Monday, March 23, 2009

## The Toxic Asset Problem: In Layman's Terms

More and more people are starting to pay attention to the economy, and specifically the actions the government is taking to rectify it. One problem that many people are running into, though, is that things in the financial world are getting pretty complicated. We have these things called toxic assets that are destroying banks, but how did they get to be toxic? Furthermore why are they causing so many problems? When most Americans hear about the plans to fix the toxic asset problem, their heads are probably spinning. Economics professor Mark Thoma to the rescue. In his blog post below, Thoma does a great job of breaking the problem — and several of the proposed solutions — down into layman's terms using a car analogy.

Imagine a car lot that has 100 cars on it. However, some of these cars have problems. Half of them will have engine troubles that total the cars - the engines blow up and the cars are then worthless - and this will happen just after purchase. The other half are perfectly fine. Unfortunately, there is no way to tell prior to purchase which type of car you will get no matter how hard you try. Thus, half of the assets on the car dealer's "balance sheet" - the cars on its lot - are toxic, and lack of transparency makes it impossible to tell which ones are bad prior to purchase.

If all the cars were in perfect shape, they would sell for \$20,000 each. Thus, there are (50)*(\$20,000) = \$1,000,000 in assets on the books according to one way of doing the accounting, but that doesn't necessarily represent the true value of the cars on the lot.

The town where this dealership is located relies upon this business for jobs, it is essential, but, unfortunately, business has fallen off to nothing. Nobody is willing to risk losing \$20,000 by purchasing a car that might die just after purchase, so the price has fallen. The expected value of a car is \$10,000, but it's an all or nothing proposition, the car runs or it dies, and since people are risk averse nobody is wiling to pay the \$10,000 expected value. In fact, the highest price they are willing to pay, \$6,000, is lower than the minimum price the dealer is willing to accept (I've assumed a reservation price of \$7,500 for illustration, and a horizontal supply curve to make the illustration easier):

So how could the government fix the problem?

1. Government purchases of toxic cars

The government could buy the cars itself, say at \$7,500 per car, or \$750,000 total for the lot, drive them around a bit (stress test them), wait for the bad ones to blow up, then sell the 50 good cars back to the public (who will no longer be fearful since the bad cars are out of the mix). If they can get anything more than \$15,000 for each good car, they will make money on the deal (well, there would be overhead and other costs to cover, but let's abstract from minor details). But if cars end up selling for less than \$15,000, they will take a loss.

(In the graph, the government intervention shifts the demand curve outward until it intersects at the kink in the supply curve at Q=100).

The problem with this option is knowing what price to offer for the cars. There is no market, and the firm's reservation price may be too high, i.e. paying the reservation price will eventually lead to a loss. And it's worse. In this example the percentage of bad cars is known, but the percentage of bad cars would also be unknown in a more realistic example, so there's no way to know how many good cars there are for sure, and what price they will sell for after the defective cars have been culled out of the herd. If the government pays \$7,500 per car, and more than 62.5% of them go bad (not that much more than the 50% estimate), then taxpayers will lose money even if they sell for \$20,000. With the percentage unknown, there's no way to know for sure what the breakeven price will be.

This is, in essence, the original Paulson plan. The only twist is that the price - the \$7,500 in the example above, would be determined by an auction among many dealers with the government accepting the lowest bid (which could be \$7,500 in this example since that is the price the firm is willing to accept). As you can see by thinking this through, there are questions about what price such an auction would reveal.

One danger in this plan is that if you overpay for the cars, e.g. give \$7,500 when the breakeven price was, say, actually \$5,000, then you have given the owner of the car lot \$250,000 more than the cars were actually worth (this will be the loss to taxpayers). The dealer may need this money to stay solvent and stay in business, but, nevertheless, it is a windfall.

There are a lot of uncertainties here, and lots of ways to lose money. But it's possible to make money too.

2. Subsidies and Public-Private partnerships

Here, the government offers a subsidy to private sector buyers. Suppose that the demand curve intersects the vertical line in the graph (at Q=100) at a price of \$4,000. Then in order to sell 100 cars, the government must subsidize buyers by \$3,500 so that the \$4,000 offer is raised to the \$7,500 the firm is willing to accept (notice that the buyer willing to pay \$6,000 gets a \$2,000 windfall, so, except at the margin, this plan gives surplus to people purchasing the assets - as with the first plan, this shifts the demand curve out until it intersects at the kink in the supply curve).

However, once again, the government will not know if it is getting this right or not. Suppose it offers a \$1,000 subsidy thinking that is generous enough. In this example, that won't bridge the gap between the highest offer of \$6,000, and the reservation price of \$7,500. Thus, the subsidy would be too small to restart the market and the plan would fail. So the answer is to make the subsidy large enough to encourage buyers, but the problem is that if it is too large, the government will be giving money away unnecessarily.

And there's another problem. If there's a large gap between what people are willing to pay and what dealers are willing to accept(the gap between \$6,000 and \$7,500 in the example), this would be problematic politically since it would require subsidies that are unacceptably large.

And I should note that it doesn't have to be a subsidy. That's one way to do this - as a giveaway - but another way is through a no recourse loan (what is being called a partnership). Suppose that the government gives (up to) a \$3,500 loan to a private sector buyer to purchase the car for \$7,500. If it's a good car and the value rises above \$7,500, say to \$15,000, then government will get paid back (with interest) since the asset can be sold profitably (another option is for the government to demand a share of this profit through warrants or other means). But if it's a bad car, the price falls to zero and the loan is forgiven - it does not need to be repaid. So the private sector agents only have to put up a fraction of the price to control the asset, and their losses are limited to the amount they put up while the gains are potentially large.

This is, in essence, the Geithner Plan. If many of the loans are not repaid, or if the subsidy is too large, it could lose a lot of money, but it could also make money too.

3. Nationalization

Now for the Saab story. Another option is for the government to simply take over the car dealership. The dealership is essential to the economy of the town, without it people will struggle, and the government - for that reason - might consider temporarily taking over the dealership to prevent failure. In doing so, it would make an evaluation of the company's assets, pay off the people who loaned the business money up to this amount, which may require having them take a haircut, i.e. accept some percentage of what they are owed on the bad loans they made, and the owner would simply be wiped out (which is a benefit since the business is insolvent and this allows the owner to escape the loans that cannot be paid through liquidation).

After taking over, the government would stress test the cars it now owns, put the bad ones in the junk pile, and sell the rest back to the public. So long as it didn't pay the creditors too much when it took over, i.e. the haircut is sufficiently large, it ought to make money on the deal. But it could lose money here too.

The Point

But, and I want to stress this, the point of these plans is not to make money, the point is to keep the economy of the town going, to keep people employed. If people place a large value on security, then even if the government takes a loss on paper, it may not be an economic loss. That is, we must put a value on the jobs that are saved and the security it brings (simply imagine that the utility function has risk as one of its arguments - by lowering the risk of job loss and the associated household disruption, you have made the agent better off, and this must be counted against any loss from any of the programs above). There is value in economic stability and security over and above whatever the government makes (or loses) on the actual financial transactions, and this must be factored into the evaluation of the policy.

This post can also be viewed on economistsview.typepad.com.

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