What To Do About Toxic Bank Assets

In a word: Nothing.

The conventional wisdom flying around the media and Washington’s corridors of power is to find a plan to lift the assets of the banks’ balance sheets. This is essentially a call by investors for the taxpayer to take the hit of any further declines in value. Ok, that will probably happen by one means or another, but there are two ways to do this.

One creates a scheme whereby the government (the taxpayer) finances the purchase of these assets and limits the downside risk to the private investors. This is the wrong way as it privatizes potential gains while socializing losses. That was the game we were playing with Fannie Mae and Freddy Mac. The loser is mainly the taxpayer. Do we really want to set up the same game that got us here in the first place?

The second way and the right way is to leave the assets on the banks’ balance sheets which now have the taxpayers as very large stockholders and therefore beneficiaries of any potential reflation of the assets as the economy recovers.

But, what if the assets decline in value further? Well the taxpayer is bearing that risk in either scenario. If they decline on the banks’ balance sheets, taxpayers will likely have to inject additional capital in return for additional equity in the banks and if they decline via private lift out purchases, the losses will be insured by the government (taxpayers). The only difference is what happens if they appreciate in value. In the lift out case, a bunch of hedge funds benefit while in the do nothing case, the bank and its shareholders including taxpayers benefit.

So should we really do nothing? Not exactly. The accounting for the assets is complicating matters causing perhaps unnecessary write downs to bank capital and compromising their regulatory capital ratios. Mark to Market is an excellent concept and provides good information to investors to evaluate the true value of a bank’s assets. But, it assumes there is a real liquid market that truly represents the value of the assets. What happens when the trading volume of a market shrinks in a panic to less than 80% of what it was? One no longer has a real “Market”, so like a private equity firm, the rules need to provide some flexibility to mark the assets to “net present value”, which is what a market is supposed to do when functioning normally. Marking to “net present value” would be evaluated quarterly by the bank’s auditors and would need to be blessed by the FDIC and the Federal Reserve Bank.