Paul:

If, as you say, we cannot put a value on these worthless assets - why doesn't the government turn these banks over to the FDIC? Let the FDIC audit their B/S, sell them, shut them down or do whatever. Isn't that what the FDIC is for - to regulate such issues relating to banks?

Q: There are lots of people like me who aren't rich-rich, but who have some money to invest. Is there an opportunity for us to play in this game through something like a mutual fund, or like a Treasury Direct system, where individuals can make non-competitive bids for new issues?

Dear Paul Solman: Thank you for your explanation of how banks do business, and why those who've engaged in greedy, risky, banking have failed. Thank you also for your explanation of how the new administration is planning to deal with this volatile situation.
However, this is no excuse for journalists to continue to peddle the absurd perception of those in the financial industry that it is the gov't's job to save them for the sake of the nation. Certainly, we want to learn the lesson of the Depression and prevent widespread bank failures. This should be by bolstering those who did not accept garbage on their balance sheet.
A TOXIC ASSET IS A GROTESQUE WORD FOR A WORTHLESS FINANCIAL INSTRUMENT! Why should we use nonsense terms like this? Please don't parrot this crap.
People who bet and fail in the markets should do just that. The gov't should bolster the responsible, reasonable bankers who did not use absurd methods and predatory lending. Please, let's use some common sense when reporting this material!

Daniel J. Leeman
Belfast, Maine

It's great that all of the banks are going to be able to unload their "toxic" assets on the government and private investors, but presumably they're not going to be able to unload them for the amount they are carrying the assets on their books. That means, I assume, that they are going to have to write off the difference between the book value and what they unload the asset for. That can still be a large amount of money. Is this going to help the banks if they are still carrying hugh losses? I've never heard anyone address this. I guess we're still talking about billions of dollars.

March 23, 2009

Dear Paul,

Thank you and your colleagues at NewsHour for your detailed coverage and explanation of the new Toxic (used to be Troubled) Assets Purchase Program. In particular, I would like to thank Ms. Judy Woodruff, Ms. Gwen Ifill, and Mr. Jeffrey Brown for asking the central question on the valuation of toxic assets. I am sure that, by now, the toxic assets have gone from over-valued to under-valued, especially, when sold in an auction. A rational TARP agency should buy the assets, if they are very under-valued, and sell them if they are slightly under-valued or over-valued. But, the government, represent the taxpayer, needs to know the solution of price determination.

For the convenience of your readers, I quoted the related comments/questions from NewsHour. Obviously, their questions were not answered directly by the interviewed. I would like to suggestion the follow-up comments/questions:

"The over-valuation of the assets was the cause of the Subprime Woe, and the fear of under-valuation is the difficulty with the purchase of the toxic assets in TARP. Can we still trust the fair market value? Or what is the use of creating a market, if the market price is always wrong?"

I really hope that economists can make a serious effort to search or solve the problem of value. So far economists and government officials have been willing to pay trillions of dollars to avoid the questions on the determination of the price and the rate of return. I hope you and NewsHour can help me and my post-science students get to the bottom of this issue on value. Enclosed please find the excerpts from the interviews. Thank you for your help.

With best regards,
Hugh

JUDY WOODRUFF (interviewing CHRISTINA ROMER): "...Buying those bad housing debts was the original rationale for the TARP last fall, but no one could say what they were worth, and it never happened."

GWEN IFILL (interviewing LARRY SUMMERS): "... How do you value that? How do you know that it's worth a government investment?"

Valuing assets is difficult

DONALD MARRON, Lightyear Capital: "...It does at least three things. First, it creates a certain amount of transparency. We'll find out what these assets are. Secondly, it will create a value for them. We'll find out what people are willing to pay for them. And, third, we'll find out who's willing to pay for them."

JEFFREY BROWN (interviewing DONALD MARRON and PAUL KRUGMAN): "I want to pick up on your, I think was it was B, or your second point there of your three. That was pricing the assets, because this has been a problem from the get-go here is, how much are they worth? So you think that by this kind of a plan that we'll start to see companies, private investors, competing against each other and really setting a price?"

Number 1 this isn't just 1 trillion dollars, I get so tired of people using just a principal amount, remember people we have to borrow this money and just because were the USA does not mean anyone will just give it to us. Were looking about 1.5 - 1.6 trillion on top of all the other trillions. The balance sheet of the United States of America has to look terrible, but we never see that if we did can you imainge the outrage?

First off the taxpayers will see zero of any of this money we all know that. We will pay for these assets, they will be sold at auction for whatevre price cna be given, and surplus will not come back to the taxpayers, so Mr. Solman needs to be honest. Does he really think that this spend first ask questions later congress will give a penny back to the taxpayer?

Number 2 we have no idea if there is a market for these assets. Say their isn't the government will again go to the taxpayer and say foot the bill.

Were heading toward bankruptcy in this country.

Geithner and the three bears: momma bear, papa bear and baby bear.

There are three scenarios for the toxic assets.

1) Some assets are worth more than the market price. The banks will not sell these at a discount.
2) Some assets are worth less than the market price. The buyers will pay a premium to purchase them.
3) Some assets are work the market price and the government subsidizes the transaction.

Or the assets are too cold, too hot or just right.

The government is still stuck buying the worst assets, the banks will hold the best assets and the rest gets bought by private investors with government subsidies.

I hope President Obama comes up with a plan to pay for the war on leverage.

Dear Paul,

This is a terrible, horrible, _____ plan! IF THERE ARE PROFITS? Of course there are going to be huge profits for hedge funds from the CASH FLOW.

1) One trillion dollars in assets @ a minimum of 5% interest per annum will yield $50 billion dollars.
2) $860 billion borrowed from the FDIC to finance the purchases @ 1.5% will cost $12.9 billion per annum.
3) $50 billion - $12.9 billion = $37.1 billion!!!! hedge-funds will clear each year on the deal after putting up only $70 billion of their own money. (Even if the government gets half of this money, which is by no means clear, the hedge-funds are still clearing $18.55 billion a year on only a $70 billion dollar investment or a 26.5% return per annum.)

The AIG flap over bonuses is piddling in comparison to this government giveaway to the super-rich.

The term 'toxic asset' is somewhat misleading. Bad loans by themselves, are merely worthless. True toxicity can only achieved via financial engineering, with a product known as 'Unfunded Credit Default Swaps'.

A 'Credit Default Swap' is like an insurance for a loan between two parties. A CDS is 'funded' if the money to be paid out is kept in an escrow account (usually paying LIBOR). A CDS can also be 'unfunded', and the current holder of the CDS contract is liable for payment on the entire loan in the event of default.

For example, let's say I have a funded CDS on a loan of $100, paying 5% over one year, and the default rate is 20%. The expected return is:

(0.8) * (100 + 5) + (0.2) * (0.0) = $84.

So on average, I can expect back 84c to the dollar. In contrast, an unfunded CDS requires you to pay up in the event of default, therefore the expected return is

(0.8) * (5) + (0.2) * (-100) = -16

Another words, it has a negative worth. Even if you buy it for nothing you will end up losing money. It is truly 'toxic'.

Unfunded CDS are what a lot of banks have on their portfolio.

Larry Summers told Gwen Ifil on Monday night's Newshour that the taxpayers would not lose a dime until the investers had lost all of their money on a mortgage loan purchased from the banks under Geithner's plan. Somehow, I feel uncomfortable with that answer.

Can you lay out, in terms we can understand, how the paln works? For example, the bank sells a mortgage loan at $100, the invester puts up X dollars, the taxpayers put up Y dollars. The laon is subsequently sold at $150, the invester gets back X dollars, the taxpayer gets back Y dollars. Then do it at a price that the invester loses all he has put up. What is that price, and how much will the taxpayer lose?

My paper, "The Put Problem with Buying Toxic Assets" at http://ssrn.com/abstract=1343625 argues that insolvent banks won't sell their toxic assets without a big subsidy.

Bravo for Paul Stein above with: "
"I hope President Obama comes up with a plan to pay for the war on leverage." and Mr. Ronin (above) is on the mark as well.

Paul Volker gave a speech in Singapore which revealed quite a bit: The subprime market was a bit over a trillion. The credit default swap (CDS) market was at that time 60 trillion. ( now it may be a "mere" 30 trillion. ) A good questioner asked: If banks were sheep and CDSs were wool, would a good shearing harm the sheep?

My guess it would hurt the sheep dreams, and the naive pension plans caught there, but business could function again.

Bankers can write down, just like Lehman did
cents upon the dollar. Yes it hurts but it is time limited. Write down a trillion in subprime at fifty cents on the dollar and lotta haircut and a lotta bargains but you have a bottom, and in today's bail-out figures half a trill is chicken feed.

But 60 Trillion? That kited market is six times larger than all US credit (as Paul Volker
said). The Credit Default market is insurance against change in the world times six. It is a bogus market. Is it that damaging to say sorry chums, but that is a bogus insurance policy? If you thought you could be insured against all change you are a chump. Get over it.

Better that than manipulating the dollar out of existence.

So Paul, was my question above so difficult? I have not found anyone on line that has explained it. Makes me wonder if this is just all smoke and mirrors. If you can't explain it can you direct me to someone who can?

Under the proposed plan, the private sector investor is actually bidding on a call option on the asset (put-call parity). Since the government is fixing the price of this option relative to the strike price (the proposed 6 to 1 leverage ratio) , the private sector is effectively picking a strike price where the call price relative the the strike price is the leverage ratio, not the price of the asset. As Ben points out above, if the strike price is below the asset price the banks says no, if above the banks say yes and the tax payers pay the difference between the actual price and the strike price. This is guaranteed to be a loss for the taxpayer.

As pointed out by the comments of Ronin the pricing of these assets is not the problem. While the default risks are uncertain if both parties have the same information and assess the risks the same they will pretty much agree on the valuation. However, if banks are allowed to use mis-valuations of the sold assets to value unsold assets they will be overvaluing the assets on their books.

This is clearly a bad, not well thought out plan.

Under the proposed plan, the private sector investor is actually bidding on a call option on the asset (put-call parity). Since the government is fixing the price of this option relative to the strike price (the proposed 6 to 1 leverage ratio) , the private sector is effectively picking a strike price where the call price relative the the strike price is the leverage ratio, not the price of the asset. As Ben points out above, if the strike price is below the asset price the banks says no, if above the banks say yes and the tax payers pay the difference between the actual price and the strike price. This is guaranteed to be a loss for the taxpayer.

As pointed out by the comments of Ronin the pricing of these assets is not the problem. While the default risks are uncertain if both parties have the same information and assess the risks the same they will pretty much agree on the valuation. However, if banks are allowed to use mis-valuations of the sold assets to value unsold assets they will be overvaluing the assets on their books.

This is clearly a bad, not well thought out plan.

I would like if you could write an article on how the concept of the falling rate of profit may or may not be the structural problem in this crisis at it's roots.