Treasury Detox

March 26th, 2009 - 8 Comments

Treasury Secretary Timothy Geithner this week unveiled the Obama Administration’s plan to “liberate the nation’s banks from a toxic stew of bad home loans,” as The New York Times puts it. Smeal’s Jean Helwege says the plan may be what the financial system needs, but cautions that banks may not automatically play along.

More from Helwege:

The Treasury plan to auction banks’ toxic assets to private investors may be just the catalyst the financial system needs. In the past, when banks have been overburdened with bad loans—for example, in the Latin American debt crisis of the early 1980s, the savings and loan crisis of the late 1980s, or the so-called Lost Decade experienced by Japan in the 1990s—allowing banks to operate under the cloud of bad assets has been destructive to the economy.
 
While it may seem like a shell game to move assets from one part of the financial system to another, removing bad assets from bank balance sheets seems to help. In the Latin American crisis, toxic assets were removed via the Brady Plan, which packaged bad loans as bonds and sold them to investors such as insurance companies and mutual funds. Because these investors had no exposure to the emerging markets and were able to buy the bonds cheaply, they did not suffer any stigma by acquiring the assets and the banks were able to clean up their images. Likewise, the S&Ls’ bad assets were moved into the Resolution Trust Corporation (RTC) and auctioned off to private equity investors. In contrast, the Lost Decade went on as long as it did because Japan did not remove the bad assets from their banks, with the result being that they operated as “zombie” banks for years. 

A critical part of the Treasury plan to remove the toxic assets is participation by the banks.  One has to wonder why these assets, which have been weighing them down for well over a year, have not yet been sold. One potential problem is a lack of liquidity: Few financial institutions have the funds available to buy them. Thus the Treasury has moved to provide financing in its auction. However, another possibility is that banks are reluctant to sell the assets. Bank regulations provide perverse incentives to troubled banks: Even when the banks and the market know the true value of a bad loan, banks resist writing down their assets to avoid having to raise more capital to secure deposits.

As long as few toxic assets are trading, bank regulators cannot easily prove that banks are operating with faulty balance sheets. Suppose a bank makes a $100 loan that subsequently goes bad. If the bank reappraises the loan at $60, it must find an additional $40 in capital to maintain its regulatory net worth. As bad as that sounds, a Treasury-sponsored auction that reveals a value of only $30 would be even worse, as it might indicate insolvency and thus lead regulators to take over the bank. Some banks would rather not participate in any plan to clean up toxic assets if the asset values they record in their books are still far from the true market values.  Instead, they will prefer to wait for recovery, no matter how slow. 

Whether the plan works or not depends crucially on banks’ incentives to participate, and this in turn depends crucially on how well bank regulators have succeeded in pressuring banks to write down assets to reflect the true losses. Treasury efforts to entice buyers with subsidies and loan guarantees will help bring them to the auctions, but their profits from buying cheap toxic loans will not materialize if the banks stay away. As infuriating as these subsidies are to American taxpayers, things could be worse if banks refused to cough up the assets on which Wall Street vultures hope to profit.

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8 Responses to “Treasury Detox”

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