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Allow toxic assets to be sold by banks

Another $787 billion in “stimulus” later and we still haven’t fixed the banking or housing issues that are hamstringing our economy. Can we relieve some of the bank issues without throwing billions more at it?

In September, I spoke with a former colleague at Crestar Bank and he suggested a low-cost solution that makes sense to me. Some background is necessary to understand his solution.

When banks purchased mortgage-backed securities a few years ago, they were purchasing AAA assets that had minimal risk-based capital requirements as compared to traditional loans. In fact, banks were not required to set aside any capital against these loans. As the housing crisis unfolded, it became clear that these asset-backed securities carried much more risk than the various rating agencies who rated these securities had anticipated.

With this new understanding of the higher risk in the mortgage-backed securities, regulators began classifying these assets in a manner that required capital be held for these riskier investments. Making the problem worse, is the fact that banks had to price or “mark” these illiquid assets to market (mark-to-market), thereby forcing the banks to write down the value of the asset and reduce capital even further. As this capital to toxic-asset ratio increased, banks became less solvent and capital access by banks decreased.
Banks dealt with these capital pressures by reducing their “risk” assets to bolster their capital position. They reduced “risk” assets by tightening lending standards and only lending to their gold-plated and long-standing customers. In lieu of lending, they invested funds in very low risk assets requiring minimal capital backing such as U.S. Treasury securities. The result is the credit crunch we’ve been experiencing.

Here is my colleague’s proposal to start thawing out the credit market: “grandfather” in the asset-backed securities with respect to the risk-based capital calculations and mark-to-market requirements for a period of time, maybe 10 years. In other words, these securities would be assigned the risk-based capital score they were originally assigned when they were considered to be AAA securities and carried on their books at a value which more realistically reflects their longer-term value.

These “grandfathered” assets would be set aside on the banks’ balance sheets and banks would be allowed to work these assets out over the grandfather period. There is intrinsic value in these assets, but it will take time for that value to be realized. Instead of the government taking on this job of valuing and selling these toxic assets, allow the banks to do so by removing the immediate pressure on their capital accounts.

Bankers are likely to take the grandfathered option because if they sell their assets to the government, the “value” of those toxic assets is immediately established and basically locks in their loss on these assets at an unrealistically low current market value. The pressure on bank capital would not be relieved. Alternatively, if banks held the grandfathered assets and they are assigned the lower AAA risk-based capital, capital pressure is relieved and banks would have the opportunity to recover these loans in the future once things have settled down and housing prices begins to recover.

The plan makes sense to me. I wonder if Treasury Secretary Timothy Geitner will unveil something similar when he fills out his outline to help the credit markets.
Used with permission from the Richmond Times-Dispatch.

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