How much to pay for toxic debt?

September 22nd, 2008

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Now that Henry Paulson has already announced of a plan to bail out the US financial system with a US$700 billion (to $1 trillion) slush fund, the next devil is the detail. In this plan, the US government will buy up unwanted toxic debts from financial institutions and then sell them to the market quietly in a few years time. Because these toxic debts are unwanted, no one wants to buy them and hence, their value are priced laughingly low. As a result, the solvency of these financial institutions are threatened.

The first problem is, how much should the US government pay for these toxic debts?

First, let’s refer to the hypothetically simplified bank balance sheet in our earlier article, Effect of write-down on bank balance sheet. As you can see from that article, depending on how highly leverage the bank is, even a small write-down means that it has to either raise that amount in the equity market or sell a lot of its remaining assets to keep itself within the right side of banking regulations.

What if the the government pays a price that is better than laughingly low but still quite a distance from the book value? Banks will still have to write down the value of its asset. Then it has to raise money to patch up that hole. Given that the credit market is quite frozen up, this is quite unlikely. Therefore, its only other choice will be to sell its other surviving assets.

What if other banks are in the same predicament? Then there will be mass selling in the markets, which will then depress prices of assets even further, which then… it’s depressing to repeat the vicious cycle here.

The basic idea is that banks will still fail anyway if the US government is not generous enough in opening its wallet to pay for junk assets. Our feeling is that $700 billion may turn out to be too conservative an estimate. The government may end up spending more money than it intends to.

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