"Toxic Assets" -- Writing in the CFA Institute's Financial Analysts'Journal Harry Markowitz (Nobel Prize, economics, 1990) suggests the feds undertake a detailed fundamental valuation of structured securities. (Something I've been doing in a related context for the past year.) My suggestion for the Fed follows. (I forgot that I wrote about this 2 days ago. The Markowitz article inspired me again. Maybe I'm getting senile, but at least my thinking is consistent even if my memory is not!)
If, for once, the feds want to be parsimonious instead of profligate with their (our) limited resources I'd suggest they structure the "toxic asset guarantees" as a collared financial guaranty insurance policy, or cashflow-CDS contract. "Collared" in that the Fed pays on the downside but receives the upside on insured ABS, RMBS, CDO, et al. The strike-prices (cashflow thresholds) would be based on some combination of the fundamental evaluation mentioned above and negotiation between the Fed and the bondholder.
For example, the bondholder picks the downside protection (lower strike) and the Fed picks the upside strike, either a zero-premium collar strike or with a premium. The guaranty maturities could be negotiated, or limited -- i.e., Fed limits itself to 5 or 10 year wraps, long enough for markets to adapt).
Importantly, for both transparency and so the Fed doesn't misprice, anyone else may place a bid with the Fed against the current bondholder, buying both the bond and the Fed wrap. Or vice-versa: they can bid to be the wrap provider (which would have to be a collateralized CDS). The Fed would compile periodic bid lists, multiple securities from multiple holders so the holders would not be revealed. The current holder could set an auction 'reserve' price (i.e., no forced "fire-sale" loss). Like normal insured bonds, Fed wrapped bonds receive a new CUSIP.
The Fed's risk on this would be systemic -- a risk it already has, but at least here they'd get paid for it! They'd be taking their own (federal govt) 'moral hazard' on mortgage modifications, too. The Fed would pay claims over time; not ballooning its balance sheet as it has so unnecessarily done (e.g., CP bailout, discussed elsewhere).
Transparency, rationality, liquidity for both the private & public sectors,supply & demand, market-clearing prices, existing contract rights respect not abrogated, parsimonious of both fiscal & monetary policy, ... all the good stuff!
Complex and labor intensive but, as Markowitz said of his (or our) idea, if they'd done it (fundamental valuations) back in 2007 they'd be finished by now instead of still wrestling with the same damn problem a year later!
JRB
2/4/09
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