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The story goes that there are many "bad" or "toxic" assets sitting on the balance sheets of the nations' largest financial institutions that are undermining the ability of these banks to lend.

Why?

  1. Mark to market accounting requires the institution to mark down the paper to what an arm's length person might pay.
  2. The mark to market loss requires the institution to take a charge against their capital base which acts as as a drag on lending.
  3. This charge means they have to replenish capital.

Enter Tim Geithner...

The Treasury and perhaps private investors too seem to believe that the actual Yield to Maturity (YTM) for much of this toxic paper is far higher than the current marks.

If only we can create a marketplace that will bid for this paper at a premium; we can then set-off a virtuous cycle to help the banking system.

  1. Private player buys toxic paper at a premium to the current mark
  2. Bank then takes new mark to revalue the rest of their paper
  3. Negative marks reverse, spreads tighten
  4. Equity capital surges
  5. Lending capacity expands

Sounds great...right???

But here is the problem.

The only way the program works is if the private bidder for the toxic asset is able to buy the paper at a meaningful discount to its intrinsic value/ytm...

Otherwise, why would I take the risk with my equity as a private player? I am certainly not going to pay the new par value, whatever that may be. My risk of loss would be too great...

This begs the question: why would a bank sell paper for less today than the cashflow stream will be worth if it is held to maturity?

Isn't this bad for shareholders?

Why should I sell something worth 60- cents for 40 cents?

What Mr. Geithner will likely discover is that banks will simply game his new Treasury built casino. Wouldn't you?

I am sure the bid side of the market will be strong, as the vultures swoop in to "help" folks bad at math...

But if I owned Citigroup (NYSE:C), I would simply punt 2% of my toxic paper to the new bid, mark up the remaining 98% using the new mark, boost my capital, and then hold the paper to maturity because the cashflow stream is worth more to me alive than if I sell it off to some vulture at a discount.

Of course, all of this tomfoolery is just a circuitous route around "mark to market" accounting and tier one capital regulations. Instead of focusing on changing or suspending the accounting rules, the Treasury is concocting ridiculous schemes to influence the marks. All the while, the actual cashflow performance of the underlying paper isn't altered in any way, shape, or form.

Instead of insisting that toxic securities need to find a home in the hands of new bidders to help improve the capital position of lending institutions, the accounting bodies should allow these securitized assets to be revalued using accrual accounting and their actual cashflow vs. an illiquid price in the securities market.

For example, if I hold ten mortgages in a bucket, five still paying and five not, I get a value of perhaps 5x par + 5x an estimated recovery of 50 cents = 75 cents on the total bucket. So, I take the 25 cent charge

What does this have to do with whether or not an arm's length buyer might only be willing to pay 25 cents due to the opacity of the security...and the required 75 cent charge?

Geithner's entire "toxic asset" proposal is built upon the single premise that this paper is worth more than the current bid side thinks. If he is right, then why not just let banks revalue them upwards vs. all of this other tomfoolery?

If the Treasury Secretary were truly interested in seeing banks repair their capital ratios, wouldn't he want these discounted, toxic assets to mature in the hands of the banks - and not sold at a meaningful discount to a private agent?

And, if the Treasury Secretary truly believes that these assets are worth more than their carrying values, why not just lower or suspend the "capital charge" on the banks' balance sheet to a new "Fed mark" that will sit somewhere between the current vulture bid and the actual YTM?

Splitting the difference seems just as simple as setting up a facility funded by taxpayer money, provided it is based upon some evidence stream, namely the underlying cashflows of the securities themselves.

Or, maybe that would be too much tomfoolery due to its obvious simplicity?

Source: Geithner's Plan: Mark to Market Tomfoolery