Treasury Secretary Paulson backed away from his plan to buy up toxic debt, and it's unlikely that anyone else wants to buy it either
When Treasury Secretary Henry Paulson first pitched the bailout in September, it sounded like a plumbing job. The "troubled assets" on lenders' books were clogging the financial system, he said, and the government needed to buy up the bad debt to get credit flowing again. But in the six weeks since the $700 billion plan passed, Paulson hasn't spent a dime on asset purchases, and on Nov. 12 he scrapped the idea altogether.
What happens to the toxic investments now? They will probably sit right where they are.
Buyers and sellers have been at an impasse for weeks. Fearful of being undercut, potential investors wanted to see what the U.S. would pay for securities backed by subprime mortgages and other troubled loans before jumping in with any offers. Financial firms were reluctant to unload holdings at fire-sale prices, hoping they could get more from Uncle Sam.
The standoff could intensify now that Paulson has changed course. The fundamental problem remains: Buyers are worried that the assets will continue to fall in value as the economy weakens, and sellers don't want to cut their asking prices, further battering their balance sheets. "There's a stalemate," says a 16-year market veteran at a major money manager.
Meanwhile the government's hasty retreat has only made the assets more poisonous. Some top-rated securities backed by home equity loans are valued at 40¢ on the dollar, vs. 67¢ when the rescue plan was announced two months ago, according to data provider Markit. Even those quotes, though, are somewhat questionable, since the market for housing-related securities is all but dead. "They're not being traded," says Christian Menegatti of research firm RGE Monitor. "The value of [some] securities might be close to zero."
With prices in the dumps, banks don't want to sell huge swaths of securities and trigger more losses. And firms have the financial flexibility to hold on to them, at least for a little while. During the crisis, most companies have resorted to selling assets to ensure their capital levels meet regulatory requirements. That's because when banks take writedowns, there are two options for keeping capital up to snuff: find more money or sell assets.
Sure, banks will endure another round of writedowns on the holdings (financial firms are expected to report $65 billion in losses this quarter). But what's different today, compared with even a couple of months ago, is that banks have a bigger safety net. The government is pumping cash into the industry by taking direct stakes in the banks. Since October, banks have raised $223 billion in capital from public and private sources, more than in the first three quarters combined.
Lack of Pressure
Then there are the loan guarantees from the Federal Deposit Insurance Corp. Under the agency's plan, banks can sell government-guaranteed debt to investors. The low-rate debt gives them a cheap way to boost capital. "If there's no pressure on banks to sell the bad assets, they're probably not going to," says Albert Kyle, a University of Maryland finance professor.
The question is whether banks are putting off the inevitable hit from troubled investments. Firms are sitting on $10 trillion of dubious debt, according to the International Monetary Fund. Many say the securities are overvalued and should be marked down. But companies seem to be betting the market will revive, the investments recover, and their profits return. It could be a risky gambit if the optimistic scenarios prove illusory. Says Kyle: "You could have it back up on you in an ugly way."