The Public-Private Partnership Does Not Solve the Root Problem: The Pricing of the Toxic Assets

The plan announced by Treasury Department to partner with private investment firms does not solve the root problem–the pricing of the toxic assets.  When one reads the Treasury’s plan, one would think that we simply have a liquidity problem–a lack of of capital in the private markets to buy up these assets.  But as has been reported,  there is plenty of capital sitting on the sidelines specifically waiting to buy these assets.  For example, back in July, Merrill Lynch sold toxic assets with a face amount or notional value of $30.6 bn to Lone Star Funds for 22 cents on the dollar–$6.7bn (and lent them non-recourse, except to the assets, 75%).

The Problem:  The Banks’ Reserve Price: The problem is not that there is a lack of capital out there chasing these assets; rather, the problem is that the holders of these assets refuse to accept the bids currently in the market.  In game theory terms, the current prices being offer by bidders are far below the banks’ reserve price or the minimum price the banks are willing to accept.  For example, a bidder will bid 25 cents on the dollar for a set of assets, but the bank will only accept 75 cents.

The reason that banks have been unwilling to sell at these current “fire-sale” prices is that the banks have these assets “marked” much higher on their books.  If a bank sells  assets below their current “marks,” the bank will be forced immediately to recognize a loss and be forced to raise capital to make up for this loss.  If a bank recognizes significant enough losses, and cannot raise enough capital, it will be deemed insolvent and will most likely be taken over by the FDIC.

Bottom line: Two undesirable consequences will likely occur from this plan:  (1) the banks continue to refuse to sell assets, because private bidders only raise their bids slightly (even with the Government subsidy) or (2) the private bidders, knowing they have very limited downside, speculate wildly and bid up to the banks’ reserve price (a price dramatically higher than they would bid without the Government backing) and buy the assets.  If the current prices in the market turn out to relatively accurate (a reasonable estimation of just how toxic these assets really are), the Public-Private Partnerships will incur significant losses.  And these losses, as detailed previously, will be borne mainly by the taxpayers.

Only if the banks’ current reserve price (or current mark) turn out to be correct, will the taxpayers come out ahead (if the banks only sell at their reserve price).  As I have learned in this crisis, the results are almost always worse than expected–in another words the banks are drastically inflateing the current value of these assets.

Coming Tomorrow Soon:  Because I do not want to be the blogger of no, here is “My” Proposed Solution–The Government should buy all of the toxic assets at the banks’ current “marks.”  In return, the sellers agree to make the Government whole for any losses that the Government actually suffers.  In other words, allow the banks to recognize the losses only when, and if, they occur.  This will stop banks from having to raise capital just to meet  so-called mark to market losses.

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One Response to “The Public-Private Partnership Does Not Solve the Root Problem: The Pricing of the Toxic Assets”

  1. “My” Solution to the Toxic Asset Fiasco « Political Junkie Goes Hollywood Says:

    […] Solution to the Toxic Asset Fiasco By mschonholz As I previewed two days ago, “my” solution to the toxic asset problem is for the government to buy these […]

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