Second Part of Obama Reform Will Remove Toxic Securities from Books of Financial Institutions

The second phase of President Obama’s reform initiative will soon begin to take shape, which is the unfreezing of lending and securitization by removing illiquid asset-backed securities from the books of complex financial institutions. The original purposes of the TARP was to get distressed debt off of the books of financial institutions, so they would clean up their balance sheets and continue to provide credit. Secretary Geither has reiterated that this remains a goal under the second tranche of TARP.

There is a growing global consensus that confidence in the banking and securities markets cannot return until these so-called toxic securities are somehow defused. Recently, European Commissioner for Enterprise Gunter Verheugen said that big companies, in particular, are not getting any more money because large financial institutions are waiting for the next wave of write downs of their asset-backed securities holdings and are, therefore, holding back their capital. No one yet knows the extent of the risks that are contained in the toxic securities, he added.

Echoing these sentiments, Fed Vice Chairman Donald Kohn noted that a continuing barrier to private investment in financial institutions is the large quantity of troubled, hard-to-value asset-backed securities that remain on institutions' balance sheets. The presence of these assets significantly increases uncertainty about the underlying value of these institutions, he said, and may inhibit private investment and new lending. In testimony before the House Financial Services Committee, he urged the Treasury to take steps to reduce the uncertainty about the values of mortgage-backed and other asset-backed securities held by financial institutions.

There are several ways that this objective could be accomplished. Under one scenario, Treasury could directly purchase the illiquid asset-backed instruments by setting up and capitalizing special banks that would purchase the assets from financial institutions in exchange for cash and shares of capital in the special bank. Treasury could also make available to banks insurance that would pay off under adverse conditions. Purchases that include residential mortgages could be combined with steps to restructure some mortgages as needed to avert preventable foreclosures.

Another component of reform could be the expansion of the ongoing Term Asset-Backed Securities Loan Facility, which is designed to stimulate securitization activity in the market for asset-backed securities collateralized by a range of consumer and small business loans. Under this program, the Federal Reserve will lend for up to three years on a nonrecourse basis against asset-backed securities. By providing this financing, the program should increase the availability of credit.

According to Fed officials, the Board will be protected from credit losses by lending amounts less than the market value of the financed security, that is, by applying a "haircut,"-and by the $20 billion of capital provided by the TARP. If successful, the program could be increased in size or expanded in scope to provide financing for additional types of securities, such as commercial mortgage-backed securities.

An interesting note was injected into the repurchase of toxic securities by Senator Maria Cantwell. During the Giethner confirmation hearings, she said that the federal tax code strongly discourages firms from renegotiating their indebtedness with holders of that debt, because the IRS will send a tax bill for the amount of debt cancelled. The senator suggested temporarily changing the tax law to allow firms to renegotiate their debts without triggering additional taxation. Secretary Giethner said that he favors simplifying the tax code such that businesses and individuals get the most out of their tax dollars, particularly at a time of unprecedented challenges.