The US Treasury and the Federal Reserve have been struggling for months now to craft a strategy that will revive the credit markets. The numbers are staggering: $350 billion extended under TARP; $1 trillion mooted by the Treasury Department this week. Yet the financial system is still swooning after Treasury Secretary Timothy Geithner’s speech on the federal program to bail out the financial system.
Stabilizing and reviving the financial sector has three legs. Clearly one leg is missing.
Leg 1: Provide liquidity to the financial system to substitute for the illiquid toxic assets. Check—we doing that with ever greater amounts and numerous facilities.
Leg 2: Inject equity to offset the declining value of the toxic assets. Check—we have done that with warrants and other equity purchases.
Leg 3: Reveal prices of toxic assets so that a market for those assets can resume. Oops—although price revelation via auction was an original element of the TARP, this leg of the stool is missing.
Why is price revelation so important? First, there is not enough money to buy all the toxic assets. Second, assets remain stuck on balance sheets (even if written down), and these illiquid assets are keeping the institutions from extending new credit. Finally, given the lack of price revelation on the existing instruments, particularly collateralized debt obligations, no new facilities of this type can be issued in the marketplace, and this is what financial institutions do these days (or did) to extend credit.
Price revelation requires willing buyers and sellers of the toxic debt. Why hasn’t a market just sprung up? The identity of the debtor is not transparent, and the assets are wildly heterogeneous, so figuring out what price to offer or accept is difficult. Asset holders refuse to sell at “fire-sale” prices, even if they have written the asset value down. And, importantly, all the liquidity being pumped into the system obviates the need to sell.
What role can the government play in setting the stage for a market in this debt? The 1980s syndicated Latin American debt crisis—also an originate, distribute, no-recourse model of credit—gives some hints: Write-down and repackage the remainder into standardized bonds, and put up a guarantee. The Brady bonds issued by Latin American countries in the 1980s, by revealing the value of existing debt, revived the market for new lending to their economies.
Price revelation in the form of standardized and guaranteed bonds, along with the other two legs already in place, will make toxic assets tradable again, which will create an environment whereby the CDO financial instrument can return to its role in the financial marketplace, extending credit to businesses and consumer borrowers.