The cost of calling off the dogs?
What do you mean, ignore anything maturing after 2010?
Ever since the capital markets’ implosion,
Who’s manipulating the taxpayers?
While Lucian doesn’t prove his theses, neither do IJ, and his marshalling of both facts and logic is instructive and therefore often persuasive.
Don’t I look persuasive to you?
His most recent one offers an explanation of the dog that didn’t bark in the night – or more precisely, the PPIP that hasn’t popped:
The Fall of the Toxic-Assets Plan
Love that House-of-Usher gloom.
What toxic assets lurk in the basement?
By Lucian Bebchuk
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.
That surprises Bebchuk, as it surprised me.
I’ve been around a long time, and I’m still surprised
The toxic assets clogging banks’ balance sheets have long been viewed — by both the Bush and the Obama administrations — as being at the heart of the financial crisis. Secretary Geithner put forward in March a “public-private investment program” (PPIP) to provide up to $1 trillion to investment funds run by private managers and dedicated to purchasing troubled assets. The plan aimed at “cleansing” banks’ books of toxic assets and producing prices that would enable valuing toxic assets still remaining on these books.
In February, when PPIP first came out, I published at my for-profit company’s Web site an essay (link in .pdf) praising it as a well-designed means of ‘auctioning your headaches’:
What the aggregator-bank model does do, therefore, is create the conditions for restructuring – pooled assets, motivated holder. The magic next step of restructuring itself will happen via large auction pools, using principles first deployed by the RTC in the very early 1990’s, and at that decade’s end in HUD’s Mark-to-Market restructuring program, in which we played a pioneering role.
Recovering on financial assets secured by real property requires action on the property itself, a bottom-up approach that takes each situation one by one at the asset level.
As my prose makes clear, I expected PPIP to be big volume, and very beneficial:
The HUD 1999 mark-to-market demonstration shows that government can auction its headaches if it uses a shrewd partnership-interest auction structure. Via such an approach, government can solve its information deficit, speed deficit, and expert-judgment deficit, while routing around the liquidity deficit.
I also though, based on the M2M demonstration and its predecessor the 1990s’ Resolution Trust Corporation (RTC), that banks would sell, buyers would acquire, and assets would rebound. We wanted to be on the buy side:
Private entities who dive in, with proper assistance, are likely to do very, very well for themselves.
A good diver can salvage something from the wreck
Yet half a year later, none of that has happened, and with the better banks repaying their TARP, it seems unlikely to happen. Why?
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.
Which they have, and which is clearly relevant.
A bank with non-performing assets bolsters its capital in either of two ways: (1) sell the non-performing asset, for cash, at a market price, or (2) raise new capital so as to hold on to the asset and recapitalize it directly.
Either way, ka-ching
A good CFO and board will look at these choices by comparing the cost of new capital (equity, preferred equity, or subordinated debt) versus their expected IRR from recovering on the unsold inventory they have.
That’s the ostensible and defensible rationale; another rationale, favored by Professor Bebchuk, is much more cynical:
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 value declines?
Pretty strong accusation; he’s accusing regulators of colluding in a fiction bordering on fraud.
Are either of us the good guys?
What happened? Banks’ balance sheets do remain clogged with toxic assets, which are still difficult to value.
Again, the explanation needn’t be nefarious. When assets are difficult to value, and must be sold to yield-voracious private equity, they are often sold at discounts well below ‘intrinsic’ value. A year ago, in bailout or bonanza?, I argued that selling at the market-clearing price would actually be below fair value, a view I still hold. When everybody has to sell something, and nobody has to buy it, the clearance price includes a bargain element – often a large bargain.
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.
Maybe, maybe not. The high-volume clearing price could have had that discount built in, and all the buyers would have done well at the expense of all the sellers.
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.
Yes, and I’ve previously rebutted that claim, in Auctioning Your Headaches.
Restructuring specialists bring fast fast fast relief!
But the willingness of banks to sell toxic assets to investment funds has been killed by decisions of accounting authorities and banking regulators.
If the pack’s no longer yapping at your heels, you don’t run as fast.
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.
That’s a big claim. What backs it up?
A month after the PPIP program was announced, under pressure from banks and Congress, the US Financial Accounting Standards Board [FASB, pronounced fazz-bee. – Ed.] watered down accounting rules and made it easier for banks not to mark down the value of toxic assets.
If it’s toxic, don’t you want to water it down?
‘Watered down’ is a judgmental phrase. As I laid out a year ago, when the assets are complex and normal trading is exploded by a capital and liquidity crunch – which we had a year ago and no longer have now, the crisis having metastasized into a plain-vanilla recession – being forced to liquefy them creates losses that might otherwise never exist.
Okay, a rocky-road recession
For many toxic assets whose fundamental value fell below face value, banks may avoid recognizing the loss as long as they don’t sell the assets.
But if the banks in fact wind up collecting all the payments due on those assets, wouldn’t it be foolish to force them to sell-low, when hold-to-maturity would yield them a better outcome? Professor Bebchuk tacitly accepts that possibility, then shrugs it off:
Even if banks can avoid recognizing economic losses on many toxic assets, it remained possible that bank regulators will take such losses into account (as they should) in assessing whether banks are adequately capitalized.
What makes a bank adequately capitalized? Setting aside the technical rules, isn’t the correct answer, the ability to provide liquidity to all its claimants who arrive seeking redemption of their money? The claimants may be trade creditors, depositors (the largest group), or bank security holders (on the debt side; common equity gets paid from the excess). Nobody keeps capital equal to 100% of its liabilities; the question is what lower fraction is reasonable, and what constitutes ‘capital’ is by no means black-and-white.
By contrast, selling [the complex assets] would require recognizing losses and might result in the regulators’ requiring the bank to raise additional capital; such raising of additional capital would provide depositors (and the government as their guarantor) with an extra cushion but would dilute the value of shareholders’ and executives’ equity.
Observe that if the government is backstopping the banks, forcing them to sell now means the government has to increase its coverage of their losses. Depositors and others aren’t likely to be shortchanged, not with TARP money in so many financial institutions and the Federal government holding large direct or indirect positions in the major banks.
Thus, as long as the above policies are in place, we can expect banks having any choice in the matter to hold on to toxic assets that mature after 2010 and avoid selling them at any price, however fair, that falls below face value.
We’re holding on at any price
Back in January, 2008, in who’s next?, I speculated all too presciently about the GSEs’ subprime debt buying habits, and followed it five months later with a deconstruction of their capital (in)adequacy, in capital, almost as good as money. Now, continuing our year and a half long strategy of banking on value, the regulators have granted the banks a grace period through the end of 2010:
In another blow to banks’ potential willingness to sell toxic assets, however, bank supervisors conducting stress tests decided to avoid assessing banks’ economic losses on toxic assets that mature after 2010.
Well, is that foolish – or wise?
The stress tests focused on whether, by the end of 2010, the accounting losses that a bank will have to recognize will leave it with sufficient capital on its financial statements.
So the regulators doing the stress analysis have asked an intermediate-term question: will the bank still be solvent when 2011 opens? Not unreasonable, if you believe – as many of us do – that even now the bank balance sheets have been written down perhaps far below intrinsic value, and that time and seasoning will allow them to recover some of those writedowns. Professor Bebchuk, as is his wont, is much more skeptical:
You think I can’t get out of this mess?
The bank supervisors explicitly didn’t take into account the decline in the economic value of toxic loans and securities that mature after 2010 and that the banks won’t have to recognize in financial statements until then.
In any case, whether it’s logical or not, waiving the necessity to write down long-term (still performing, don’t forget, otherwise they’d have to recognize an impairment now because of the non-performing or default status) calls off the dogs.
Together, the policies adopted by accounting and banking authorities strongly discourage banks from selling any toxic assets maturing after 2010 at prices that fairly reflect their lowered value. As long as banks don’t sell, the policies enable them to pretend, and operate as if, their toxic assets maturing after 2010 haven’t fallen in value at all.
Let’s pretend our assets are all grown up
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.
An excellent point – there will be some data. How comparable will it be depends on whether the assets sold are similar to those still held. But I’ll be watching with interest.
If these auctions produce substantial discounts to face value, they should ring the alarm bells.
Yes.
Are they about to ring?
Nobody’s ready to declare victory yet.
