Geithner's Plan: Mark to Market Tomfoolery

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 (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?

Comments

[User 192956:]

Sir,

Your attitiute here shows that you have not lerned a lot from this whole mess. The Government is trying to resolve a tough problem doing everything humanly possible and with reason. To continue to critisize them is folly. Also, banks will indeed seel the toxic stuff as the record shows so far, because it gives them an out of a hard opsition. Maybe they dont deserve it , but the alternative is a massive global fiasco made in the USA.

Asher Jospe

Mar 24 05:09 AM

[PROXIMO:]

Matt----Thanks for outlining the faults in Geithner's plan. I enjoy your posts, and hope you are back posting on a regular basis now.

Mar 24 08:15 AM

[petyaczar:]

MArk to MArket is the root cause of our accounting problem that became a balance sheet problem, that begat a financial problem that turned into a financial panic as it cuased credit tightening.
The politicians created mark to market, the politicians should simply kill it, restore Glass Steagall, and the uptick rule on short sales.

Mark to Market is based on the crazy notion that a willing owner (unwilling seller) must mark down a protfolio of performing assets discounting the price of those assets down to the point where an unwilling/disinterested potential buyer might become a willing buyer. - THIS IS BEYOND STUPID.

Your analysis rightly points out the straighforward solution eliminating the circuitous route concocted by the Treasury.
However, the straigh forward solution has one fatal flaw. It does not allow the politicians to take over and control the free enterprize system. The politicians have pulled off a Coup deTAT of the free enterprize system, and are now in control. The politicians will not easily give up that control - we must wrest it from them, at the time of the next election.

We defeated the Communists - Thanks President Ronald Reagan -The commies have become Capitalists and returned for the next round of competition. Meantime, the U.S. has turned to Socialism and the politicians are now in charge of compensation, benefits, meeting agendas and locations, corporate jets, and everything else they can glom onto.

Will we win the next round of competition with the morons in Congress attempting to run the economy from their poilitical tower? remains to be seen.

Vote em out of office in the next election. IMO

Mar 24 11:09 AM

[Chancer:]

"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?"

Probably, because Geithner and Obummer are less interested in saving banks than they are with the "wow" factor of looking like the "smartest guy in room" saviors.

Mar 24 01:15 PM