What to do about Toxic Assets

I've never professed to be an economist, and I know little about politics and economic policy. I do try to apply common sense, sprinkled in with morsels of demand/supply dynamics and market timing. I've never proffered up solutions to our global financial crisis due to its depth and severity, but it's gotten to the point where I feel the need to throw my hat into the wring. So here goes:

Credit default swaps (cds), which basically insured the collaterized mortgage obligations (cmo), were transacted between private parties (banks, sovereign funds, pension funds, hedge funds, private equity funds, AIG), outside of exchanges. The quants used algorithms (specifically, Gaussian copula) to price these mortgage-backed securities and swaps, and the software models blew up when real estate values plummeted and defaults skyrocketed. We've covered this topic ad nauseum.

For equities, we have the NYSE, NASDAQ, and other stock exchanges around the world. For fixed-income (bonds), derivatives (options, futures), and commodities, we have the CBOE and COMEX exchanges, for instance.

How about the buyers of these swaps open up their kimonos, and expose these assets? If they don't like the mark to market pricing, put them all onto an exchange, where all parties can see the composition of assets, and then let the markets decide how much they are really worth. If that means they are only worth 20 cents on the dollar, so be it--let them take a bath on them. That's better than burying it in their portfolio, pretending they aren't there. And once exposed, perhaps they are worth more than current panic levels....maybe they would get 60 cents on the dollar. Mark to market accounting prices these assets at liquidation levels, so they would be lucky to get 10 cents on the dollar. The underlying environment is that over 90% of mortgages are not delinquent--yet mark to market valuation prices in a 30% default rate.

Banks have what consumers are experiencing: 401K syndrome. Individuals aren't even opening up their mail because they are scared to see how much their 401K statements have declined.

During the Savings and Loan (FSLIC) crisis, the RTC was formed to consolidate these bad loans, write them down, price them, and sell them off. Granted, today's financial crisis is orders of magnitude greater, but the concept should be the same. Put a Bill Seidman in charge of disposing the assets.

To just sit on the these toxic assets--hoping home balance sheets will magically improve, and defaults will magically decrease--is lunacy if unemployment keeps rising.

In other words, because these transactions were synthetic, outside the auspices of an exchange and subject to mispricing, wouldn't it make sense to put them all into an exchange, and have markets price them in a transparent environment?

For instance, on a micro level, when a borrower defaults, no one knows how much that house is worth anymore. Other homes in the neighborhood are affected, and the more foreclosures, the more distorted the pricing. But put them up into an auction in a foreclosure sale, and the market determines the value of that house--and other homes in the neighborhood.

It seems logical, but I'm not sure the government will figure it out. They're just going to throw more good money at bad money, bailing out special interest groups, and distorting market pricing even more, prolonging any chance of a bottoming out process.


Having said that, the government doing the exact wrong thing makes it easier for investors. Just keep playing the reflation thesis.