With the release of the Treasury Department's latest program to deal with toxic assets, it might be helpful to go back to basics. Here is the general problem, as outlined by Tim Geithner in an oped in the Wall Street Journal:
Many banks, still burdened by bad lending decisions, are holding back on providing credit. Market prices for many assets held by financial institutions -- so-called legacy assets -- are either uncertain or depressed. With these pressures at work on bank balance sheets, credit remains a scarce commodity, and credit that is available carries a high cost for borrowers.
Last November, Hank Paulson made a very revealing comment in an interview in the FT :
"There are two ways of getting at illiquid assets," he said.
"One is to purchase them and have a price discovery that comes with that and the capital flows that come with that.
"The other is making sure banks have plenty of capital and encouraging them to continue the process of recognising losses and selling these assets."
For some time, we have been following the latter approach, referred to as "recapitalization" or, by some, as "nationalization." The new plan is based on the former.
In either case, there are a few major challenges. The financial system needs some incentive to disclose and get rid of the toxic assets (now called "legacy assets"). Some banks have already bitten the proverbial bullet and written-off those losses. Others seem to be unwilling to take the hit - probably for good reason since such a write-down might jeopardize their very existence. In some cases, they appear to be holding out for the "mark-to-myth" solution where market-to-market accounting rules will be suspended and they can value these illiquid assets at whatever looks good for the balance sheet. The danger with this approach, however, is that it simply allows the bad assets to fester. And, as long as the bankers and everyone else is sitting there looking at a pile of junk being counted on the balance sheet, lending will not resume. Therein lies the way to create our own "lost decade" similar to Japan in the 90's.
Creating the incentives to get the bad assets off the books is therefore key - Paulson's "encouragement." The nationalization route, to me, never had enough of an incentive to the banks to take the write-off hit. Bankers could simply take the cash and sit on it. Even with almost compete national ownership, the government had limited control -- witness AIG. So I have long favored the bad asset purchase approach.
In this case, however, the political system has put constraints on the process. Politicians and the public understand that the government has to absorb the risk if the banks are to give up the bad assets. But they don't want the government to put taxpayer dollars at risk. At the same time, they are putting pressure on the accounting system (through calls for suspension of mark-to-market) to lessen the regulatory requirements to write off the bad assets.
In other words, everyone is looking for a no-cost way to get around the basic fact that trillions of dollars of asset value has vanished. As long as the financial system refuses to write off those losses, the system will remain both frozen and fragile.
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