Sunday, March 22, 2009

What Toxic Assets and Pawn Shops Have In Common

I always have loved oxymorons. If 'Toxic Asset' isn't one, I'll eat my hat.

Now there is plan to deal with these bank busting beasts of the balance sheet nether world. It seems to be to try and get auctions for these market outcasts by sweetening their intrinsic cyanide with low interest loans, government partnerships and limited liability. Hey, how do I get in on that? Oh, as the tax-payer I fund it? Thanks guys!

The give-away seems substantial. Will it work?

GREAT EXPECTATIONS...good expectations?
There are several aspects of this question. Will it get transactions going? Will it help to solve the TA problem in a meaningful way? As to the former I'm guessing it will get some transactions; as to the latter I don't think this is a systemic barn-burner of a solution.

Reality GAP
The REAL problem with these toxic assets is the gap between a FORM OF REALITY and the PERCEPTION of reality. Since no one is really closing this gap the plan is swimming up stream against a strong current. The one form of reality is the mark to market price. The perception is the long term value where all good bankers expect their loan values one day to one climb.

We have seen the enemy...
Let me return to a familiar theme: mark-to-market is the ENEMY. Economists glorify markets but we know there are malfunctions and distortions from time to time. There are even markets to bridge the gap when those things happen. Consider this: the Pawn Shop as a model for what toxic assets really are and how they are treated.

Government plan as a GIANT PAWN SHOP
Pawn shops have existed for many, many years and business cycles. I note this to make the point that THEY are part of a system and not a 'malfunction' per se. But these shops cater to a particular clientèle. They lend a fraction of the value against assets of various sorts. Why? Why do people put up so much collateral than what a loan is really worth? The answer is because they need quick money (liquidity). Also because they do not want to really sell the item for good and they have hopes of buying it back. Moreover, it's because if they did not put up the asset for collateral they would get money by borrowing at a very high rate.

Banks as pawn shop customers...
Compare this to banks and their toxic assets. Banks do not sell them because in time they think they will be worth more. They do not sell their assets for pennies on the dollar also because they do not need the liquidity- the Fed has provided plenty of that. So banks are not being forced into liquidation (no forced liquidity/solvency) crisis. They mistrust one another on the value of the other guy's assets but remain steadfast that their own TAs are going to prove to be worth more in time. So how does the Treasury plan poke through this double-dealing facade of value?

The Treasury plan: drum roll please...
Basically it doesn't. If it provides enough VIG to the investors they might step up to the plate and get aggressive enough for banks to part with a few of their TAs and take the loss. But the banks get nothing from this. The do get to unload their TAs, but at close to mark-to-market prices, something they have tried to avoid. I see the banks- the asset sellers- as the problem here. Buyers are getting some good incentives to buy and to sweeten prices (their bids) but they need the lure of a gain and that means they need to NOT PAY long term value. So what breaks that log jam? Listen on Monday. As of yet I have not heard it.

Mark to mythology with St Mark
Mark to market accounting is still the villain here. It forces banks to mark to a market that is depressed and that requirement further depresses prices and those acts, in turn, make the market illiquid. It is this wedge between long term value and mark-to-market that is the issue/problem. Get rid of mark-to-market and the Treasury plan could work. Keep it and I don't see a solution.

Still, stay tuned for new news on the plan on Monday from Timmy G.

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