Davidson on Toxic Assets

Our friend Paul Davidson has recently penned a piece over at RGE Monitor (if, by the way, you are not reading the commentary over at RGE Monitor, you should be — and not just because I am a contributor). Davidson offers a solution to mitigating a the economic downturn as well as preventing future markets for toxic assets.

First Davidson highlights the problems with the Paulson Plan:

These securitized assets have no well organized, orderly market with a market maker. Given the housing problem, there is no orderly market price to evaluate the worth of these toxic assets. No one knows exactly how to evaluate the MBS, and other exotic financial assets on the balance sheet of holders. The SEC had made a rule of mark -to-market for traded securities. In these days, however, the last market price in the disorderly markets of these TOXIC assets might have been “a fire sale price” , for example, at 50 to 70 per cent discount. Accordingly if the financial institutions holding these assets marks these assets to market, they will be insolvent. The original Paulson plan [only 3 pages long] gave Paulson the right to buy these illiquid assets at a price not to exceed the price the holder originally paid. If the price was at or near the original holders’s purchase price, this would improve balance sheets tremendously and take away the fear of insolvency.

[…]

What will the Secretary of the Treasury use to decide fair market value?

This has been my major misgiving all along.

Next, Davidson proposes a two-step process to mitigate recession:

  • Re-create the Home Owners Loan Corporation (HOLC) to purchase mortgages at a discount and renegotiate the terms with home owners at monthly payments they can afford.
  • Institute a temporary payroll tax holiday through the end of February 2008.

The HOLC was remarkably successful the first time around as it did ultimately earn a profit (it’s one of the few New Deal programs that doesn’t draw my ire). Further, the tax holiday would amount to a progressive tax cut that could aid those falling behind on mortgage payments.

Davidson further presents a guide to preventing future markets for toxic assets. He is fundamentally correct that we need to ensure markets are well-functioning. When market trading breaks down due to information asymmetries and/or the realization of uncertainty, there is a tendency for herd-like behavior that can detach the price of assets from their underlying value. A primary problem is that with MBS, CDO, and various other securitized assets is that they were not truly understood. As Davidson mentioned, in an ergodic world, one can easily price the present value of the future payments. However, in a non-ergodic world, when this calculation breaks down, the assets in question can revert back to illiquidity.

Where I disagree, however, is with regards to private securitization and the re-creation of the Glass-Steagall Act. First, I do not think that we need to abandon the ability to securitize private debt. However, we need to create transparency with regards to securitization such that the holder of the asset knows where the underlying loans were originated. Finally, I do not know that a re-creation of Glass-Steagall would be sufficient. The separation of lending institutions from investment banks would not necessarily prevent the securitization of private debt so long as investment banks have the ability to purchase illiquid assets from lending institutions. Nevertheless, Davidson’s post is certainly worth a read.

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