The report did not mention that this change was apparently influenced by the
public recommendation published in the New York Times by Paul Krugman that,
instead of purchasing the troubled assets, equity capital could be provided to
the banks directly in exchange for preferred stocks. This approach would
strengthen the financial position of the banks, encouraging them to lend into
the economy. Dividends would be paid to the government on the preferred shares.
Krugman's recommendation echoes the approach used in dealing with savings and
loan crisis of the 1990s, when the government ultimately appropriated $105
billion to resolve the crisis. After banks repaid loans through various
procedures, there was a net
loss to taxpayers of approximately $124 billion by the end of 1999. The
approach was also used in the Fanny Mae and Freddie Mac takeovers in September
2008. This approach would avoid the difficult valuation problem encountered in
direct purchase of mortgage backed securities (MBS).
Ten months after the establishment of TARP, at the time of the COP August 2009
Report, substantial troubled assets remain on banks' balance sheets.
The COP report raises several questions about the Treasury's Public-Private
Investment Program (PPIP), initially designed as an effort to restart the
failed mortgage-backed security market. The questions include whether
accounting rules that allow banks to carry assets at higher valuations will
diminish their willingness to sell, and whether potential buyers may decline to
participate due to concerns about new political interference or government
restrictions. PPIP was expected to jump-start the troubled asset market, but
serious questions remain about its effectiveness.
For smaller banks, those not among 19 stress-tested big bank holding companies,
troubled assets pose special challenges that have not been acknowledged by the
Treasury. These banks' troubled assets are generally not securitized
instruments but whole loans, which are not currently being addressed by
Treasury's TARP or PPIP initiatives. These banks also hold greater
concentrations of commercial real estate loans, which pose a threat of high
defaults. These banks also have more difficulty accessing the capital markets,
which heighten concerns about their stability.
The report calls for Treasury and relevant government agencies to move toward
greater disclosure of the terms and volume of troubled assets on banks' balance
sheets. Because banks typically disclose few details about the toxic assets on
their books, it is difficult to gauge the magnitude of the risk that these
assets pose to the financial system. Greater transparency would allow for
better judgments about the scale of the problem and the adequacy of the
government's response.
The report says that if the economy worsens beyond the levels considered in the
recent stress tests, stress tests should be repeated. Stress tests have the
potential to gauge the impact of troubled assets on bank capitalization and to
measure the risk that troubled assets could once again trigger instability. The
COP recommends that stress tests be adapted to consider the challenges facing
smaller banks, including the adequacy of these banks' capital (see
Credulity caught in stress test, Asia Times Online, May 13, 2009.)
"If the economy worsens ... then defaults will rise and the troubled assets
will continue to deteriorate in value," the report says. "If the losses are
severe enough, some financial institutions may be forced to cease operations."
The COP report also cited other concerns, including: Valuing assets: For example, the report notes that in April
regulators gave banks more leeway in how they assign value to assets on their
books. Before the rule change, banks had been required to "mark to market". The
problem was that market prices had been beaten so low that banks would have
been forced to incur losses on assets that they were willing to hold on to.
Now, however, the greater latitude for valuation creates confusion about the
health of the banks.
PPIP: The report came as federal agencies were about to kick off
the PPIP bailout program. It's meant to address more directly problem
securities, but it has been off to a slow start and the report said it's
"unclear" whether banks will participate. Health of smaller banks: The report identifies small banks as a
major source of future problems, since they have greater concentrations of
commercial loans. And they also won't benefit as much from the federal PPIP
program because smaller banks tend to hold whole loans - the PPIP program will
be aimed at securities. In addition, the recent stress tests to assess the
health of the banking system focused only on the 19 largest banks.
Size of the problem
Nobody really knows how big the pool of troubled assets is because there is no
agreed upon definition of troubled assets. The Financial Accounting Standards
Board (FASB) issued Statement of Financial Accounting Standards No 157: Fair
Value Measurements ("FAS 157") in September 2006 to provide guidance about how
entities should determine fair value estimations for financial reporting
purposes. FAS 157 broadly applies to financial and nonfinancial assets and
liabilities measured at fair value under other authoritative accounting
pronouncements. However, application to nonfinancial assets and liabilities was
deferred until 2009.
Absence of one single consistent framework for applying fair value measurements
and developing a reliable estimate of a fair value in the absence of quoted
prices has created inconsistencies and incomparability. The purpose of this
guidance is to eliminate the inconsistencies by developing a solid framework to
be used in any fair value measurements.
FAS 157 defines fair value as follows: the price that would be received to sell
an asset or paid to transfer a liability in an orderly transaction between
market participants at the measurement date. This is sometimes referred to as
"exit value".
FAS 157 emphasizes the use of market inputs in valuing an asset or liability.
Examples of specific market inputs mentioned include: quoted prices, interest
rates, yield curve, credit data, and so forth. Fair value is, by definition,
derived from a current transaction which happens in an active market with
knowledgeable and unrelated parties. When fair value is not available due to
the lack of an actual transaction, it is logical to use information from an
active market. However, sometimes quoted prices might not represent the best
estimate of fair value.
The basis of the framework centers on a fair value hierarchy that indicates
reliability of inputs used to estimate fair value. The hierarchy is broken down
into three levels. Level one is for liquid assets with quoted price; level two
is based on market observables.
The COP panel looked at "level three" assets based on non-observable
assumptions, which are considered difficult to assign a value. Among the top 19
stress-tested financial firms, federal officials found $657.5 billion in "level
3" assets in the first three months of 2009, a 14.3% rise in those assets from
three months earlier.
The panel recommends, as it did in an earlier report, that bank supervisors
repeat stress tests if economic conditions worsen. And the panel suggests that
the Treasury must consider new ways to restart the market for troubled assets,
if PPIP should fall flat.
It also suggests that federal agencies should push banks toward more disclosure
of the terms and volume of troubled assets on banks books, to allow markets to
flow better.
The COP report warns that if the economy worsens and unemployment rises
further, the troubled assets on bank balance sheets could lose even more value.
The report reminds Congress that the bailout was initially pitched to help deal
with troubled assets, hence the name: Troubled Asset Relief Program. Yet the
TARP program has not relieved banks of their troubled loans.
The bailout money has instead been used to help banks boost their capital to
withstand future losses. Capital injections help ease pressure and potentially
free up money for lending - but the toxic assets are still festering.
Not all members of the Congressional Oversight Panel agreed with the report's
findings. Texas Republican Congressman Jeb Hensarling suggested that the toxic
asset market is "already beginning to heal itself" and that further
intervention could be "inappropriate - if not counterproductive."
Next: Politics of the financial crisis
Henry C K Liu is chairman of a New York-based private investment group.
His website is at http://www.henryckliu.com.
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