The "Toxic Assets" Challenge

For more than two years we have watched all sources of information in the discussion about the valuation of illiquid assets.

Unlike most of the people participating in this debate, we did not start with an opinion.  We arrived at conclusions after examining data.

Analyzing the Arguments

The key question is whether the distress sale prices of illiquid securities are meaningful.  One body of opinion holds that many of these assets are "performing."  The cash flows continue, even though some asset holders are selling at distressed prices.

There are many substantive examples.  Here is a recent illustration from Bankstocks.com:

One Alt-A MBS expert, Thomas Patrick, chairman of New Vernon Capital and a former Merrill Lynch vice chairman, calls mark-to-market accounting a “swamp” in this environment, an “accounting fiction” better reflecting the “financial desperation of sellers than the value of the securities sold.” 

 In 3,700 mortgage securitizations he examined, Patrick found that of $1.4 trillion in Alt-A mortgages, $948 billion were current on interest and principal, while $452 billion were delinquent more than 30 days.   Further, banks carried the performing mortgages at an average 50% of par.  Patrick observes that if owned directly as loans, the banks would carry the mortgages closer to par.  He concludes that the mark-to-market fiction has created enormous financial difficulties.

There is something seriously wrong with a method that applies one valuation to a loan and another to a securitized loan.

From the perspective of these analysts, the required regulatory capital of these companies has been dramatically reduced without any basis in reality.  The regulation affects the overall capacity for lending.

But let us consider the alternative viewpoint.

Many commentators applaud mark-to-market prices.  I have only seen one actual piece of analysis -- one example of a security -- where the marks were challenged.  Watch this for yourself.  Those taking this viewpoint state confidently that the "toxic assets", and they ALWAYS use that term, are worthless.  This is not a fair response to those who have examined the various pieces of complex securities and done a discounted cash flow analysis.

Conclusion:  This is Important

M2M did not cause the economic problem, but it was an accelerant.  At "A Dash" we try to be  descriptive rather than prescriptive. On November 5th we made an exception, with our "open letter" to the President. We explained why fixing this problem was the single most important thing he could do.

Almost everyone disagreed at the time, preferring direct investments in financial institutions. Three months later we can see that solution for what it was -- a stopgap.  If we would solve this troubled asset problem, whether through price discovery or by suspending M2M, the government could get out of the banking business. We need market-based incentives rather than Rep. Frank and his committee setting rules governing business decisions. This means that we need an accurate measure of regulatory capital. Without stabilizing this problem, how can we expect fresh private investment in these institutions? They also will not get deposits with many pundits saying that the banks are insolvent.

Several experts on TV have been saying that the toxic asset question is no longer crucial. They are so wrong.