Troubled Assets Are Ba-ack…

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Remember, for that brief period of time, when the Treasury Department’s $700 billion “Troubled Asset Relief Program” was meant to buy up banks’ actual troubled assets? You know, those groups of toxic mortgages packaged into securities, or even whole toxic mortgages themselves? (Toxic, that is, because it’s doubtful these loans will ever be paid back in full or at all.) Removing those toxic assets, we were told, would bolster banks’ balance sheets and free them up to lend more to businesses and consumers and get the economy back on its feet. Yet not long after, the Treasury Dept., led by then-Secretary Hank Paulson, Jr., decided instead to use TARP money to invest directly in crippled institutions. Evidently Paulson hoped this cash infusion would pad their capital reserves, let banks write down losses from these assets, and help them resume lending even with toxic assets still on their books.

The question that has since lingered over the TARP, then, has been this: What happened to those toxic assets? And how are the banks and the government dealing with them now? That’s what the Congressional Oversight Panel, one of the leading watchdogs led by Harvard Law Prof. Elizabeth Warren, set out to answer with its August report, released yesterday—along with how financial institutions intend to deal with these assets left on their books going forward.

First, there’s the issue of valuing these toxic assets. This is difficult to do, because their value in large part relies on the ability of the loan borrowers to pay back their loan(s). And with the economic future still uncertain right now—unemployment has decreased slightly and several positive signs have emerged, but will the green shoots grow?—it’s difficult to discern borrowers’ future ability to repay their loans. “No one has a good handle how much is out there,” Warren told Reuters Television. “Here we are 10 months into this crisis…and we can’t tell you what the dollar value is.”

Banks’ ability to operate with toxic assets on their books poses another issue. The Treasury Department’s stress tests of the biggest bailed-out banks was supposed to determine whether they could weather a worsening economic climate; as a result, some banks were deemed healthy enough with existing capital to deal with further declines in the economy, while others were told to go out and raise more money to boost their coffers. But as the COP and others have pointed out, the various scenarios in the stress tests (e.g., an “adverse” economic scenario and a “worst-case” scenario) have largely been surpassed in the real economy, and could get even worse if this more recent good news proves short-lived. Thus we might need to stress-test banks again, the COP finds.

Worse still, there’s the possibility that some of the biggest bailed-out banks—perhaps even those that have repaid their TARP funds—could be forced to ask for government funds again. According to an analysis by MSNBC.com and American University’s Investigative Reporting Workshop, many of the biggest banks still have considerably high troubled asset ratios (a comparison of a bank’s troubled assets against its ability to withstand losses, i.e., a bank with $20 million in troubled assets and $200 million worth of capital to absorb losses would have a 10 percent ratio) on their books: At the end of the first quarter, JPMorgan Chase’s ratio was 23.5 percent, up from 20 percent from the quarter before; Bank of America’s was 29 percent, from 22 percent; Wachovia Bank was 29 percent, up from 23 percent; and SunTrust Bank in Atlanta was 37 percent, up from 32 percent last quarter. Granted, a handful of these banks, including JPMorgan Chase, recorded staggering profits not too long ago, meaning they’ll be better able to withstand losses from toxic assets.

Finally, the COP’s report references the Treasury’s plans for valuing and dealing with toxic assets still on banks’ books. A centerpiece of this strategy is the Public-Private Investment Program (PPIP), a largely flawed idea that heavily and unnecessarily favors the private sector and that has rightly been ripped by economists and other experts. Here’s how Nobel laureate, economist, and Mother Jones contributor Joseph Stiglitz described it:

“Consider an asset that has a 50-50 chance of being worth either zero or $200 in a year’s time. The average ‘value’ of the asset is $100. Ignoring interest, this is what the asset would sell for in a competitive market. It is what the asset is ‘worth.’ Under the plan by Treasury Secretary Timothy Geithner, the government would provide about 92 percent of the money to buy the asset but would stand to receive only 50 percent of any gains, and would absorb almost all of the losses. Some partnership!

Assume that one of the public-private partnerships the Treasury has promised to create is willing to pay $150 for the asset. That’s 50 percent more than its true value, and the bank is more than happy to sell. So the private partner puts up $12, and the government supplies the rest—$12 in ‘equity’ plus $126 in the form of a guaranteed loan.

If, in a year’s time, it turns out that the true value of the asset is zero, the private partner loses the $12, and the government loses $138. If the true value is $200, the government and the private partner split the $74 that’s left over after paying back the $126 loan. In that rosy scenario, the private partner more than triples his $12 investment. But the taxpayer, having risked $138, gains a mere $37.

In short, it gives private investors all the upside and sticks the public with all the risk and exposure to losses.

Though the COP doesn’t come right out and say it, it’s clear the Treasury, which has yet to articulate any kind of unwinding plan or endgame for the TARP, needs to develop more fair, equitable strategies for dealing with toxic assets—and preventing banks from suffering further losses because these pools of mortgages remain on their books. Letting private investors buy them on the cheap with generous government backing ain’t the answer.

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