Are We There Yet? Part II

The U.S. effort to subsidize the private purchase of toxic assets from banks has apparently collapsed. Banks and potential buyers remain far apart on prices even with public subsidies. Ezra Klein, for one, describes the consequences of this:

[W]hen the . . . PPIP plan died last week, it did so with a whimper. A couple of news articles. A smattering of blog posts. This was the center of a trillion dollar effort to rid the balance sheets of toxic assets, and it just....disappeared.

But that doesn't just mean the loans weren't purchased. It also means they weren't priced. That, after all, was the primary virtue of the PPIP plan: The government would pay private investors (by offering them the 6:1 financing deal) to uncover the market prices for the "legacy loans." Once the market could agree on a price for these assets, it could also agree on a form of resolution for the banks -- either the assets could be sold or the institutions nationalized.

Observers suggested there were two ways for this to go. Either the assets would be priced and sold, or they wouldn't be priced because the banks wouldn't be able to sell them without blowing a hole in their balance sheets. In that scenario, the market would have proven the banks effectively insolvent, and we could respond accordingly. Hopefully, this would all happen in tandem with the stress tests, and by the end of the process we'd know two things: Whether the banks could sell their toxic loans, and whether the banks could survive the continual worsening of the economy.

In fact, we know neither. The adverse scenario envisioned in the stress tests looks increasingly mild. The tests imagined a world in which unemployment reached 8.9 percent. Last month, unemployment reached 9.4 percent. The PPIP's loans program has died, the assets sit unpriced, but there is still no judgment as to whether that means the banks are insolvent or, conversely, in such surprisingly good condition that they can let the loans mature on their balance sheets.

In other words, it doesn't seem like we know a lot more than we knew a few months ago. The economy certainly "feels" better, and that's been enough to drain the urgency from some of these questions. But have the questions really gone away?

No they haven't.

As I have argued so many times, massive subsidies and dubious accounting rule changes have allowed banks to return quickly to profitability, however unreal, and thus to drive up share value. No doubt this will mark a return to bonus-pig heaven for Wall Street managers. Why would the banks want to spoil their party by throwing cold water on this balance sheet fantasy?

This is of course yet another huge gamble. Wall Street and the Obama administration are betting that a strong recovery will return troubled banks to real solvency before the reality of their situation becomes clear.