“My” Solution to the Toxic Asset Fiasco–Revised

As I previewed two days ago, “my” solution to the toxic asset problem is for the government to buy these assets at the value the banks currently have for them on their balance sheets—what they have the securities marked at on their books (I use the scare quotes because I cannot remember if I came up with this idea on my own or read about elsewhere).  In return, the seller gives the Government essentially an insurance policy that they will pay for any losses the Government actually suffers, but only when those losses are suffered.  Essentially, the Government will not only be purchasing the assets, but also be purchasing a Credit Default Swap from the bank. This plan solves two problems:  (1) pricing of the assets (assuming the banks reserve price is at or below the current marks) and (2) provides downside protection to the Government.  As I said in one of my previous post, I believe the biggest hurdle facing the Treasuy’s plan will be the banks’ unwillingness to sell at any price below the banks’ current marks.  Under my proposal, assuming that banks’ reserve price is equal to or is lower than their marks, the banks will sell the assets at their current marks.  Second, the insurance policy the Government purchases eliminates any loss the Government may suffer because of defaults in these securities.

What this plan does is allow the banks to move to cash flow accounting and away from mark to market accounting.  As I said previously, the banks have had to record significant losses, and had to raise capital to meet regulatory requirements, because the assets they were using to meet those requirements had decreased in value based on their current market prices (market to market losses).  Under this plan, by selling the securities and issuing CDS policies, the banks will only have to recognizes losses if, and when, those losses actually occur.  This will benefit the banks in two ways (over the current situation):  (1) If the securities do not produce losses or produce losses that are a lot lower than what the current prices imply, the banks will not have to raise as much capital as they would under the mark to market system and (2) if the banks do have to raise capital, it will most likely be some time in the future when the environment for doing so will more friendly.  Moreover, by purchasing these assets at the value on the banks’ books, the banks’ creditors and depositors will be protected.


There are obvious costs and risks with this plan.  First, the Government will have to raise money presumably by selling bonds to the public.  Therefore, it will have to pay interest on that debt.  But given the current intereston US Sovereign debt, that cost will be minimal.  Second, by purchasing the CDS from the banks, the Government will face counterparty risk.  An insurance policy, as we saw with AIG, is only as solid as the company that issued it.  There is no guarantee that the banks will not default on the insurance payments when the policies are triggered in the future.  The Government could mitigate that risk by purchasing another CDS policy, this time on the bank (a hedge against that risk).


The CDS’ will need to be structured so that the banks, who are selling the toxic assets, do not have post collateral when there are only market to market losses (as AIG had to when they got downgraded in September) because then we would be basically in the same place we are now.  But the obligations to the Government will have to be structured in such as way that they are senior enough in the capital structure to protect the Government.


But given my lack of training and experience as a corporate lawyer, I do not know how to do this; it’s over my pay grade.

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2 Responses to ““My” Solution to the Toxic Asset Fiasco–Revised”

  1. Stephanie Schonholz Says:

    Matt,

    I have to say your blog has been incredibly helpful for me. As your younger sister I hate to admit when you’re right about something or admit when I could possibly learn something from you, but these blog entries have shed light on the economic disaster we find ourselves in better than anything else I’ve read.

    And I’ll put it in writing just this once: Older might actually equal wiser (sometimes)!

  2. Bethany Says:

    Do you think you could lighten this up a bit by including some recipes? Perhaps we could have “toxic brownies” or “stimulus pie.” TARP fries. Bacon, AIGs, and ham . . .

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