There was a great deal made about how pricing of the nonperforming bank assets (aka “toxic” assets), as an element of government intervention, would tip all the dominoes. Bank rescue programs such as PPIP would inherently wind up setting price for banks that sold assets as well as those that didn’t. Fair value accounting would cause another trap door to open under the value of the nonperforming assets reported on all banks’ balance sheets. They’d all be impossibly undercapitalized and insolvent, as opposed to just hugely undercapitalized and insolvent, as they are now.

In a fairly valued transaction, the price paid for the nonperforming financial assets (MBS, CDO, etc.) is going to be principally based on the performing cash flows, with a negotiated discount for estimated additional erosion in performance. A previous blog in October highlighted this as a routine element of executing a failed asset repurchase program at the federal level.

The banks know the substantial balance of these loans are performing. They can look at their holdings database. It’s not 98% but not 35% either. This is beginning to dawn on some outside of banking. The larger point is that the government can hold these assets and collect the cash flows to fund the debt it puts on to buy them from the bank. The value is in the performing cash flows of the securities and the US will own that cash stream. It doesn’t need hedge funds or private equity involved.

The act of repurchasing the assets will immediately exert a substantial force on market value to reflect the level of underlying cash flow performance. The market for credit instruments can further stabilize and find its footing because the US can hold the assets as long as it likes or reissue the cash flow performance as a federal security. The US is guaranteeing them whether the banks hold them or the US holds them.

The only relevant issue is the cash coming in on them. Assume the performance rate is a weighted average 70%. When the nonperforming assets remain on banks balance sheets, they get valued based on a fear discount, expressed by investors lack of demand for the asset class, which puts them at 15% or 20% of par. When they move onto the US’s balance sheet, where they can be allowed to stay and pay, the value rises to near the true cash flow performance level. And that lifts the value on all banks’ balance sheets. This improves industry capitalization significantly without any new capital added, through the unwind of fair value reporting’s liquidation basis stranglehold.

It also highlights a true flaw of fair value reporting. Genuine fair value is the recoverable cash flows. It’s not spot price , which is heavily shaped by the speculative agents of greed and fear.

Being able to sustain the performance rate on the repurchased assets is separate from the rescue element. Once the US owns the assets, the fiscal policy side of its action has to stabilize employment and then create genuine, lasting job growth, so people can pay mortgages. Further erosion in the nonperforming assets would mean less cash flow from the assets to pay the US Treasury debt funding them and that leads to more government borrowing and so on.

Other obstacles remain. House prices must still fall to what wages can pay for them and consumers must pay off substantial debt. The debt reduction is a years long task in the face of limited wage growth and will require sense be established in household financial management.