Perspectives Thought Leadership Bottoms Up
Bottoms Up
"Bottoms Up Or it's Time to Establish and RTC‐Like Entity By Mark A. Greenberg Published February 13th Issue of Business First Columbus"
How long will it be before the economy rights itself? Answer: I have no idea and that no one else does either. The one reasonable but unnerving comment to offer at the moment is that the economy will begin to turn when the marketplace finds the bottom. What is the bottom? It is the point at which buyers decide that the asset acquired (read also, the asset guaranteeing) is unlikely to decline further, and the potential for return and recovery exceeds the probability of loss. You can apply this reasoning to every kind of investment and every assumption of risk, including bank loans.
The apparent bottomlessness and illiquidity of the subprime market was after all what drove the original strategy proposed by the architects of TARP when the plan was to acquire and offload toxic assets from financial institutions and consolidate them in a financial markets equivalent of a superfund site. No one could find a way to price those assets (perhaps more an issue of will and timing than ability), so it was decided to shore up bank balance sheets instead by direct investment rather than take on the task of pricing and acquiring the assets.
In hindsight, both direct investment and the offloading of toxic assets were needed.
With more than 90 days since the declaration of a crisis, it turns out that President Obama has nothing on Henry Paulson and the TARP architects when it comes to hope. Opting for temporary life support -very temporary as recent news from Citigroup, B.O.A. and others have confirmed-rather than radical surgery has served to swell the taxpayer bill by tens of billions of dollars and may yet result in the death of a few large patients who would have otherwise survived the surgery‐‐the surgical procedure being the sale of toxic assets at a meaningful discount to book value to a governmental agency and the consequent, and likely significant, charge to earnings.
While one can only speculate about the crosscurrents and pressures that drove TARP's initial direct investment strategy, any rational observer of financial news and markets should now find it dumfounding.
It seems certain now that given the complexity and enormity of the subprime mess and illiquidity and credit crisis it spawned ‐‐‐ millions of bad mortgages, impossibly complex derivatives, massive, unhedgeable portfolios, the AIG credit‐default swap portfolio, for example-that reaching market equilibrium might take a long time and that much damage would result before equilibrium returns, if it ever returns. Couldn't the TARP architects predict that until there was an engaged market of buyers and sellers that these toxic assets would continue to devalue (along with other assets caught in the vortex)
and when marked‐to market, would further erode bank balance sheets and threaten required liquidity ratios thereby virtually ensuring that bank lending would be severely constrained and sparing at best?
Hindsight is the artificial victor in most contentious arguments. But, aren't these logical and predictable outcomes?
From the beginning of the subprime meltdown, observers have pointed to the Resolution Trust Corporation as an applicable model. By all measurements, the RTC did the job it was established for and did it well. Billions of dollars of distressed savings and loan assets were offloaded to the RTC and worked‐out successfully over several years, and in the time this occurred, the economy thrived.
Here's my vote-set up an RTC -like entity, put some exceptional people in charge and acquire the toxic assets. And do this soon.
Apparently Treasury Secretary Timothy Geitner has something like this in mind, but instead wants to provide highly favorable loans to private investment firms to acquire the toxic assets. While I applaud the idea of using the marketplace, I am doubly skeptical. Can this be done quickly without the fiat‐like power that might otherwise reside with an RTC‐like entity? And do we really want to re‐empower and enrich the hedge funds, the group which will clearly be the most rewarded by a public ‐ private partnership?
The banks will naturally have to take the largest charge to earnings in the history of capitalism. But by doing this, economic death by a thousand cuts we are experiencing would likely end. With any luck, once this is accomplished, the FASB might also thoughtfully revisit the marked‐to‐market provisions of FASB 157‐‐‐deciding, perhaps, that it worked too well.
Meanwhile, the RTC‐like entity would be responsible for sorting out the mess and recovering tax dollars expended to purchase the toxic assets, probably at a profit to the tax payers, through the sale of those assets and properties as underlying values recover over time.
Will underlying values recover over time? Sure. It defies logic that a piece of real estate, for example, can be ultimately worth nothing. And it follows that the financial instrument‐‐ regardless of how convoluted‐‐holding some part of the indebtedness would also end worthless. We are already seeing buyers enter the real estate market as prices have fallen, and that's not surprising.
Is the job of sorting this mess out in every way daunting? Yes. There was plenty of talent put to use getting us into this mess; some of that talent might be gainfully employed figuring out how to get us out.
Can the toxic assets be priced? Can financial instruments be created that would allow the RTC‐like entity to acquire those assets at a reasonable margin of safety up front, and if needed, deliver risk‐adjusted differences in value over time for the assets as a way to bridge current, risk‐adjusted valuation gaps? Certainly! However, if the latter is really an issue a bottom is already forming, at least in someone's mind. Gaps in valuations are bridged and adjusted for risk all the time in business transactions and they can be here as well.
Is this all that should be done? No, but it's a significant and important step.