The trouble with troubled assets

There is a great op-ed piece in today's Wall Street Journal that summarizes the problem with banks' troubled assets. Peter Wallison, a senior fellow at the American Enterprise Institute, reviews the rules of mark-to-market accounting for banks with mortgage-backed securities (which includes almost all banks.) The rules require the banks to calculate what is called the "net realizable value" for these assets based on their best estimates of the cash flows generated by the assets. The net realizable value is then discounted to a price that would reflect market values.

What happens during times like these when there is no market? The banks mark the value down even further to make sure they are being conservative. The net effect of this process can lead to erroneous conclusions. This appears to be what is happening today. According to Wallison,

Paradoxically, many of the banks' most troubled assets are flowing cash near their expected rates, and thus their net realizable values are higher than the values to which they have been written down.

To support his point, Wallison points to last weeks' testimony by Vikram Pandit, the CEO of Citigroup, to the House Financial Services Committee. In that testimony, Pandit stated that the mark-to-market values of its assets are reflected in the losses the bank has taken. He further pointed out that management has a duty to shareholders to not sell assets below their economic value. He flatly stated, "And the duty is, if it turns out [the assets] are marked so far below what our lifetime expected credit losses are, I cannot sell [them]."

This is the trouble with the banks' troubled assets. We have allowed accounting doctrine to paint us into a corner. Finding a way out of the corner has been one of the thorniest dilemmas confronting public policy in my lifetime.

Wallison suggests an elegant and effective solution: the government should simply buy the assets at the net realizable value. This will be a win-win solution for taxpayers, banks, and the broader economy. A broadly diversified portfolio of assets purchased at net realizable value will likely perform well for taxpayers. The purchase price banks will receive in excess of the current market-to-market value will infuse capital into the banking system. And the broader economy will benefit from a functional banking sector.