Scaling back on toxic assets

Lucian Bebchuk of the Harvard Law School has an insightful analysis over at the Wall Street Journal's Real Time Economics blog on The Fall of the Toxic-Assets Plan:

The plan for buying troubled assets -- which was earlier announced as the central element of the administration's financial stability plan -- has been recently curtailed drastically. The Treasury and the FDIC have attributed this development to banks' new ability to raise capital through stock sales without having to sell toxic assets. But the program's inability to take off is in large part due to decisions by banking regulators and accounting officials to allow banks to pretend that toxic assets haven't declined in value as long as they avoid selling them.
. . .
What happened? Banks' balance sheets do remain clogged with toxic assets, which are still difficult to value. But the willingness of banks to sell toxic assets to investment funds has been killed by decisions of accounting authorities and banking regulators.
Earlier in the crisis, banks' reluctance to sell toxic assets could have been attributed to inability to get prices reflecting fair value due to the drying up of liquidity. If the PIPP program began operating on a large scale, however, that would no longer been the case.
Armed with ample government funding, the private managers running funds set under the program would be expected to offer fair value for banks' assets. Indeed, because the government's funding would come in the form of non-recourse financing, many have expressed worries that such fund managers would have incentives to pay even more than fair value for banks' assets. The problem, however, is that banks now have strong incentives to avoid selling toxic assets at any price below face value even when the price fully reflects fair value.

In addition to the changes in accounting, Bebchuk points to the failure of the bank stress test to look at the value of longer term assets.

So, with the introduction of "mark-to-myth" accounting, what should have been a program of price discovery has become an irrelevancy.

However, Bebchuk points out that the problem could resurface later this year.

While the market for banks' toxic assets will remain largely shut down, we are going to get a sense of their value when the FDIC auctions off later this summer the toxic assets held by failed banks taken over by the FDIC. If these auctions produce substantial discounts to face value, they should ring the alarm bells. In such a case, authorities should reconsider the policies that allow banks to pretend that toxic assets haven't fallen in value.

At that point, look to see whether the mark-to-myth model can hold up.