It’s Impossible to Remove Toxic Assets

Information came out yesterday and today that the Obama administration is about to unveil their plan to buy up toxic assets from banks.  They plan to use up to a trillion dollars from the previous bailouts, help from the Federal Reserve and a form of a public/private partnership to accomplish this.  After the uproar over the AIG bailout and bonuses, the administration does not want to go to Congress for more money.

However, it does not matter what kind of plan the Obama team comes up with for one key reason:  Banks will not sell any of their toxic assets.  They will not sell because the second they do, they will have to revalue their assets to the market value, and that will lead to failures across the board.

They would rather sit with billions of dollars of toxic assets on their books, not try to get rid of them, and collect billions from the government.  The only way banks will sell their assets is if the government suspends the mark-to-market accounting rule.

Mark-to-market means that banks have to value assets for their market value.  This is similar to how things operate in the real world for you and I.  Previously, they could use “mark-to-model” accounting, which meant they could value their assets using a computer model to determine their value.

For example, if we bought a home for $500,000, and we want to refinance or pull out equity, the bank will look at the value of our home if we sold it, or the market value.  If it’s value has dropped to $450,000, we have to adjust our plans for the new value.

You will hear some “economists” argue that banks should not have to use mark-to-market because there is no market right now and prices are artificially depressed.  There is a market right now, it’s just that no one will price assets that low because it will trigger all the other banks having to write down their assets.

If the value of these assets was artificially depressed, people should be buying them because their true value is really higher.  Just because it involves millions of dollars and the banking industry does not mean that the rules should be different.

If we suspend mark-to-market it will only lead to inflated prices for worthless assets.  Then the government will buy them and lose all their money and the losses will be stuck on the American taxpayer.  Sounds like a great idea to me.

There is a very simple alternative to all the bailouts and failed schemes – let the banks fail and let the bad debt be liquidated.  Only one politician has been a proponent of this, Ron Paul, and only a small handful of economists have called for this alternative.  It is amazing how the debate is limited to how many billions we should give away and how mad we should get for less than 1% of those billions being handed out in bonuses.

If you talk about bank failures, you are bound hear about Lehman Brothers and how disasterous that was.  I would argue though, that the Lehman failure has nothing to do with the crisis we are in.  Sure, lots of people lost money, but it was pretty orderly, proving the bankruptcy system worked.   Shareholders got wiped out, bondholders settled for 20 cents on the dollar, and the derivatives settled for about $6 billion.

Are we still talking about Lehman?  No.  Are we still talking about another firm that failed but had a government negotiated failure, Bear Sterns?  No.  The government got involved and arranged for a way to settle the debts and found a buyer.

Are will still talking about firms the government has tried to rescue through all the bailouts?  AIG?  Fannie and Freddie?  Bank of America?  Citi?  I know this is anectdotal evidence, but it seems that firms we let fail have gone by the wayside, and those that we’ve saved have just kept causing more trouble.

The point is that spending more taxpayer money and coming up with more schemes to help the banks are futile attempts to put humpty back together again.  The banks will not cooperate and liquidate their debt when they have the promise of government overpaying for worthless assets.  However, we will keep these insolvent institutions alive by giving them money to offset the writedowns on their bad debts.  It is an endless cycle with no light at the end of the tunnel.

The only way to move through this is to let the insolvent banks fail, liquidate their debts, and let the healthy or new institutions fill the void.  Until we do this, the current crisis will continue and eventually lead to the failure of the dollar and our economy as a whole.

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