Tuesday, March 31, 2009

$ 1 trillion Toxic Assets – Will the recovery plan work ?

The term "toxic asset" is a nontechnical term used to describe certain financial assets when their value has fallen significantly and when there is no longer a functioning market for these assets, so that they cannot reasonably be sold. This term became common during the financial crisis that began in August 2007. Toxic assets played a major role in that crisis. When the market for such assets ceases to function, it is described as "frozen".

Markets for some toxic assets froze in 2007, and the problem grew significantly worse in the second half of 2008. Several factors contributed to the freezing of toxic-asset markets. The values of the assets were very sensitive to economic conditions, and increased uncertainty in these conditions made it difficult to estimate the value of the assets. Banks and other, major financial-institutions were unwilling to sell the assets at significantly reduced prices, since lower prices would force them to significantly reduce their stated assets, making them appear insolvent.

US Treasury Secretary Timothy Geithner has unveiled a plan aimed at persuading private investors to help rid banks up to $1 trillion in toxic assets that that are seen as a roadblock to economic recovery.

The US treasury has invited private entities and individuals to buy some of the toxic assets in the bank books at rock-bottom prices. The banks have partially marked these assets to the market and booked huge losses in recent quarters. There are additional incentives for investors to buy these assets at heavily marked-down prices.

The private investor is being asked to bring in less than 10% of the acquisition cost and the treasury is willing to fund the remaining 90% or more. Also, the government is ensuring private investors could walk away if the value of these assets falls further. So there is no further downside for the private investor.

There are many problems with such a scheme. It has been debunked by a Nobel prize winning economist as “cash for trash”. The main flaw in the scheme is that there is no knowing whether banks such as AIG, City and Goldman have fully marked these assets down to their real value. Over 60% of the housing derivatives were traded and acquired outside the exchange in over-the-counter deals. Since there is no liquidity, one cannot ascribe any value to them.

The treasury plan seeks to discover a price with private partnership. But nobody is sure whether any reasonable price will be discovered for these toxic assets. The biggest irony is that the treasury is trying to discover a price by allowing the private investor a nine-fold leverage! Is this sustainable for US citizens, already over-leveraged.

The Fed's Term Asset-Backed Securities Loan Facility, or TALF, received lukewarm response heightening fears private capital will also shun the government's toxic-asset plan amid public outrage over outsized executive bonuses.

A closer examination of the US treasury plan would suggest that the scheme might need a lot more fine-tuning before it is able to provide some succour to the ailing American banking system.

Contributed By:
Prof. J. N. Mukhopadhyay
(Globsyn Business School)