Feds to suck poison from economic wounds

National – lead, follow or get out of the way: There is a new buzz word circulating in Washington D.C. Bundled defaulted mortgages are no longer to be called "toxic assets" but rather "legacy assets." In this new guise the Treasury announced today that it plans to buy up to a trillion dollars worth of these "legacy assets" from banks … sort of.

The problem is simple: So long as the economy was growing and home sales appreciating wildly banks were more than happy to buy mortgages and mortgage backed derivatives. When the bubble burst banking rules required the banks to list these "legacy assets" at their current value. The trouble was that the market for mortgages and their derivatives stopped so it became impossible to sell these assets at any price. The value of these assets effectively fell to zero.

When this new reality became apparent most large banks, AIG and all the Investment Banks suddenly found themselves well underwater. Without these "toxic assets" most banks, insurance companies and investment bankers were as profitable as they were, say, five years ago. The bulk of their assets were still good but banking regulations required that the banks close up shop until their balance sheets met reserve requirements. This is the so called "mark to market" rule that bankers whine about. However, even with a change in accounting rules these assets would weigh heavily on the balance sheets of many financial institutions. The new Treasury Plan unveiled today by Timothy Geitner promises to begin removing these now "legacy assets" from the books of the banks.

The Treasury had two problems it had to solve before it began buying these assets: First, what should it pay for assets that couldn’t be sold at any price, second, how to create a market for these assets that no one clearly wants, least of all the U.S. Treasury. The hoped for solution includes a public/private scheme to remove these assets from Americas financial institutions. Here is how it is supposed to work:

1. Banks identify the assets they want to get rid of
2. The FDIC will conduct an auction of these assets. The highest bidder can ask the Feds to share up to 50% of the cost of the assets. This established a price and a market for these "legacy assets."
3. Here’s the kicker: If the seller agrees to the price (and the seller might rethink the value of their assets) then the buyer can sell FDIC guaranteed bonds to finance the purchase while paying the FDIC a fee for that guarantee. If the bonds default then the FDIC owns the underlying asset.
4. The private buyer will manage and control the assets until they are finally liquidated (subject to FDIC oversight) and the Treasury paid off.

The beauty of this plan, if it works, is that it re-starts a market for these assets and established a price without the U.S. Government having to simply buy everything. When the price for real estate begins to rise again (and it will) the U.S. Treasury may make some serious money.

See also The Fed Plan, Mark to Market