The Financial Times on Monday (2008.11.10) carried an article quoting Tim Ryan, president of the Securities Industry and Financial Markets Association, as saying that the Troubled Asset Recovery Program (TARP) needed to start buying the troubled assets at the heart of the credit/financial crisis. I completely agree.
The program was created on the theory that uncertainty in the value of these troubled assets left lenders unsure of the risk of loaning to any other financial institutions. They simply would not extend any credit because they could not confirm that the borrower did not have an unhealthy amount of these "toxic" assets and would not default, even over the short term.
Pre-existing "mark-to-market" regulations regarding these sorts of assets should have had banks completing their write-downs by now. (I'll use the term "banks" here to mean all financial institutions that might own such assets.) None of these assets has appreciated this calendar year, so any financial statements before October should have reflected the difficulty of selling the assets and should have valued all of them at presumed market value, or near zero. (It was not until October 1st that the SEC issued an interpretation of the mark-to-market rule that allowed banks more latitude in evading purely market-based valuations.) It is obvious and ignored that most banks have blatantly disregarded this rule, the likely reason being that had they marked their assets to market, their capitalization would have fallen below regulatory limits, leading to credit downgrades and putting them on the road to failure.
Yet we're still hearing about more write-downs. Obviously banks are only making public a level of loss which keeps them just barely above the level at which investors will believe they are about to fail. So at the heart of the crisis still is uncertainty about the value of hidden assets on bank balance sheets. Even with increased capitalization from US Treasury infusions, we don't know which institutions will make public a level of loss on these assets that makes their survival unlikely, and we don't know when they'll choose to divulge such information.
There will be no market setting of the value of such securities without the Treasury's lead, and therefore the Treasury has enormous power to set the value of these securities to accomplish whatever priorities it sees fit. What priorities should it set?
Obviously, since it is buying (some of) the assets itself on behalf of the US taxpayer, it should intend to make a profit on them. This is easier said than done, since even a knock-down value on them could produce a loss if the US economy grinds to a halt. So targeting a price based on predicted profitability is a risky strategy.
It could try to keep the financial institutions healthy by targeting a value that it believes the assets could reach if held to maturity, but this seems to be flying into the face of taxpayer and economist revolts. Taxpayers do not want highly compensated "Wall Street" executives to get rewarded for running their banks into the ground with bad decisions, and economists similarly to not want to encourage actions that will result in the "moral hazard" of executives believing that they will be bailed out in the future after taking unwise risks. The taxpayers and economists both want bad decisions to result in failure.
So the prominent priorities in valuing the assets seem to be in pushing the prices down. How low is too low? They become too low when too many institutions fail. If too many institutions fail, the FDIC will fail, and all investor confidence in the banking system will fail with it.
This therefore leads to the sole priority the Treasury should follow in buying troubled assets: It should target a desired failure rate for banks and other financial institutions, and should value the troubled assets at the level which will achieve that failure rate. Targeting a bank failure rate will keep asset purchase prices for the US government to the lowest level possible, will satisfy taxpayers desire to punish at least some of the individuals and institutions responsible for the crisis, and will remove the uncertainty from the books of those banks which accurately report their holdings and which did not buy too many risky investments in the first place.
After the prices are set, it will be up to banks to mark their assets to the levels set by the Treasury. Some, of course, will still not report or value troubled assets on their books for fear of failure. They might fail a year or two later after trying to lie their way through it for a while. The Sarbanes-Oxley law, however, remains a tool with which to prosecute any such executives that fail to come clean when the asset values are set.
The Treasury will have to rely on Depression-era data on bank failures and sentiment in order to determine what is a "tolerable" level of failures. I'm guessing that 1 - 3% of banks might be acceptable. Some failures may lead to other failures. However, the fact that the Treasury has at its disposal the tool of making direct capital investments into banks should provide a stop-valve for any domino effect. Of course this means that it will "play God" to some degree in who survives and who fails, but this activity should be limited to the after-effects of failures as opposed to failures caused by the presence of high levels of troubled assets on banks' books.