Saturday, September 20, 2008

The Feasibility of a Toxic Relief Fund

The new proposal to deal with the financial crisis involves the U.S. Government setting up a special fund to acquire toxic or illiquid financial assets on bank balance sheets. The Times Online has a report:

“Henry Paulson, the US Treasury Secretary, hopes to nationalise the global risks associated with America’s sub-prime mortgages by setting up a toxic relief fund to buy up the mortgage assets that are poisoning banks’ balance sheets and sowing the widespread distrust that has prevented banks from lending to each other. Although the assets involved and the pricing of them will be much more complicated, the nearest equivalent is the Resolution Trust Corporation. This operated from 1989 to 1995 to buy up the toxic paper of almost 800 banks which failed in the US Savings & Loans crisis.”
Such a fund appears similar to the asset reconstruction companies (ARCs) that have been set up in India in the last 5 to 6 years for acquiring non-performing assets. The Indian ARCs are left with the task of acquiring mostly plain-vanilla financial assets such as loans, bonds, leases, while this new entity in the U.S. will have the more onerous task of acquiring complex financial instruments that have arisen through securitisation, collateralised debt obligations, derivatives and the like (that now suffer the ignominy of being alluded to as “toxic” assets). The key problem there is the issue of valuation as these assets are essentially illiquid and hence incapable of precise valuation. Such issue has no easy solution, as notes:

“The list of questions is daunting. What assets should be considered toxic or illiquid? How should they be valued – implicit market prices from earlier this week, from just before Lehman Brothers collapsed, or something still higher? The higher the assets are valued, the bigger the costs to the taxpayer; the more they are valued in line with current conditions, the less it will help.

Then there’s the matter of who will participate. Can hedge funds, private equity houses and institutional investors? And how will the government detoxify its new portfolio? Who on earth can be trusted to run it?

Perhaps the intelligence and skill which went to create all these infectious instruments can be turned to unwinding them. But it’s almost inevitable that the most irresponsible market players will end up getting the greatest relief.”

(Update – September 21, 2008: The details of the Rescue Plan are now available, with the Government committing a maximum of $700 billion for the purchase of mortgage-related assets.)

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