Carl Steidtmann
Carl Steidtmann

Fair Value and the Economic Crisis

Deciphering the intense debate over fair value.

April 27, 2009
by Carl Steidtmann

“Panics do not destroy capital; they merely reveal the extent to which it has been previously destroyed by its betrayal into hopelessly unproductive works”.

John Stuart Mill
British philosopher, political economist, civil servant and Member of Parliament

Unlike past recessions, the current recession finds its origins on the balance sheets of the banks. The collapse in the asset backed commercial paper market back in July 2007 was the tipping point for what has been a massive credit contraction. At the heart of the contraction is an intense debate over fair value.

Rising foreclosures and falling prices have greatly reduced the value of the mortgage backed securities that many of the threatened banks hold. Since the start of this crisis the banks have collectively written off $1.3 trillion in losses. The panic that set off this recession did not destroy capital, as Mill so keenly observed. The origin of the bank balance sheet problems lay in the housing market but has spread well beyond housing. The key question that remains is how many more bad assets will the banks have to write off and at what price? 

The plans put together by the US Treasury and the Federal Reserve to restore the banks to health is aimed at recapitalizing the bank’s balance sheet. The size of that effort centers on the issue of fair value. There are two competing views of fair value. The simplest view of fair value is what the market will pay for a particular asset. Many banks and regulators don’t accept this point of view because the banks are being forced to sell these assets under distressed circumstances. From their point a view a fair market prices should be the market price when neither buyer nor seller is being forced to act. 

A second view of the fair value of these assets is the net present value of the cash flow the asset is expected to generate over its lifetime. This latter point of view is expected to generate a higher price for many of the legacy assets held by the banks. How this issue gets resolved will be central to bringing the current financial problems of the banks to a resolution. By generating a higher value for these assets, the banks will not necessarily need to raise as much additional capital for government and private sources in order to recapitalize.

Reader Note: Meet the author at AICPA's upcoming
Fair Value Measurement Conference in Chicago, IL, June 8-9

The Geithner Plan

The Geithner Plan — proposed by Timothy Geithner, current United States Secretary of the Treasury — assumes that many of the assets held by the banks are undervalued due to the distressed nature of the market for mortgage backed securities and other assets held by the banks. The centerpiece of the Geithner bank plan is the creation of a series of P-PIP’s or Public-Private Investment Partnerships that will buy up what are now euphemistically referred to as ‘legacy assets’. The plan extends low interest non-recourse loans from the FDIC and Treasury to the P-PIP’s to buy up legacy assets, allowing them to pay a higher price for them than other non-P-PIP participants. While the gains from any of these purchases will be shared, the downside risk falls mainly to the U.S. taxpayer.

The plan’s viability and likelihood of success has been vigorously debated among economists. Liberal economist and Nobel Prize winner Paul Krugman emerged as a vocal critic. His case against the plan is that even after you give huge windfalls (gold plated toasters in “Krugmanese”) to hedge fund speculators and bail out the bank’s equity holders, you still have zombie banks. These legacy assets are not mis-priced as the Geithner plan assumes. To be solvent the banks need to get at least 80 cents on the dollar for their legacy assets, the market is offering them 30 cents and the P-PIP’s might get them 50 cents due to generous government subsidies but that still leaves the banks short and insolvent.

The counter argument to Professor Krugman is that the purpose of the Geithner plan is not to rescue the banks outright, but to buy them time. The Treasury may not have the resources or the political support to save the banks but if they can give the banks some time, they might be able to save themselves. The banks still have strong business models. With bank spreads as wide as they are, it’s a good time to be a banker. Several large money center banks recently announced that since the first of the year they have been making money. Even in the worst of times the banks can earn billions each quarter in free cash flow. With enough time, they can earn their way out of their balance sheet problems.

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Carl E. Steidtmann, Chief Economist for Deloitte Research, is a nationally recognized expert on economic forecasting of consumer, technology, investment and general economic trends.