"TOXIC" ASSETS TO THE RESCUE

If you haven’t noticed by now it should be abundently clear that the private sector hasn’t a clue how to recover from the economic slump in which we now find ourselves. The only “White Knight” with a lance long enough to slay this “dragon” is Uncle Sam. You might ask, “How can the government solve the problem when the best minds in the private sector are not able to come up with a solution?”

To understand why the Feds can succeed when “market economics” fail you have to go to the fundamental difference in how the Feds hold assets and how the private sector holds assets. The private sector borrows money to make investments and the return from the asset must be at least enough to cover the cost of the borrowing in order to make a profit. If the assets decline in value to less than what one owes he is technically bankrupt, i.e. liabilities exceed assets.

“Securitized” debt,the so-called “toxic” assets that have led to the economic slump, are mortgages and other loans bundled and sold as bonds with each bond representing a share of the total group of loans. In this they resemble mutual funds where the fund buys a group of assets and sells a share in the total amount to investors. The theory of combining these investments into packages to sell in pieces is that it distributes your ownership over a large group of assets instead of just one or two. This increases your chances for gain and reduces the potential for loss.

However, while mutual funds are traded on open markets, ”securitized” debt does not have such a market. In the absence of a visible market, “securitized” mortgages, have been devalued to the depressed value of the property market. However, the mortgage is not the underlying property. While the home may have dropped in value by 30% or more, the mortgage has only lost value due to foreclosures and defaults. Since foreclosures stand at 3% of mortgages and defaults stand at 7%, valuing these mortgages to the property has greatly exaggerated the loss.

So much for how the private sector holds assets. The Federal Government has a different position. The Federal Government does not borrow against the value of its assets, it borrows against the “full faith and credit” of the country itself. Since his ability to borrow is for all intentions unlimited, Uncle Sam can afford to hold assets as long as he likes. In short Uncle Sam can hold these assets as long as he likes without having to watch market conditions, since he has no intention of selling the assets nor do their value affect his ability to borrow.

But Uncle Sam does have to watch his earnings from the assets, since if they do not pay his low costs of borrowing, the deficit will have to be made up by taxes or additional borrowing. Fortunately the average return on the assets he has acquired and expects to acquire is still higher than his cost of borrowing, so he will not have to raise taxes or increase borrowing in the future to pay for a shortfall in earnings.

Now that we see the difference between how the private sector and the public sector, meaning here Uncle Sam, view assets we can now understand why the Feds can now propose curing the economic malaise by cranking up “securitized” debt again. This crisis has made everyone understand that the only way we can obtain the vast amount of credit required to drive our massive economy in today’s world is through “securitized” debt. Say what you will about how these debt instruments are “toxic” and so on, they are needed to make the engine work. To state it bluntly, the so-called “toxic assets” that are blamed for our ecomoic slump are now required to make the economy revive.

To reiterate, private owners of the debt instruments have to match these holdings or assets against their liabilities in order to see if they are still solvent. They do this by seeing what price they fetch in today’s market. The market now tells them that these instruments have lost allot of value. Thus they are judged to be not “solvent.” Uncle Sam has a different test, he only has to show that the average return on the assets, NO MATTER HOW THEY ARE VALUED, covers his small cost of borrowing to buy the assets.

While Uncle Sam can hold “toxic” and other assets without regard to the market for these assets, private investors, under present valuations, cannot do this. This why I have asked to suspend the “mark-to-market” valuations while private investors are forced to hold securitized debt instruments because at today’s “maket prices” they would lose their shirts if they sell them. This would put private investors on the same footing with Uncle Sam, i.e. hold the assets without regard to the market and focus on long term earnings from the assets. In the case of mortgage based assets this means the balance due on the loans, times the interest rate, times the duration of the loan, minus a 3% loss to foreclosures. Unfortunately this has not been done.

If it were not such a terrible problem I could find some humor in the situation. The way to save the economy is to go right back to creating massive amonts of “secritized” debt or “toxic” assets, the very thing blamed for the chaos. However, this time it can work without the problems caused by market valuations because the “securitized” debt will be controlled by the Feds. No, Uncle Sam will not become the sole holder of “securitized” debt, he will simply be its nexus and thereby in a position to make it work better.

To conclude with my constant reference to the “New Economy,” or one in which the Federal Government will play a greater role, this new development will add to making Uncle Sam’s control over the economy even more complete.

Leo Cecchini
March, 2009