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The Toxic Asset Plan

Written by A Forex View From Afar on Tuesday, March 24, 2009

Today, the equity markets around the globe rallied as the Treasury was unveiling its plan, meant to save the financial system.

Overall, the plan looks simple, since its only scope is to provide liquidity in the secondary market. This is because the Treasury treats the current credit crunch as a liquidity problem, and (still) considers the banks’ assets fundamentally sound.

The newly announced plan proposes to use the taxpayer’s money to leverage the investors’ funds, up to 6:1 for a loan, and 1:2 in order to buy the assets. In addition, these loans will be insured by the FDIC, so in essence, investors would support only a very small fraction of the actual cost of the distressed asset.

However, this still does not guarantee that investors will overpay for these assets, because the private investors will be the ones to suffer the first losses. Therefore, it will be in the investors’ best interest to come up with a low bid for the toxic assets, reducing their risk exposure.

In this case, banks will not be tempted to sell their assets. It would seem that, if these assets are really worth something (the Treasury treats them as fundamentally undervalued), why would banks want sell them at huge discounts. Secondly, many of these assets are still overvalued on the bank’s balance sheets. Even if the bank would want to sell them, they would have to write-down their value first, something that might not be too good either for the bank or for the overall system because it will trigger systematic write-downs.

With a bit of luck, maybe the new asset plan will get some traction in the financial markets otherwise today’s rally might turn around very quick. Additionally, as some market commentators have pointed out, it might be among the administration’s last shots at saving the financial markets.

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