Mark to Market (WAS: The Geithner Plan FAQ)

In article
<135ab793-059d-40a9-a426-2a70145d73fb@xxxxxxxxxxxxxxxxxxxxxxxxxxxx>,
JGibson <james.m.gibson@xxxxxxxxx> wrote:

On Mar 24, 12:00 am, Steve Cutchen <max...@xxxxxxxxxxxxx> wrote:
http://delong.typepad.com/sdj/2009/03/the-geithner-plan-faq.html

 March 21, 2009
The Geithner Plan FAQ

Q: What is the Geithner Plan?
A: The Geithner Plan is a trillion-dollar operation by which the U.S.
acts as the world's largest hedge fund investor, committing its money
to funds to buy up risky and distressed but probably fundamentally
undervalued assets and, as patient capital, holding them either until
maturity or until markets recover so that risk discounts are normal and
it can sell them off--in either case at an immense profit.


This is the part I just don't get. How are these assets fundamentally
undervalued? If most of the assets were built up on the housing
bubble, what makes them undervalued? House prices are still above the
historical trendline, and likely need to come down farther still. I
only see the assets being undervalued if the housing bubble can be
reinflated.

This is going to take a bit, so be patient...

The key comes down to an effect of mark to market accounting when asset
values are dropping in a non-liquid environment. The financial balance
sheets go into a death spiral of lower and lower shareholder equity,
stopping the institutions ability to make loans and drive the economy,
and eventually going bankrupt.

Mark to market requires that assets on a balance *** be valued as if
you had to sell them today. They are marked to market price. This
system replaced the system of Historical Cost Accounting whereby assets
were kept at the price you paid unless certain significant events
happened that required that they be revalued. This sounds good. Value
everything at its actual value, not at what it used to be worth.

But mark to market causes more than that. When an asset value is
dropped, the balance *** must be adjusted to still balance, and so
what eventually is getting dropped to balance it is shareholder
equity.

Shareholder equity represents the safety net for how far your asset
values can drop. When shareholder equity drops to a point, EXISTING
CREDITORS get worried and want to get paid off. They demand their
money back. And they are not interested in reloaning to you.
POTENTIAL CREDITORS look at your low shareholder equity and won't lend
to you either. And, at a point, REGULATORS will require a minimum
safety net or take action. Also, your BOND RATING is dropped, and this
raises the amount of cash you have to have on hand to do business.
Suppliers want to be paid in advance. That kind of thing.

So what can you do? Well, obviously you can't borrow the money with
loans or bonds. You could sell stock, but it's going to be at a really
low price, and you'd be diluting how much each share represents,
driving the price even lower. So this is not a good idea. About all
you can do is sell assets to raise cash, and in the balance *** this
will raise shareholder equity. But your assets are way down in value.
That's what triggered the crisis. And selling into this depressed
market will drive prices down even more and will reduce the safety net
even more. You are in a huge pickle. And the choices... the only
choices are a bailout from someone, most likely the government but
maybe another company that buys you, or bankruptcy.

With the Toxic Assets, there is even another problem. These are assets
that don't have a liquid market. So if you have to sell them into a
thin pool of customers, they know it, and it has to be a fire sale. So
this makes things worse not better. The safety net lowers even more due
to the action you took to try to raise it. It is a death spiral.
Exactly the death spiral that took down Bear Stearns until Merril
bought them with goverment money, which Paulson hated to do, and what
then took down Lehman Bros, which Paulson allowed to go bankrupt
because he didn't want to keep bailing folks. And when Lehman went
bankrupt everyone realized how interconnected everything was, and that
took down the financial system, grinding it to a halt. No one knew who
had what in their assets. No one knew who would pay them back, or
could. So everyone simply held their cash.

OK. So returning to your question. Why are the Toxic Assets so
undervalued? Part of the drop in value is real, due to the artificial
run up in value that could not be sustained; the run up in value caused
by making loans to folks that shouldn't have been made, artificially
increasing demand too high and at the same time causing future defaults
and foreclosures. But part of the drop in value is an effect of the
crisis; the death spiral caused by trying to mark these assets to value
on balance sheets. And no one knows how much is due to each part
because no one can tell what the inherent values are without a market
to set it.

This is what Geithner's plan is meant to correct. Provide a market
backed by the government that will allow folks to bid on and buy these
assets, and provide an incentive, the possibility to make a lot of
money, to get them to participate. The assets are purchased with
bidder and government money invested 50-50, and with a guarantee by the
government against subtantial loss in the form of a loan that pays a
large part of the price. If the prices eventually return to what was
bid or more, they can pay off the government loan to no cost to the
taxpayers. This is as compared to the original TARP plan which would
have had the government paying for and owning the assets with 100%
taxpayer money, with no bidding process or private sector involvement.

Selling the Toxic Assets will remove these assets from the balance
sheets and will enable the safety nets on the balance sheets to return
to normal. This will allow financial activity to return to normal
because folks will be willing to release cash again, which will, in
turn, allow business to return to normal, and the recovery to begin.
As opposed to what Japan did in the '90s, keeping the assets on the
books of the financial institutions until THEY could work them off...
and thus keeping the financial institution balance *** safety nets so
low that they could not make loans and kick off new business like they
are supposed to... and extending the recession.

Hopefully, with government guaranteeing much of the money that is being
invested, the prices paid will high and will cancel out the death
spiral part. But not so high that they are raised into that
artificially high part caused by sub prime loans, This should be the
case because bidders should not be interested in paying that high a
price, even with the government guarantees. They want to make money
more than they want to be reimbursed for loss. They then hold the
assets until the economy recovers or until the term of the mortgages or
whatever, and make a profit. If they make a profit, not only does the
government not have to pay the guarantee, they split the profit with
the bidders because of the 50-50 part where they co-bought the assets.
.

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