I don't know how to solve the banking crisis. Let's get that out of the way.
What I do know is that if people are thinking about the problem in the wrong way, they're less likely to come up with a good solution. One of the wrong ways that people are thinking about the problem relates to the notion of "toxic assets".
Here's one example from Fortune:
Don't forget those toxic assetswhich includes the following quote:
The trouble is that the toxic assets did not melt away on their own and they contaminate the ability of banks to redress the quality of their balance sheets. Until the banks do so, they stand virtually no chance of returning to more normal lending activity. BACKGROUND
Banks serve as intermediaries between savers (who have money) and borrowers (who want it). They take money from savers in the form of checking accounts, savings accounts, and CDs. From the bank’s perspective, these are liabilities. In order to generate funds to satisfy the savers (e.g., to pay interest on savings accounts), pay their operating expenses, and earn a return for the owners (shareholders), banks need to invest that money. Sometimes they’ll lend that money directly to borrowers who want to buy a house or a car or go to school. These loans outstanding are assets from the bank’s perspective. As long as the borrowers make their payments as expected (homeowners make their mortgage payments), the bank can pay its employees, satisfy its obligations to the savers, and have money left over to return to shareholders.
However, when the bank’s assets don’t perform as expected, banks run into problems. So when homeowners begin defaulting on their mortgages at higher-than-expected rates, banks’ assets are worth less than expected, and they have difficulty satisfying their obligations. Right now, banks are having a problem because their assets (money they have lent to borrowers) aren’t worth enough to satisfy their obligations. So that’s the big issue.
BANKS’ ASSETS AREN’T SUFFICIENT TO SATISFY THEIR OBLIGATIONS (which effectively means meeting regulatory requirements that asset values have to exceed liabilities by a certain amount).
WHAT IS CAUSING THE DECLINE IN ASSET VALUE?
Now there’s some argument about why this is the case. In short, assets could:
1. Be worth a very small amount because, over the life of those assets (i.e., the term of the loans), the borrowers simply don’t make nearly the dollar amount of payments that banks expected. So a bank that simply holds on to its mortgages for the entire 30-year life gets far less than what was originally borrowed. Consider this a “real” or “permanent” decline in value because it reflects the fact that, in hindsight, banks made stupid loans and they’re going to lose money on those loans.
2. Have a low “market price”. That is, certain assets the bank holds (like investments in pools of mortgages) may actually be traded on an open market. The value of those assets on any given day is based on the observed market price of the asset (just as the value of my assets is based on the quoted prices I see in my brokerage account). Those market prices, in turn, are based on the market’s expectations of what the assets will generate in terms of future cash flows. So the market is trying to estimate, for a given pool of mortgages, say, how many of those mortgages will be paid early, how many of those mortgages will be satisfied over the contractual life, and how many of the mortgages will go in default because the homeowner doesn’t pay. Furthermore, the market has to estimate, for the expected defaults, how much of the mortgage they’ll recover through foreclosure or short sale.
Generally, markets are quite good at estimating the fair value of assets, even very complicated assets. But sometimes there is so much uncertainty that investors simply give up. That is, a bank may have an asset ABC that in 2006 was worth $100,000 based on observed market pricing. But now, investors simply have no idea how much the asset is worth, because they have no idea how high default rates are going to be, or how high recovery rates on foreclosed properties will be. So they say something like, “I wouldn’t be willing to pay more than $5,000 for that asset. But I wouldn’t sell it for less than $95,000. I simply have no idea how much it’s worth and I’m not going to risk money on something with so much uncertainty.”
So now you’ve got banks holding on to assets with highly uncertain values. They don’t want to sell the assets because no one is willing to buy them at what the bank deems a fair price. In the prior example, you might say the expected value of the asset is $50,000 based on the midpoint of the two estimates, but if the bank sold it they’d only get $5,000. These assets with highly uncertain values are being identified as “toxic assets”. And the argument that I see in stories like the Fortune article is that if you can simply remove these toxic assets from the bank’s Balance Sheet, the bank will be perfectly fine.
SO WHAT’S THE PROBLEM?
The argument doesn’t make any sense. The banks aren’t harmed by having those toxic assets on their Balance Sheets. The assets aren’t toxic in the sense that they will actually contaminate any other assets in close proximity. The banks are harmed because they have toxic assets
and insufficient other, non-toxic assets to satisfy their obligations.As an analogy, suppose I borrow some money and use that money to invest in baseball cards. In particular, I use all of the borrowed funds to buy a large supply of 1968 Johnny Bench rookie cards.
Subsequently, it turns out that nobody wants Johnny Bench rookie cards anymore – I can’t sell them, except at super-distressed prices. So I’m stuck. I’ve got to make payments on the loan and all I have are these toxic baseball cards. BUT SIMPLY REMOVING THESE CARDS FROM MY BALANCE SHEET DOES ME NO GOOD. If I burned these baseball cards, I still have no other assets and I still owe money. I can’t be better off by removing the assets from my Balance Sheet. The real issue is that I need some other assets with which I can satisfy my obligations.
The same is true for banks. They don’t benefit by simply removing the toxic assets from the Balance Sheet. They need other, more liquid assets. Framing the problem in any other way is simply obfuscating the central point.
THE SOLUTION
The end result is that troubled banks will either receive capital, be allowed to survive with reduced regulatory requirements, or fail. Regardless of how you feel about letting banks fail in a structured fashion or letting them continue with reduced capital requirements (I think there are merits to both), if banks are going to receive capital from the government, the primary question is “what does the government get in return”. Does the government get shares of equity (common or preferred), does it get debt (and if so, what is it senior to?), does it get the “toxic” assets (i.e., a straight asset sale), or is it simply an injection with no strings attached?
Determining the right structure is difficult for many reasons, even putting aside the dollar amounts (e.g., should the government have voting rights, should the government be allowed to jump ahead of senior claimants in terms of debt priority?). But the dollar amounts are difficult for precisely the reason that these assets are “toxic” to begin with – nobody really has any idea how much they’re worth. So whether it’s a loan or an equity injection or an asset purchase, the question is going to be “how much does the government get in return?”
I don’t know the right way to do this. But I do know that solutions posing as “removing the toxic assets from the Balance Sheet” aren’t doing anyone any favors. If those arguing for removal really mean converting the illiquid assets into cash, they should say so. And they should provide the mechanism by which the dollar amount should be determined. And they should indicate why an asset sale is better than a debt or equity injection. (The market in banks’ common equity is still liquid, so at least the government is more likely to get a fairly-determined price if they were to purchase equity compared to what they’d get if they purchased illiquid asset-backed securities.)
And if those arguing for removal actually believe that simply removing the assets from the Balance Sheet will solve the problem, they should be ignored. And they should send all their unwanted assets to me.
