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The Top 10 Ways to Deal with Toxic Assets

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The Top 10 Ways to Deal with Toxic Assets February 2009 The Top 10 Ways to Deal with Toxic Assets BY NICOLE IBBOTSON AND KEVIN PETRASIC The recent re-branding of the Troubled Asset We all know by now that there are no easy Relief Program (TARP) as the “Financial Stability answers and yes, it will take time for this to be Plan” (FSP) by Treasury Secretary Timothy resolved; but we still do not know how it will be Geithner and his subsequent roll-out of the FSP resolved. There have been numerous solutions outline and, more recently, the Capital put forth by national and international finance Assistance Plan (CAP) has done little to stem the and economic experts for the bad asset problem fallout of the ongoing financial crisis. Rather that will allegedly guide us out of this mess. than having a stabilizing effect, the lack of meaningful detail and transparency has The following top ten list contains those solutions appeared further to roil the markets. The reason, that stand out for their promise, creativity of course, is the bad assets – still there hanging and/or sheer audacity. While we reserve like a weight on the neck of the American judgment for the reader on the merits of each, it economy. While criticism focused on the lack of is likely that one or more of the following, either detail and direction in the FSP and a confusing alone or in tandem, may hold the keys for how rationale for the CAP, the main issue remains: to resolve the current economic crisis. In there still exists a lack of consensus among addition to addressing some of the pros/cons for industry experts on how to remove toxic assets each proposal, we describe whether the proposal off banks’ existing balance sheets. includes elements similar to those described in Treasury Secretary Geithner’s outline for dealing Private equity funds and investment companies with bad assets pursuant to the FSP. First, it is complain that until the U.S. government important to understand the “toxic asset” issue establishes a plan to valuate and liquidate these and the challenges it presents. bad assets, there will be no purchasers willing to step forward with solutions. Issue: Valuating “Toxic Assets” While much has been written about the Based on long-standing guidance, banks are weakness of the FSP, there have been few required to carry assets at “fair value,” which is analyses of the possible ways to address its the price received to sell an asset in an orderly perceived shortcomings. The most striking transaction between current marketplace absence in the FSP is any direction on how to participants. Most of the “toxic assets” now on resolve the bad asset problem. Clearly, this has bank’s balance sheets are real estate and further spooked an economy already writhing in mortgage-related assets, including derivative or the throes of the worst financial crisis since the other bundled securities backed by residential Great Depression. mortgages. Falling real estate values coupled with recent and continually increasing 1 homeowner defaults and home foreclosures allowing banks to set the prices (i.e., colluding directly impair these assets. This has created a banks could signal pricing intentions and keep downward spiral as the value of these assets has prices artificially high, thus reducing the loss for plummeted and most markets for real estate- such institutions). Of particular concern, if related assets have seized up. The result is that Treasury pays too much for assets, taxpayer there are no willing buyers, and there is no losses could quickly mount. market. And without a market, there is no “fair value.” Conversely, if Treasury pays too little for the assets, the auction could accelerate an already Arguably, an asset price must be over-valuated difficult pricing situation. If institutions sell if there are no purchasers willing to pay the securities at fire-sale prices, rather than at or asking price. The net effect is that the fair value near hold-to-maturity prices, banks holding of these assets is diminished. similar assets would be forced to write down their values to match the auction price. This Under mark-to-market accounting, banks are could speed up bank failures, erode banks’ required to mark down assets to reflect the capital base and further restrict the ability of current market or “fair value.” Marking down banks to borrow and lend. asset values leads to further loss of investor confidence and may force institutions to sell This plan was ultimately abandoned for a these assets at fire-sale prices which increases number of reasons, including (i) that the bundled banks’ leverage and reduces capital ratios. assets are too diverse with little available Effectively this creates a spiral effect of further comparative information; (ii) determining an declining funding liquidity, further write-downs, optimal price was too difficult; (iii) the further distressed asset sales and, potentially, government was unwilling to risk inaccurately additional bank failures. While the problem is valuating these assets; and (iv) the reliability of clear, the challenge is how to solve it. the auction method itself was questioned. Top Ten Proposed Solutions 2. Additional Capital Infusions 1. Seller’s or Reverse Auction Infusing capital into troubled financial institutions has the very obvious positive effect In Fall 2008, Federal Reserve Chairman Ben of increasing banks’ available capital. However, Bernanke proposed a reverse or seller’s auction as the public recently discovered, increasing where financial institutions would place bids with banks’ capital does not necessarily increase Treasury for the sale of toxic assets at prices available credit, nor does it do anything they deemed close to held-to-maturity values. immediately or directly to address how to Treasury would then purchase the offers most resolve the toxic assets still sitting on banks’ attractively priced to the government. balance sheets. The first round of TARP funds Underlying this approach is the notion that, after were directly invested in financial institutions these purchases, banks would have a basis for with few conditions on the use of such funds. As valuing toxic assets. Rather than using fire-sale a result, TARP I has been criticized as failing to prices, which would accelerate capital mark encourage banks to use infused capital to extend downs, the auction prices would provide a better loans to businesses and consumers. gauge. Also, taxpayers would benefit to the extent that assets are purchased for a price Advocates of capital infusion for the second lower than hold-to-maturity value. round of TARP funds ($350 billion) emphasize attaching strings to the grant of such funds to Critics of this proposal pointed to the difficulty in prevent the same failed result. The House of evaluating the hold-to-maturity value, as well as Representatives passed a bill in January 2008 2 which implemented accountability and their investment of TARP funds in banks via an transparency by restricting use, requiring increase in available credit. It remains to be reporting and monitoring by regulators, seen whether these conditional capital infusions allocating funds to particular types of businesses will fix the credit crunch. The track record so far and small financial institutions, among others. is not particularly optimistic. Although it is unlikely to be considered by the Senate, the bill has had a significant influence on 3. Suspending Mark-to-Market Accounting Secretary Geithner’s FSP. Many bank executives and banking groups The CAP component of Geithner’s FSP contains a advocate suspension of mark-to-market capital infusion element with the following accounting temporarily or permanently. On the conditions: up-side, this would stop the spiral of marking down assets, reducing investor confidence, and Banks desiring TARP II funds must undergo a lowering available capital. “stress test” to determine the extent to which they require additional capital. On the down-side, this invites speculative valuation by substituting the internal valuation of Banks receiving TARP II funds must submit initial a subjective management team for an illiquid “intended use” plan and monthly use reports market price. It also provides less transparency which are available to the public. and potentially widely varying valuations by institutions for the same underlying assets. This Recipients of TARP II funds must participate in plan has been rejected by most governmental mortgage foreclosure mitigation programs, and regulators because the consequences appear too are restricted from (i) paying excess dividends, undesirable. More fundamentally, diverging from (ii) repurchasing privately-held shares until TARP mark-to-market accounting creates a financial II funds are repaid, (iii) acquiring healthy firms system structure not subject to the same rules in cash deals, and (iv) various executive as the markets and industries it serves. compensation arrangements. 4. Write Down and Fire-Sale At the heart of the new CAP is the notion that banks requiring additional capital will have six Many Wall Street traders and analysts suggest months to raise it from private sources. Those that banks should write assets down and add unable to do so will receive federal government capital, no matter what the costs. This would funding with all the strings attached. The require banks to disgorge their toxic assets for problem, of course, is that banks with capital whatever price they can get, even if this means holes are not particularly attractive investments. selling for pennies on the dollar. Bank analyst It is difficult to understand why private investors Meredith Whitney recommended this approach in would put a dime in an institution that has a big mid-2008. Shortly thereafter, Merrill Lynch sold capital hole. More fundamentally, it is to Loan Star Funds over $30 billion worth of questionable that a savvy investor would put any collateralized debt obligations for the bargain money in an institution that has a capital hole, price of $6.7 billion, or 22¢ on the dollar, particularly if the federal government appears compared with the 36¢ valuation Merrill Lynch ready to fill that hole six months from now.
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