Time for Plan B? Wasn't the key to restoring the credit markets eliminating the banks' toxic assets?

• Author: Boskin, Michael

Early signs of a manufacturing rebound, already strong in Asia, lend hope for some modest recovery from today's deep global recession. But a strong and durable economic expansion is unlikely until progress is made in dealing with the toxic assets poisoning the balance sheets of financial institutions and bedeviling policymakers almost everywhere.

The financial system is a complex interaction of lenders and borrowers, buyers and sellers, and savers and investors. When it functions well, it balances risk and reward, and innovation and safety.

Banks and other financial firms borrow short--increasingly in recent years from the commercial securities market, not deposits and lend long at higher interest rates, taking on both credit risk (of default) and interest rate risk. Increasing leverage boosts returns on the upside but is very risky on the downside. No surprise, then, that the large financial firms that failed--Bear Steams, Fannie Mac and Freddie Mac, AIG, and Lehman Brothers--had the highest leverage, in the range of thirty or forty times their capital.

From 2002-07, trillions of dollars were loaned for subprime and prime mortgages, autos, credit cards, commercial real estate, private equity, and more, on the assumption by (most) borrowers and lenders that strong global growth, rising home prices and cheap, readily available short-term credit would continue for the foreseeable future. Once the music stopped, the assets plunged in value. The complexity of securitized pools of loans that were sold worldwide--bilaterally over the counter--as pieces of various tranches, meant that nobody was certain about who owned what or what it was worth.

This difficulty in valuing what are now called toxic assets remains at the core of today's credit difficulties. The immense response by central banks and finance ministries has eased the strain. The U.S. Federal Reserve's commercial paper facility was helpful in reopening the commercial paper market (although other of its facilities have been less successful).

The barometer of stress watched most closely by experts, the LIBOR-OIS (Overnight Indexed Swap) spread is down substantially from its stratospheric crisis levels. Some government programs are shrinking from lack of demand. But there remain little new securitization and bank debt offerings without government backup.

The original idea for the U.S. government to buy up (some of the) toxic assets with the $700 billion Troubled Asset Relief Program (TARP)...