Wednesday, January 21, 2009

What are Illiquid Assets Really Worth?

For the most part, I agree with Paul Krugman’s take on the “Bad Bank” proposal. But I think he takes the case a little too far:
It looks as if we’re back to the idea that toxic waste is really, truly worth much more than anyone is willing to pay for it
But isn’t it obvious that the toxic assets are worth much more than anyone is willing to pay? The value of an asset depends on the rate at which one discounts its cash flows. For assets that are risky and illiquid, the discount rate includes a risk premium and a liquidity premium. By any measure I can think of, risk premia and liquidity premia today are stratospheric, which means that asset values in terms of reasonable risk and liquidity premia are much higher than in terms of the wild and crazy premia we’re seeing today.

Moreover, the toxic assets are particularly illiquid – and therefore demand a particularly high liquidity premium – because the technology for valuing them has proven faulty. Over time, presumably, the bugs will be fixed, and some of the liquidity will be restored. And by the way, what better way to fix the bugs than to create a buyer that has $350 billion to spend? Such a buyer – if its objective were to make a profit – could easily afford to spend a few hundred million on research to find out how much it should be paying for the assets.

There remains the philosophical question of how much an asset is inherently worth. But surely to the federal government – which can afford to be patient, and which can afford to absorb a lot of risk, and which can afford to sit on these assets until they mature or until someone is willing to buy them at a profitable price, and which doesn’t have to worry about capital requirements or even about solvency – these assets really are worth a lot more than any private entity is willing to pay for them.

Moreover, the government’s risk-free discount rate is probably negative. Today it can print all the T-bills it wants, and there will be no ill effects. At some point in the future (or so one hopes!), the government will once again have to pay for the money it borrows. For the private sector, a negative discount rate doesn’t make sense, because anyone can just hold assets in cash and receive zero interest. But the government cares about the effects its actions have on the economy as well as about its own financial health. It isn’t willing to hold its assets as cash, because that doesn’t help the economy. For the government, a negative discount rate does make sense. So add a negative risk-free rate to some reasonable risk and liquidity premia, and the government should be willing to pay quite a lot more for these assets than the private sector pays.

But should the government actually pay what it should theoretically be willing to pay? I’m inclined to say no, or at least, not necessarily. Demand curves slope downward, supply curve slope upward, and most people, under most circumstances, pay less for whatever they buy than what they would be willing to pay. In a competitive market, buyers pay only as much as the marginal seller is willing to accept. (Granted, the market for illiquid assets is, by definition, not competitive, but if a major buyer emerges, there will be competition among sellers.) If the government pays more than a similarly mandated private investor would have to pay, then it is merely transferring public wealth to the banks’ stockholders. And I’m confident that I speak for the majority of Americans when I say, “To hell with the banks’ stockholders!” What the government should be willing to pay for $350 billion worth of assets is whatever the market price would have been if there were additional $350 billion of private sector funds buying those assets.

And not even that, perhaps. Part of the reason these assets are so illiquid is that banks are reluctant to sell them because that would force them to own up to how little the assets are worth. If the government bid a little higher, presumably, more banks would be willing to sell, but there would still be an incentive for the banks to hold out for book value. My view is that banks should get the stick as well as the carrot. Instead of relaxing accounting standards, we should go the other way and be aggressive about forcing banks to write down their toxic assets, so they won’t have an incentive to hold out for unrealistic book values. When all is said and done, the government can recapitalize the banks that survive, and hopefully they’ll be willing to lend again.

I think the call that many economists made, when the original TARP came out, for recapitalization rather than reliquification, was misinterpreted. The idea, I think, was that banks need more capital because much of their existing capital will disappear once they write these assets down to a reasonable value. If you give them a token amount of capital without forcing them to write down the assets, it doesn’t solve the problem: their balance sheets may look good now, but they’re still afraid to lend if they’re uncertain about the value of their existing assets.

In any case, the whole enterprise should be, and can be, carried out in such a way as to be profitable – in an average expected return sense – for the government. The government can force banks to write down assets, and then it can buy those assets at a price that will leave a reasonable expected return. The banks that no longer meet capital standards will disappear. Of the remaining banks, many of them will need capital, and those will make up a substantial fraction of the banking sector. Banking – when one is willing to do it – is generally a profitable activity, and over time those banks should generate sufficient profits to compensate the public for the risk it is taking. If there’s anything left over for the stockholders, that’s gravy.

DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.


Anonymous said...

Great post. I think the TARP approach (overpay, undercapitalize, don't write down)comes from a fundamental misconception about equity capital.

"We need to attract private capital to fix this mess," is the rallying cry. Followed by, "so we need to treat shareholders well,".

What people don't understand is that the interests of current and future shareholders are diametrically opposed. Current shareholders, obviously, want their investment to retain value. Future shareholders want the most attractive unlevered returns they can get.

So the reason your idea makes sense is that it delivers big unlevered returns to new capital. In the process in wipes out old capital. This dichotomy seems too much for most "capitalists" to understand.

Anonymous said...

... then you hold them, chump.

Anonymous said...

"But isn’t it obvious that the toxic assets are worth much more than anyone is willing to pay? The value of an asset depends on the rate at which one discounts its cash flows."

And what if the cash flows don't come, if the underlying homeowner or shopping mall defaults? What if the asset used leverage to puff up its returns as long as underlying prices were rising? What if the asset assumed the independence of events that are now highly correlated?

I can't see how people can possibly make blanket statements like "toxic assets are undervalued" without going into specific detail about how these assets were constructed.

Anonymous said...

“These assets really are worth a lot more than any private entity is willing to pay for them.”

Is that so? And you know this after how many hours of painstaking examination of these very complex securities?

Call me a dumb wild-eyed free market ideologue, but I tend to believe that if there isn't a market for these assets, someone smarter than me who’s actually looked at them decided they're not worth what the holders want. So why do the holders keep holding out, striking aggrieved poses and declaring they will not sell at “fire sale" prices?

Because there’s a fat-wallet chump waiting in the wings: your friendly U.S. taxpayer. The banks know if they play their cards right, they can offload a lot of this junk for more than what it's worth to the U.S. government.

Liquidity issues? The biggest one is the one Wall Street created: it hoisted itself on the petard of its own financial engineering. These securities are too damn complex to sell easily and freely. But other than that, be very very suspicious of the liquidity argument. This is being very much oversold by banks trying to wash their hands of blame.

If you have $100 million of distressed assets, and you say they're worth $60 million, and the market will give you only $20 million, and you don't want to sell because that could trigger an implosion of value in your mark-to-market portfolio, guess what?

The assets become “illiquid.” It's not YOUR fault you can't sell them. (Point of curiosity: why not look at some of the few “fire sales” of these assets last year on the private market and what prices they fetched and how their value is holding up -- my guess is you’d find that the "fire sale" price doesn't look so cheap anymore.)

TDM said...

Private buyers risk all losses on illiquid assets while the the banks will likely have further losses subsidized. Private buyers will also pay taxes immediately on gains while banks will have reduced losses that will reduce offsets against distant discounted taxes (and the government does not pay any taxes on gains). The exact same cash flow is worth more to the government than to the banks and more to the banks than to private buyers. This means that we cannot expect any private buyers for the banks' illiquid assets in the current environment.

The government should probably pay the minimum price needed to keep the banking system functional. It definitely looks like City and BofA make up the margin. If all banks less solvent than them fail the system should be OK, add them and it's not. That would make the price needed to make City and BofA barely survive should be the target clearing price for a government auction. Hopefully that price is less than what the assets are worth to the government.

Anonymous said...

Interesting article. It would be even better if you defined "toxic assets". Do you mean primarily Collateralized Debt Obligations? Or, is there a broad mix? What disturbs me about your proposal is that this is almost exactly what Wall Street firms would do to a "client" whose assets still were paying, or still had value, but had become difficult to sell. They would take away their funding and buy assets on the cheap. Why is this a function of the Government? If indeed these assets are worth "more" than they can be sold for, the actions of the Government should be looking for ways to make them marketable (don't ask me what), not to squeeze their holders out of existence.

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