On Toxic Assets
Lawrence A. Hunter
March 9, 2009
The argument over mark-to-market disguises the real debate, which is whether or not to extend forbearance to banks deemed “too big to fail” due to the “systemic risk” they pose for the system. Those favoring forbearance ASSUME the whole asset is really worth the sum of the asset's component parts but for some reason the market cannot ACCURATELY access that TRUE (whole = sum of parts) value right now; Houston, we have a TEMPORARY problem; however, not to worry, the anti-MTM reasoning continues, whatever impediment is currently confusing the market will sometime in the (near?) future go away and the market value of the whole asset will then once again rise to equal the value of the sum of its parts.
In other words, there is a hidden premise here that the toxic assets will detoxify themselves. The hidden assumption is that the TRUE value of the asset is being temporarily and unjustifiably suppressed so it is "wrong" to force owners to evaluate their value at what they would fetch currently on the market. This line of reasoning seems even more persuasive to many people in the case of banks since forcing banks to mark down the value of these assets impairs their capital ratios and sets off a whole string of events.
Banks have successfully spun this morality tale to present themselves as the victims of a series of unfortunate events. For lack of a better term, this is a "market disruption" argument meant to head off a finding of "insolvency." First it was just a "liquidity" problem; now it is a "market-disruption" problem. In other words, in a spectacle reminiscent of the famous Monty Python Dead Parrot sketch, the bankers are like the clerk making all kinds of excuses as to why the disgruntled customer is wrong when he cries, "This parrot is DEAD!" It seems to me that if you are revolted at the thought of M2M, you must really believe deep down that these institutions are NOT REALLY insolvent because their assets are REALLY worth more than the market is currently evaluating them at. It's the market that is failing, not the institution.
My contention is that the WHOLE asset will never detoxify itself; it will only rot more with time. The only way to recoup the true value of the sum of the asset's component parts is to actually disassemble the toxic asset into its component parts, each of which then can be assessed individually and sold on the market separately (or repackaged with other component parts). The impediment to disassembling this junk asset (to switch metaphors) is LEGAL, which is why a bankruptcy proceeding is a prior condition on handling these assets properly so they can literally be "parted out" like you would take a junk car apart piece by piece and sell each part separately (or as a special package) on Craig's List. The legal encumbrances that prevent the toxic assets from being disassembled and sold off separately can only be vitiated in a bankruptcy proceeding.
Or, if it makes it clearer, try another metaphor. The WHOLE toxic asset is like a bushel full of apples that is hermetically sealed with a top to which a "do-not-remove-under-penalty-of-law" tag is attached. There is also a label pasted on the side of each bushel placed there at the time the bushel was filled and sealed that accurately states the contents of the bushel at the time it was labeled.
The problem is, there is now a stench emanating from the bushel that makes it clear that some of the apples are rotting. How many are rotting? Which ones are rotting (the Delicious or the McIntosh varieties)? How many are still in top condition and could be sold separately if you could only get them out of the sealed bushel? How many are not so great but still could be saved and sold at a discount for applesauce? At what rate are the rotting apples contaminating the remaining good apples? How long before the entire bushel will be rotten?
Potential buyers of the bushels are told, "You may not remove the top and look inside the bushel or the lawyers will get you." Moreover, potential buyers are also told, "If you purchase the bushel, you still may not remove the top and by no means may you take the apples out, sort them into new piles and repackage them for resale or sell off the remaining good apples one at a time. You can only sell the bushel whole, in tact, or hold on to it for future sale." Finally, everything the current owners of the bushels read and hear from the government suggests that the government eventually is going to take the bushels off the owners' hands by purchasing the bushels for some high fraction of their original value when they were packed and first sold.
What do you think would happen? Owners of course would be reluctant to sell the bushels for much of a discount as they anticipate being made close-to-whole by the government (BAILOUT), and potential buyers will not pay a price for the sealed bushel anywhere near the total amount they WOULD pay for all of the component parts IF they could inspect and purchase them individually, or even if they were forced to take the whole bushel as long as they knew exactly what was in it and were free to dispose of the contents of the bushel as they chose once they owned it.
The key, I believe, is to understand that the whole asset is not the same commodity as a package of the component parts—they are literally two different commodities—and there is no reason to expect or demand that the whole asset sell for the same price as its component parts would sell separately, especially when the whole asset is irreparably rotting while a substantial portion of the component parts could be cleaned up.
The two (the whole asset and the package of component parts) are only equivalent commodities when there are no impediments to parting out the whole and arbitrage can act on a continuous basis to eliminate any differential in price. Or said another way, in order for the price equivalency to actually hold in the real world, a potential buyer must be indifferent between buying the asset whole and buying the asset's component parts separately. Under current market conditions and any conditions foreseeable in the future, potential buyers are FAR FROM INDIFFERENT between this choice.
In fact, the market price of toxic assets is telling us that potential buyers don't want the whole assets, legally encumbered and opaque as they are, at any price. HOWEVER, I'd bet the farm on my belief that if the asset could be disassembled and the component parts sold separately, buyers in total would in fact be willing to pay a large percentage of the price at which the whole asset originated. But you cannot validly infer from this counterfactual that the TRUE value of the whole asset right now is the same as the sum of the prices the component parts WOULD fetch under the counterfactual conditions, especially because there is no way those counterfactual conditions can ever hold without actually closing the institutions that currently own the toxic assets.
This is why I insist that the only way to handle unsellable toxic assets is for a solvent owner to write them off entirely and to put insolvent institution that owns them into a judicially overseen bankruptcy-like proceeding in which legal encumbrances can be vitiated after which the “parting out” can commence.
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