How do you define ”toxic”? That is the $700bn question hanging over Washington and Wall Street.
The principle behind the bail-out proposed over the weekend by Hank Paulson, Treasury secretary, is clear. To get the maximum bang for its considerable but limited number of bucks, the Treasury wants to concentrate on those “toxic” mortgage assets that are damaging the whole financial system by eating holes of unknown size in the balance sheets of financial institutions holding them.
But therein lies the problem. It is the uncertainty as well as the size of the losses that is causing such reluctance among institutions to trade with each other.
Unlike previous episodes such as the 1980s savings and loan crisis, the widespread use of financial derivatives backed by mortgages has both magnified the losses and ensured that quantifying them has depended on models.
Charles Goodhart, an economist at the London School of Economics, says that in the end, the important thing is that banks will be swapping what is now an unsaleable asset for a saleable one in the form of US Treasury securities. “[US authorities] could buy the chairman’s secretary or the pictures in the boardroom as long as they give [banks] something saleable in return,” he says,
But getting the pricing right is politically as well as economically important. “If it is too generous, taxpayers lose and it becomes politically problematic,” Prof Goodhart says, especially since foreign-headquartered banks as well as US institutions can be bailed out.
The political fallout from using US taxpayers’ money to pay too much for US mortgage assets to investment banks based in Europe or elsewhere could be considerable. “But if the prices are set too low, no one will take it up. It is an almost impossible exercise to do.”
And the more discretion that the Treasury has to define which assets are toxic, the more potential for the appearance of political bias and the operations of sharp lobbyists, as has happened with similar exercises in the past.
Even using the most basic of tools to define an asset price – its credit rating – is highly problematic.
It was those credit ratings, economists say, that helped Wall Street get into this mess in the first place. The repackaging of subprime mortgage debt into top-rated securities is one of the main means by which financial groups justified taking large amounts of high-risk assets on to their balance sheets.
As Douglas Elmendorf from the Brookings Institution in Washington points out, buying assets at auction based on their credit ratings “would be placing undue weight on ratings that have been widely derided”. It also rewards the financial institutions that have made the worst decisions.
In practice, the Treasury and whoever else ends up directing the rescue operation are likely to have to proceed by feeling their way forward. On one thing everyone agrees: a clean and easily applicable definition of what constitutes a toxic asset does not exist.
Get alerts on Global Economy when a new story is published