s common shares. However, because BBUS will not have recourse against the institution for anything but common stock, this should not impair the credit worthiness of the institution or its ability to raise capital via debt or preferred stock.
The BBUS approach would solve the problem of toxic assets once and for all, while minimizing the costs and risks to both taxpayers and financial institutions. It would do this by side-stepping the problem of assigning prices to assets that are deemed toxic specifically because their value is currently so uncertain.