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A toxic solution to the crisis

A toxic solution to the crisis
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First Published: Tue, Jun 23 2009. 12 30 AM IST

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Updated: Tue, Jun 23 2009. 09 27 AM IST
The financial crisis is largely a result of toxic assets held by banks. However, bailouts, originally designed to buy these toxic assets, are now trying to eliminate the liquidity crisis —but that’s only a symptom. The real problem is solvency.
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Finance geeks would tell you that the current financial crisis began when investors lost confidence in the value of securitized mortgages in the US resulting in a liquidity crisis that, in turn, caused a substantial injection of capital into financial markets by the US Federal Reserve.
Now in English.
Imagine that the string of monthly loan instalments one has to pay for a mortgage—the security for the loan—is akin to a string of pearls.
Banks dismantle entire necklaces, the pearls mixed up, repackaged into beautifully designed earrings or bracelets and sold to other banks. Let’s call them securitized mortgages. These new designs ensure high prices for pearl jewellery, often more than the value of the original pearl necklaces.
But some people offer fake pearl necklaces as a loan’s security. When the necklaces are dismantled, the fake pearls are mixed up with the real pearls and distributed across new pearl jewellery. Initially, no one knows that only part of their jewellery is real, but soon there are complaints regarding fake and missing pearls. Consequently, all the new pearl jewellery becomes suspect. Let’s call these toxic assets. Soon there is panic.
Since no one trusts the mixed- up pearls any more, the “fake pearl scandal” leads banks to stop lending money for home loans. Further, since banks raised cash by selling pearls, the banks have no money to pay people because the pearls have plummeted in value and banks are facing losses. This is our liquidity crisis.
In response, the government announces it will buy the fake pearls and will give banks money in return to continue their usual business. This is a bailout, or a substantial injection of capital.
Under the Term Asset-Backed Securities Loan Facility (Talf), the US government’s idea was to buy toxic assets from the banks with some private investors and sit on these suspect jewels for as long as it took for them to recover some value.
This is where the glitch began. The crisis was caused because banks could not assess the value of the pearl jewellery. The government faces the same problem: It has no idea how much it should pay for these toxic assets. Since the banks and the government don’t agree on prices, the government directly infuses capital into banks.
But more importantly, what makes these assets toxic? It is the prices at which pearls are currently trading—they are low enough to leave gaping holes in banks’ balance sheets.
This price reflects many things: if the pearl is fake, the level of risk and uncertainty in the pearl market, or other information.
So, are these “toxic asset prices” a good thing? Nobel Prize-winning economist F.A. Hayek would certainly think so. According to Hayek, the “most significant fact about this (price) system is the economy of knowledge with which it operates, or how little the individual participants need to know in order to be able to take the right action… Therefore, in abbreviated form, by a kind of symbol, only the most essential information is passed on and passed on only to those concerned.” The price of the pearls is more than just what is on the sticker. Prices give away millions of small bundles of information to millions of individuals. If these prices are manipulated, or fixed by the government, they will distort the knowledge given by the prices.
Currently, banks want the fake pearls to be expensive: They want these assets to be priced higher in the bailout so that others believe them to be valuable and they receive more money. The government, even more wishful in its thinking, believes that buying fake pearls for enormous sums of money will give the banks the money required to trade in pearls again.
On the one hand, the government wants to take the toxic assets off bank balance sheets in exchange for money to be used to keep the bank afloat. But on the other hand, it tells the banks to trade with other banks with questionable solvency caused by the very same toxic assets. More importantly, banks have no ability to distinguish good assets from toxic ones, which merely means that the presence of liquidity does not solve the banks’ problem regarding lack of solvency, which can only be solved by the market.
What would happen if the government did not intervene? In this case the toxic assets would be valued in the market, leading to insolvency of many banks. On the one hand, the nature and cause of the insolvency will be exposed and the banks that are not facing the greatest threat will come to the forefront. This kind of information can only be gained in the market once the toxic assets and the banks’ balance sheets are correctly valued. The bailout, on the other hand, overvalues these assets in the hope that if they believe it is highly valued long enough, it will come true.
Therefore, the bailout money is a complete waste. It doesn’t get the toxic assets off the balance sheets. It involves the government directly running the banks. It does not tell banks anything about the nature, risk or uncertainty of the assets they hold. Nor does it solve the problem of solvency caused by the very same toxic assets. It only takes money from taxpayers and uses it for directly running banks, which then have a greater incentive to declare more assets toxic to get more taxpayer money.
Shruti Rajagopalan is a graduate student at George Mason University in Virginia, US. Comments are welcome at theirview@livemint.com
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First Published: Tue, Jun 23 2009. 12 30 AM IST
More Topics: Government | Banks | Prices | Assets | Financial crisis |