Feb

20

There is no way around pricing the toxic assets

February 20, 2009 | 3 Comments | Sam Wylie

A central problem in the banking crisis in the US is the uncertainty about the value of toxic property related assets on the balance sheets of banks.  The Troubled Asset Relief Program (TARP) program was originally intended (just 4 months ago) to purchase up to $700 billion of troubled assets.  But buying the assets meant valuing them, and the Treasury seemed to throw its hands up at the difficulty of this problem. 

Some advocates of the nationalisation of  banks in the US believe that nationalisation gets around the problem of valuing the assets.  It is simple they think.  The Government takes over the zombie banks, then the toxic assets go into a “bad bank” where they are held to maturity.   The part I don’t understand is how the US Government nationalises the banks without valuing the assets of the bank, including the toxic assets. 

Imagine that Sheila Blair, the head of the FDIC, calls Vikram Pandit, the CEO of Citigroup and tells him that the FDIC is seizing the assets of Citigroup.  What is his reaction going to be? — we will see you in court.    The US Constitution makes it difficult for the Federal Government to seize the assets of citizens even after Congress has passed an act with the intention. 

To seize the banks the FDIC needs to show that their liabilities exceed the value of their assets, which of course means valuing the assets.  You might think that the FDIC would simply market the toxic assets to market, which would assign overall bank assets a value below their liabilities, and the FDIC could seize them.  However, what is being measured here is book equity, not market equity.  The accounts of Citigroup must currently show considerable book equity, otherwise it would not meet its Basel Accord capital adequacy requirements and it would have been taken over by the FDIC already. 

I suspect that when pundits adovate the seizure of the banks they are thinking of the ease with which Fannie Mae and Freddie Mac were taken over by the Federal Government.  But it is not the same.  Fannie and Freddie were created by Federal Government charter as government sponsored enterprises.  Nor is the situation akin to Bear Steans or Lehman Brothers.  Those investment banks died for want of liquidity, but commercial banks only die if they are bankrupt and that means their book asset value must be less than their liabilities. 

Any attempt to seize Citigroup without the consent of the shareholders would be a train wreck of monumental proportions.  The Federal Government may be able to reach a deal with the shareholders of Citigroup to take over the firm.  But that essentially involves the parties pricing the overall business, including the value of the toxic assets. 

There really is no way of solving the banking crisis without valuing the toxic assets, so the Obama administration should strive to make that easier.  It should treat the pricing of the assets like an engineering problem — which it is.  President Obama should set up an agency that publishes all the information needed — that information that looks backwards through all the securitisation structures to the individual underlying assets.  Then promote R&D for objective valuation of the assets.


Comments

3 Responses to “There is no way around pricing the toxic assets”

  1. Milton Recht on February 20th, 2009 11:28 am

    FDIC procrastination is the way around pricing the toxic assets.

    Cit is not cash flow insolvent and is still in a position to lend. It is likely book value insolvent or at least capital insufficient if the assets are repriced to market value, but on a cash flow basis, it can continue to operate and lend and honor normal deposit withdrawals.

    Deposits are stable. Many of the toxic assets are receiving payments and are cash flow positive. Plus, Citi has liquid securities, such as Treasury securities, that can be converted to cash to further increase lending.

    As long as Citi is not seeing a run on its deposits and as long as Citi can continue to lend, there is no functional need for the FDIC to step in and takeover Citi.

    As you correctly state, buying or moving the toxic assets requires a repricing of the assets to a current market value and destroying much, if not all, of Citi’s capital base. However, as long as Citi is receiving payments on the toxic assets, despite accounting rules, it can avoid writing down these assets until they default arguing that the assets are more like loans than securities. It may face some future shareholder and SEC lawsuits, but that potential liability will be small in comparison to a FDIC takeover.

    Assuming that not all the assets will default at the same time and that Citi will have positive earnings from the rest of its lending and investment portfolio, Citi can survive and come out of this crisis (although bruised) over the next few years. It will write down over the next few years its toxic assets (as it is already currently doing) as they default in their payments and these write downs will be offset by earnings from the remainder of Citi.

    30 years ago, the large banks faced a crisis over sovereign debt until the Baker Plan and were technically insolvent, but were not required to write down those assets to a market value. Similarly, 20 years ago, there was a commercial real estate crisis and the banks took loan losses but not market value write-downs.

    The current banking crisis with toxic assets is not like the S&L crisis. With S&L’s there was a moral hazard because large shareholders controlled the bank and use the delay to take on very high risk as the only hopes of salvaging their wealth and many in effect bet the bank and lost. But many also survived.

    Sometimes, banks have to wear the emperor’s new clothes. Over time, the toxic assets will disappear through repayments and write-downs. Quick fixes are not always the best solutions. In the case of the large banks, procrastination is possibly the best answer.

  2. Andrew Butter on February 22nd, 2009 9:22 am

    The lack of progress on either (a) buying the toxic assets or (b) nationalizing the banks that own them, is as you correctly point out, because “no one knows how to value them”.

    This “vexing” problem, was also pointed out on http://blogs.ft.com/economistsforum/2009/02/a-strategy-of-contingent-nationalisation/

    The problem of valuing assets when markets are in what International Valuation Standards (IVS) calls “disequilibrium” is not a problem that was unanticipated by the valuation profession.

    Perhaps one of the problems at the moment is that neither accountants nor bankers are specialists in valuation, which may explain why they are running around like a bunch of demented chickens with their heads cut off.

    For a somewhat tongue in cheek analysis of this issue please see http://www.marketoracle.co.uk/Article8177.html , or for a more “serious” analysis (with the expletives deleted) see http://www.accountancyage.com/accountancyage/features/2236285/fair-value-confidence-trick.

    IVS forewarned of the dangers of the current situation and the events that preceded it (where a disequilibrium in the housing market led to assets being overvalued (at least in terms of any sensible holder of those assets), which caused the bubble; and now exactly the same thing is happening, except in reverse).

    For example, in July 2003 the International Valuation Standards Committee wrote to the Bank of International Settlements warning that valuations used to assess capital adequacy were, quote: “fundamentally flawed and bound to be misleading”.

    AS far as the record appears to show, there was no reply, but what just happened was just that…since 2003.

    Perhaps instead of looking inside the banking or the accountancy profession for a direction on how to value those assets, (and Please God don’t ask an economist how to do a valuation), it might be sensible, after all this time, and given the “gravity” of the situation to call upon the valuation profession to suggest how to do a valuation?

    The logic here is if you have a tooth ache, best to call a dentist, not a plumber.

    Just an idea!

    IVS considers TWO types of value …”Market Value” and “Other than Market Value”. What we have here is clearly “Other than Market Value” because as the accountants and bankers are (very) slowly realizing, the market is not working.

    There is a procedure under IVS whereby Other Than Market Value can be estimated, and by the way it is not “book value”, “held to maturity”, “mark-to-model” or the most hilarious one I heard so far “mark-to-quote” (I’m not joking some of the Maiden Lane transactions were done on that basis), or indeed any vague or elaborate fudge in between.

    There is a very precise and proscribed procedure under IVS which if applied by two independent third party valuation specialists (independently) should deliver the same result.

    So perhaps the way to solve the “vexing” problem of how to value those assets would be to actually hire someone who knows how to value them instead of having a long debate by people who DON’T know how to value them?

    THEN: You would have an OPINION of value – it could be wrong, it could be right, but at least it would be transparent, in conformance to a well established methodology (the first edition of IVS was 2000, not much changed since then), and also unlike any of the voodoo valuations flying around, explained in plain English in language a non specialist can understand (a requirement of IVS).

    This opinion would be broadly the estimated value of the assets IF the market was working.

    So – to get the assets off the balance sheets (1) get an independent valuation by someone who knows how to do one, and specify IVS; then (2) pay that amount.

    OR MUCH BETTER:

    Pay 10% to 15% less than the “Other than Market Value” BUT grant the bank that sold the assets the option of buying them back at a later date at the same price plus a reasonable pre-agreed margin.

    After all the government is not interested in either owning those assets or making a profit out of the transaction (at least not a windfall profit), what it is worried about is making a loss.

    The bank on the other hand is worried about losing out, the biggest problem I have at the moment is finding anyone who wants to sell any toxic assets (of course that could have something to do with the idea floating around that Big Uncle Dumbo will eventually come along and pay too much).

    Using that formula what might happen next is that a market would emerge for the options, this would be a small step in perhaps re-starting the wholesale market, which is basically what is required to “get the banks lending again”.

    And if that ever happens, I suggest that from now on the government mandates that assets be valued according to IVS instead of the mishmash of voodoo ideas that are flying around at the moment. That would prevent another bubble.

    In that context it is perhaps worth remarking that the section on valuation under IFRS is less than a page, US GAAP is not much longer, International Valuation Standards are 462 pages.

    That’s because it is slightly more complicated under IVS than IFRS or US GAAP. There is a reason, it is complicated.

  3. Belittled on February 24th, 2009 12:27 pm

    Why buy these assets? Instruct the banks to put these  currently toxic assets into bad bank. In return they get a percentage of whatever they ultimately realise in 5 or 10 years time.  Let markets value the expected discounted value of these assets and price the shares of these banks accordingly.