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Pandit's Amortization Trial Balloon: Can It Float US Out of Crisis?


Here's how the scheme might work.


At yesterday's congressional hearing, Citigroup's (C) CEO Vikram Pandit floated what looked to me like a trial balloon that may turn out to be the path out of the credit-induced economic crisis and, in the process, put to bed the doomsayers' chatter about insolvent banks.

In reply to a question from Congressman Gutierrez from Illinois -- who started off referencing a meeting the congressman and Mr. Pandit had the day before -- Mr. Pandit, with an intriguing smile on his face, described what sounded to me like an amortization scheme in which the mark-to-market created losses for certain assets could be realized by the banks, not as an immediate and complete hit to the income statement (thereby impacting the balance sheet and, therefrom, the capital requirements of the bank), but on an amortized basis over time, which will have the effect of limiting the preposterous losses induced by illiquid markets and their last sale/"fair value" price.

To refresh your memory, mark-to-market is an ancient theory tied to the belief that markets are efficient and that the last price represents the fair value of an asset. This is an absurd view of reality and human nature - one that should have died a long time ago but still lingers in the minds and hearts of the free-market advocates and their closet efficient market cohorts (who don't have quite the faith in unfettered markets as free-market advocates do, yet still can't buy into the behavioral-science fact of inefficient markets in illiquid assets and over short time frames).

The Pandit amortization balloon would, in effect, achieve what the alteration and/or elimination of mark-to-market would have accomplished - a conciliation between the last sale = fair value mark-to-market ideologues and those grounded in the reality of the behavioral sciences. In other words, a normalization of value that could be adjusted when markets are less stressed.

By surrendering their "toxic assets" to the Private/Public Investment Bank (PPIB) proposal of Secretary Geithner at an acceptable price to the buyers (hedge funds and others who will demand to buy at the lowest possible price), banks would not be forced to record the entire "loss" all at once, thereby generating hits to their balance sheets, thereby incurring further capital charges (making them "insolvent"). This results in what it's resulted in thus far: limited lending.

While I don't know exactly what Mr. Pandit had in mind, here's how the amortization scheme might work:

  • Bank surrenders certain "toxic assets" to the PPIB

  • Bank declares such assets as a "loss" but does not record the entire loss to its income statement

  • Bank writes down a portion of the "loss" immediately and schedules to do same over the life of the asset

  • Bank retains the ability to revalue such assets over time via a note from PPIB

In dollars and cents, here's how this works:

  • "Toxic assets" held on the books for $0.80 on the dollar are surrendered to PPIB at $0.30 on the dollar

  • PPIB (Treasury and investors) own the assets at $0.30

  • Bank lists a $0.50 off-balance sheet "loss" that is amortized at 10% per year, or $0.05 to the income statement (and then to the balance sheet)

  • Over time, markets become more normalized, the economy recovers and the "toxic assets" rise in value to $0.60, where they come due and cease to exist

  • Bank, which has written down the loss over several years, say $0.30 cents in total, now realizes a $0.10 gain ($0.60 cents final value, $0.50 amortized value still on the books, $0.10 gain)

Investment Strategy Implications

Mark-to-market, the disastrous decision that turned a bad recession into a credit -- and now economic -- crisis, needs to be dealt with. Since the forces aligned against its elimination and/or modification are too formidable for the current and past government officials to overcome, getting around the insane rules is the next best thing. Amortizing the losses for illiquid assets with the prospects of capturing any price recovery would make infinitely more sense than continuing the current regime of efficient-market fantasy thought.

Who knows what plans are being hatched behind closed doors. Maybe the above scenario is wishful thinking on my part. However, if this or some variation of getting around the consequences of mark-to-market, produces anything that approaches the above scenario, the economic crisis will clearly become a whole lot less intense. And the global economy will benefit immensely.

Maybe that's why stocks have withstood so much recent bad news and appear to be building a solid base for a sustainable rally.

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