The U.S. Treasury, the Federal Reserve, and the Federal Deposit Insurance Corp. (FDIC) continue to struggle with how to deal with “toxic” assets on the balance sheets of banks and other financial institutions.
The concept of an “aggregator bank” or “bad bank” seems to hold the most promise, yet the methodology to implement this concept has proven elusive.
The core of the problem is valuing the assets. If the aggregator bank acquires toxic assets at the original cost or a value above current market value, the aggregator bank and its investors are likely to suffer significant losses. If the assets are valued at current market value, the erosion of a financial institution's capital would be profound, threatening its regulatory capital requirements. This is why many institutions are unwilling to sell these assets. Today's market cannot be characterized as having willing and able buyers; the spread between the ask and bid prices are too far apart.
The solution involves two components. The first is the creation of a number of aggregator banks funded partially by the Treasury with a significant private sector investment; the organization would be owned by investors. The second is to reform mark-to-market accounting.
The model for the creation of aggregator banks might draw upon Chile's private pension system. It established private pension accounts in 1981. These privately held pension administrators competed for government-mandated deposits. Everyone had to save, but where they invested was a private decision. The system was based on freedom of choice, private-sector management, and property rights in the retirement accounts.
A flaw was the requirement that everyone had to save, and that savings had to be invested with one of the pension accounts. Instead, our financial institutions would not have to sell any of their assets to an aggregator bank. Why? Valuing assets at fair value—via an efficient private-sector market—is key to overcoming the big gap in current bid-ask spreads.
Mark-to-market accounting should be adjusted in such a way that assets would be valued at fair value. Fair value is the expected cash flow to be returned, discounted by an appropriate rate for a quantifiable risk factor.
While determining fair value is subjective as it relies upon assumptions of expected cash flows and the “riskiness” of the asset, investors of financial institutions as sellers and aggregator banks as buyers must be provided transparency and consistency of approach. These institutions should be required to disclose their discount rates by asset type, asset performance, and geographic region.
The discount factor would correlate to the status of the asset. Assets performing as agreed would be discounted less than nonperforming or impaired assets.
Financial institutions and the aggregator banks would be required to carry the asset on their books at fair value as opposed to its historical cost basis.
At the time of sale, financial institutions would recognize not only the cash consideration received but also any contingent consideration. The expected discounted value of any contingent consideration would reduce the loss recognized by the seller.
The FDIC also would offer for sale any pools of assets taken over from failed financial institutions to the aggregator banks. Utilizing an auction process, the aggregator banks would provide market-clearing prices for the assets. The FDIC could negotiate a portion of the consideration as contingent in order to minimize the ultimate cost to taxpayers.
Jamie M. Pirrello is president of Berkeley-Columbia Partners and acts as CFO and San Antonio division president of Michael Sivage Homes and Communities. He may be reached via e-mail at firstname.lastname@example.org.