Evaluating Toxic Assets – And Where Do We Go Next

Remember that the original Paulson bailout plan and the major function of the revised TARP rescue legislation is an attempt to prevent massive insolvencies in financial institutions that have, on their balance sheets, “securitized” assets (e.g., Mortgage Backed securities [MBS, CDOs, credit default swaps ,etc] that had become virtually illiquid as the market for these “securitized” have failed.

There are three points that I wish to discuss. One: what was the cause of the failure of these securitized markets? Two: what policies do we need to put in place to present toxic asset problem from recurring again? Three, even with the passage of the TARP “rescue” (bailout) plan, the U.S. economy is experiencing a recession. What should the government due to constrain the downturn until a new Administration takes office next January? I have written an article entitled “Securitization, Liquidity, and Market Failure” that was published in the May/June 2008 issue of CHALLENGE . It explains at length why these securitized markets were bound to ultimately fail.

In the good old days, before “securtization “, when a bank made a loan, especially a mortgage loan, the loan contract was basically an illiquid asset that was listed on the asset side of the bank’s balance sheet. What value was put on these illiquid assets on the balance sheet? If there was no market for these illiquid assets — one cannot mark to market the asset!! So they assets were typically carried on the balance sheet at the value of the outstanding loan — until, it was paid off — or defaulted on!

Now a good neoclassical theorist would have said that the value of the outstanding loan contract is the computed present value of the future stream of cash receipts including the discounted value of the pay off of the principle (in the case of an interest only loan). Of course, the implicit neoclassical assumption underlying this type of present value calculation is that the future was “known” at least with statistical reliability, i.e., the future is determined as an ergodic stochastic process. If the future stream of payments are known with statistical reliability, then anyone who took a course in economics can calculate the “objective” actuarial present value. (And remember under the rational expectations hypothesis – the subjective probability distribution equals the objective probability distribution that governs future outcomes.) If, however, the future is uncertain, i.e., nonergodic, then the present value depends on the subjective evaluation as to whether all the contractually payments specified (in monetary terms) to specific dates are actually going to be met by the borrower. A large down payment on a mortgage loan created a cushion for the banker in case a future, unpredicted, default occurred.

For assets that are liquid, as I specify in my JOHN MAYNARD KEYNES (Palgrave, New York, 2007) book and the  securitization” article in CHALLENGE, there must be an well-organized and orderly markets. Liquidity requires a market maker to assure orderly markets– so that a holder can always make a fast exit and sell their holdings of any liquid asset at a price not much different that the previous transaction price.

The break down of regulations separating banks who make illiquid loans and investment bankers whose function is to float new issue assets in orderly (liquid) markets is the basis of the current crisis. Starting in the late 1970s some Federal Reserve Bank decisions were made that encouraged securitization of illiquid bank loans to a limited extent. But ultimately the firewall between banks and investment banks was destroyed with the repeal of the Glass Steagall Act in 1999– by an act where Phil Gramm was the senior sponsor of the repeal. [See my January 2008 Schwartz CEPA Policy Note entitled “How to Solve The U.S. Housing Problem and Avoid a Recession: A Revived HOLC and RTC”]

Thus beginning with decisions made almost three decades ago the seeds were planted and the ultimate fruition occurring in 1999 with the repeal of the Glass Steagall Act, more and more illiquid assets were securitized — but without a credible market maker for these securitized assets. Securitization may have made underlying illiquid assets look like they were liquid assets -but they were not always going to be liquid — thus they could become toxic – when some unforeseen event occurs that induces herd behavior for a fast exit.

These securitized assets have no well organized, orderly market with a market maker. Given the housing problem, there is no orderly market price to evaluate the worth of these toxic assets. No one knows exactly how to evaluate the MBS, and other exotic financial assets on the balance sheet of holders. The SEC had made a rule of mark -to-market for traded  securities. In these days, however, the last market price in the disorderly markets of these TOXIC assets might have been “a fire sale price” , for example, at 50 to 70 per cent discount. Accordingly if the financial institutions holding these assets marks these assets to market, they will be insolvent. The original Paulson plan [only 3 pages long] gave Paulson the right to buy these illiquid assets at a price not to exceed the price the holder originally paid. If the price was at or near the original holders’s purchase price, this would improve balance sheets tremendously and take away the fear of insolvency.

But this would mean the holders of these assets might get away scot free after making horrible investment decisions. [After all, neoclassical economists would say that if you make a bad decision, the market should punish you — and if that means bankruptcy so be it. It will prevent the moral hazard problem in the future.]

On 9/30/08, the SEC suggested possible new accounting principles for evaluating these essentially toxic [illiquid] assets using “fair value” instead of mark to market.. The SEC news release is as follows:

SEC Office of the Chief Accountant and FASB Staff Clarifications on Fair Value Accounting FOR IMMEDIATE RELEASE 2008-234

Washington, D.C., Sept. 30, 2008 – The current environment has made questions surrounding the determination of fair value particularly challenging for preparers, auditors, and users of financial information. The SEC’s Office of the Chief Accountant and the staff of the FASB have been engaged in extensive consultations with participants in the capital markets, including investors, preparers, and auditors, on the application of fair value measurements in the current market environment.

There are a number of practice issues where there is a need for immediate additional guidance. The SEC’s Office of the Chief Accountant recognizes and supports the productive efforts of the FASB and the IASB on these issues, including the IASB Expert Advisory Panel’s Sept. 16, 2008 draft document, the work of the FASB’s Valuation Resource Group, and the IASB’s upcoming meeting on the credit crisis. To provide additional guidance on these and other issues surrounding fair value measurements, the FASB is preparing to propose additional interpretative guidance on fair value measurement under U.S. GAAP later this week.

While the FASB is preparing to provide additional interpretative guidance, SEC staff and FASB staff are seeking to assist preparers and auditors by providing immediate clarifications. The clarifications SEC staff and FASB staff are jointly providing today, based on the fair value measurement guidance in FASB Statement No. 157, Fair Value Measurements (Statement 157), are intended to help preparers, auditors, and investors address fair value measurement questions that have been cited as most urgent in the current environment.

* * *.HOW is that for determining “fair value”? What will the Secretary of the Treasury use to decide fair market value?

Mitigating the current recession. 

The bailout bill may buy some time to prevent a complete collapse of the financial system – but it will not prevent the recession that the US has already entered. What is needed is at several additional policy actions;

(1), To prevent any further houses becoming vacant due to foreclosure, another HOME OWNERS LOAN CORPORATION [HOLC] (similar to the one created in the Roosevelt Administration) is needed. The HOLC would buy up mortgages (at a discount) and renegotiate new mortgages with home owner-occupiers at monthly payments they can afford possibly (a) by lengthening the life of the mortgage perhaps to 40 years,(b) by reducing principle, and c) by lowering interest rates. If the homeowner- occupier still can not make monthly payment requirements on a renegotiated mortgage, the HOLC should rent the house on a month to month lease to the occupier at a rent he/she can afford until it can be sold for at least the value of the mortgage that the taxpayers bought out. (See my Schwartz CEPA Policy Note)

This will at least limit if not end the fall in housing prices. Until housing prices recover, the economy will remain in a funk .

(2) A quick, temporary stimulus plan should be done in order to limit the depressing effects of the recession and to carry the economy over until at least February 2009 when a new Administration can develop investment policies`in repairing infrastructure, alternative energy R&D, tax sharing with local and state municipalities, etc. For example, as suggested by Warren Mosler, a temporary payroll tax holiday effective immediately and lasting until February 28, 2009 should be enacted. This is equivalent to giving most wage earners a wage increase of over 6 %. It will also provide business firms with a reduction in their costs of production in a period where working capital loans are difficult to obtain.

Policies to prevent future toxic assets

Given the current experience of failed toxic asset markets, it would appear that the SEC has been lax in pursuing its stated mission of investor protection. Accordingly the United States Congress should require the SEC to enforce diligently the following rules:

1. Public notice of potential illiquidity for securities traded in markets that do not have a credible market maker. Since the mandate of the SEC is to assure orderly public financial markets, and “require that investors receive financial and other significant information concerning securities being offered for public sales, and prohibit deceit, misrepresentations, …. in the sale of securities”, it is would seem obvious that all public financial markets that are organized without the existence of a credible market maker should, either (1) be shut down because of the potential for disorderliness, or (2) at a minimum, information regarding the potential illiquidity of such assets should be widely advertised and made part of essential information that must be given to each purchaser of the asset being traded.

The draconian action suggested in (1) above is likely to meet with severe political resistance, as the financial community will argue that in a global economy, with the ease of electronic transfer of funds, a prohibition of this sort would merely encourage investors looking for higher yields to deal with foreign financial markets and underwriters to the detriment of domestic financial institutions and domestic industries trying to obtain capital funding.

In my KEYNES [2007] book, I have proposed an innovative international payments system, that could prevent US residents from trading in foreign financial markets that the U.S. deemed detrimental to American firms that obeyed SEC rules while foreign firms did not follow SEC rules. If, however, we assume that the current global payments system remains in effect, and there is a fear of loss of jobs and profits for American firms in the FIRE industries, then the SEC could permit the existence of public financial markets without a credible market maker as long as the SEC required the organizers of such markets to clearly advertise the possible loss of liquidity that can occur to holders of assets traded in these markets.

A civilized society does not believe in “caveat emptor” for markets where products are sold that can have terribly adverse health effects on the purchaser. Despite the widespread public information that smoking is a tremendous health hazard, government regulations still require cigarette companies to print in bold letters on each package of cigarettes the caution warning that “Smoking can be injurious to your health”. In a similar manner, any purchases on an organized public financial market that does not have a credible market maker can have serious financial health effects on the purchasers.  Accordingly, the SEC should require the following warning to potential purchasers of assets traded in a market without a credible market maker: “This market is not organized by a SEC certified credible market maker. Consequently it may not be possible to sustain the liquidity of the assets being traded. Holders must recognize that they may find that their position in these markets can be frozen and they may be unable to liquidate their holdings for cash.

Furthermore, the SEC should set up strictly enforced rules regarding the minimal amount of financial resources relative to the size of the relevant market that an entity must possess in order to be certified as a credible market maker. The SEC will be required to re-certify all market makers periodically , but at least once a year.

2. Prohibition against securitization that attempts to create a public market for assets that originated in private markets – The SEC should prohibit any attempt to create a securitized market for any financial instrument or a derivative backed by financial instruments that originates in a private financial market (e.g., mortgages, commercial bank loans, etc)

3. Congress should legislate a 21 century version of the Glass Steagall Act. The purpose of such  an act should force financial institutions to be either an ordinary bank lender creating loans for individual customers in a private financial market, or an underwriter broker who can only deal with instruments created and resold in a public financial market.

8 Responses to "Evaluating Toxic Assets – And Where Do We Go Next"

  1. Lloyd Gillespie   October 3, 2008 at 8:25 pm

    I guess no-one realizes that computer trading systems, lacking official “market makers”(specialists or “dealers of last resort”), are actually required for credit and equity markets to again function, once broken as now, or someone would have posted a comment already… So, let me just state, the above article and the two included links are some of the most important information, posted on this site offering ideas of an “efficient necessity” of solutions, so, we’d all be wise to take a deep look. We’re not going to solve this crisis without serious work and total understanding of these complex markets’ mechanics. Now, who is large enough to act as “market maker” for the toxic assets of the collapsing “Shadow Banking System”? Can the Fed handle the job? Can the Treasury handle the job? Can a group of major banks and corporations handle the job? Or, will it actually take the full power of the U.S. Government, to set up such a necessary duty? And, what will Europe do, since power is under the “Euro-Land” umbrella, as it will certainly be required to face the same computerized trade malfunctions?(and that’s with full knowledge of sources of troubles)I guess the first thing is to wake people up___all around the world___to the fact that the broken computerized trading markets___”absolutely require” true “market makers” to re-start this giant “frozen” global credit market, along with all the other ideas Nouriel and others have put forward. Paul above, has offered many of the same solutions, with the extra ones necessary, yet they all will require a well co-ordinated effort by everybody, especially the fight against the “wild card” of global politics…

    • Antonio Foglia   October 9, 2008 at 3:04 am

      Dear Sir,I do not agree. The only markets that have remained functional in the current (and previous) turmoil are equity markets precisely because they do not have the sort of market maker you wish for.Market making is legalized front running in normal markets and simply ceases to exist at times of stress.Best regards

  2. Ron   October 4, 2008 at 1:57 am

    A civilized society does not believe in “caveat emptor” for markets where products are sold that can have terribly adverse health effects on the purchaser. Despite the widespread public information that smoking is a tremendous health hazard, government regulations still require cigarette companies to print in bold letters on each package of cigarettes the caution warning that “Smoking can be injurious to your health”.

    • Lloyd Gillespie   October 4, 2008 at 8:24 am

      Civilized society may now have to trade “caveat emptor” for “caveat venditor”, when the entire economic health of the nation is at stake. Which is the wisest course presently___”Let the buyer beware”, or “let the seller beware”…?

  3. Guest   October 4, 2008 at 11:32 am

    Can someone explain to me how the US can ‘buy up mortgages’ when many of the worst stuff has been securitized and has, in effect, hundreds of owners as a result of being sold to investors? I’m sure the government can identify the mortgages (via the loan tapes provided by the servicer) but wouldn’t they be violating contract law by changing the terms of the individual loans? It seems to me the government would have to identify all individuals (globally) with a fractional interest in each loan and get them to tender their bonds to the US. Does this make sense?

  4. interested reader   October 4, 2008 at 2:26 pm

    Much simpler solution: put everything on exchange, with disclosure of underlying asset quality, margin calls etc. If the market is fundamentally unviable with full disclosure, it will not take off. Many securitizations and re-securitization such as CDOs would never have occurred without the help of rating arbitrage and lack of disclosure.

  5. Anonymous   January 17, 2009 at 3:55 pm

    How will an aggregator bank work to free up credit and liquidity, when this system is virtually unregulated?