The rescue plan to buy up to $700 billion in toxic assets may not be enough to save some banks, which experts say may be forced to absorb gigantic losses if they sell their bad mortgage-related assets.
The rescue plan for the government to soak up the mortgage-backed securities would be the biggest bailout plan since the Great Depression. However, experts say a critical issue will be how much it actually pays for the bad mortgage-related assets.
How the government might acquire banks' toxic debt is still being ironed out. However, one approach advised by Treasury Secretary Henry Paulson involves a process under which financial institutions would propose a price for their mortgage-backed securities and the government would pick up the lowest bids.
Ironically, if banks sell at the proposed price, say 50 cents on the dollar, then accounting rules would require companies to take the losses on their balance sheets before getting the troubled assets off their books. According to industry experts, for weaker banks buffeted by the deepening credit collapse, the losses may hinder their ability to go out raise capital, make loans and ultimately stay afloat.
According to Vincent R. Reinhart, former director of the Federal Reserve's monetary affairs division, there is a risk that there will be bank failures to come. While the reverse auctions could help banks set a clearing price for damaged assets, he said that the price does not mean that every financial company will be solvent after those toxic assets are sold.
Reinhart added that another risk is that if the bids set too low a price for mortgage-related assets, other institutions with bad debt may be forced to take the distressed valuation onto their books under mark-to-market accounting rules. Mark-to-market rules involve adjusting the price of an asset to reflect its current market value. The worst impact is if the auctions do not go well, it will drag down everybody's balance sheet that marks to market.
The financial system has been battered by $500 billion in losses from the financial crisis, and the International Monetary Fund (IMF) has measured the price tag could ultimately top $1 trillion.
According to the Federal Deposit Insurance Corp., the collapse has forced 11 federally insured banks and thrifts into failure this year. Another 117 banks and thrifts were considered to be in trouble in the second quarter, the highest level since 2003, with the total assets of unhealthy banks tripling to $78 billion. The agency does not disclose which institutions are on its list, but on average, 13% of banks that make the list fail.
According to senior vice president and managing director of Institutional Risk Analytics, Christopher Whalen, about 110 banks with assets worth $850 billion are in danger of failing by next summer. He said the Treasury Department's proposal has not given him reason to be more optimistic. Moreover, he said the government might decide that the only choice to save some banks is to pay full price for the assets in exchange for equity that could be sold later.
Nevertheless, that could be risky because if the government pays too high a price, it will be difficult if not impossible to go out and sell the assets for a profit in the future, meaning any losses incurred would be absorbed by taxpayers. However, paying too little also is problematic because banks will be forced to take steeper losses that they may not be able to recover from. According to Marvin Goodfriend, professor of economics at Carnegie Mellon University, the government should be able to arrange to pick a price that helps the banks but also that allow the government to turn around and make a profit down the line.
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