How to Handle Toxic Asset Purchases
Assuming we’re not creating a parallel banking system, the following is a good plan for how to handle toxic asset purchases in a rational and transparent way:
I'd like to see it done something like this. We form a new company, call it LoanCo. The Federal Government capitalizes LoanCo with some amount of money, say $500 billion. LoanCo agrees to hold weekly reverse auctions. Each auction is held with specific types of mortgages or mortgage securities. For example, one week might be OptionARMs with a certain FICO range, original loan size range, vintage year and interest rate. The next week would be a different set of characteristics.
Each bank would offer to sell their block of loans at some price, expressed as a percentage of original loan amount. LoanCo would have a pre-determined total amount they will be buying. The purchases would occur at the lowest price that "cleared" the market. Essentially, banks would be giving LoanCo limit sell orders. Bank of America might say they'd sell some set of loans at 60% of par or better. If LoanCo gets all the loans they want by paying 30%, then B of A is left out in the cold. If LoanCo winds up paying 70%, then B of A simply gets better execution.
But rather than get cash for the bad assets, the selling bank gets stock in LoanCo. All interest received by LoanCo is initially retained, but all principal is immediately returned to shareholders. The government guarantees half of the principal in these loans. In exchange, the government keeps all interest payments until LoanCo starts winding down and keeps any principal payments over the initial purchase price. So for example, if a loan was sold to the government at $60 but they eventually recover $80, taxpayers keep the $20.
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