Insolvent banks and Imaginary fire sales

This is a critique of the view that toxic assets are incorrectly priced due to illiquidity. This article could explain why the financial system seems so happy about the TARP plan. Financial stocks have been rising of late. Perhaps as the recent stress shows banks are not really insolvent but are being kept afloat by government injection of funds. THis article obviously disagrees with economists such as Krugman.

http://www.businessinsider.com/insolvent-banks-and-imaginary-fire-sales-2009-4The government's official view that toxic assets are incorrectly priced dueto illiquidity "fire sales" is wrong, a new study by Harvard and Princetonfinance professors suggests.You can read the whole paper by Harvard's Joshua Coval and Erik Stafford andPrinceton's Jakub Jurek below. The striking conclusion is that the lowprices of toxic assets actually reflect the fundamentals, rather than beingdriven by an illiquidity discount."The analysis of this paper suggests that recent credit market prices areactually highly consistent with fundamentals. A structural frameworkconfirms that bonds and credit derivatives should have experienced asignificant repricing in 2008 as the economic outlook darkened andvolatility increased. The analysis also confirms that severe mispricingexisted in the structured credit tranches prior to the crisis and that alarge part of the dramatic rise in spreads has been the elimination of thismispricing."This contrasts sharply with the analysis that underlies most of thefinancial rescue programs launched by the Federal Reserve and the TreasuryDepartment. The white paper released to support the Private-PublicInvestment Partnerships, the program that seeks to encourage private firmsto buy toxic assets with government subsidized loans, took the oppositepoint of view."Troubled real estate-related assets comprised of legacy loans andsecurities, are at the center of the problems currently impacting the U.S.financial system...The resulting need to reduce risk triggered a wide-scaledeleveraging in these markets and led to fire sales," the Treasury and theFed claimed.Many prominent economists--including such diverse types as Anna Schwartz andPaul Krugman--have taken with this official view, saying the government wasmistaking a solvency crisis for a liquidity crisis. This latest papereffectively demolishes the "fire sale" view. It draws three importantconclusions.** - *Many banks are now insolvent. *"...many major US banks are now legitimately insolvent. This insolvency can no longer be viewed as an artifact of bank assets being marked to artificially depressed prices coming out of an illiquid market. It means that bank assets are being fairly priced at valuations that sum to less than bank liabilities." - *Supporting markets in toxic assets has no purpose other than transfering money from taxpayers to banks.* "...any taxpayer dollars allocated to supporting these markets will simply transfer wealth to the current owners of these securities." - *We're making it worse. *"...policies that attempt to prevent a widespread mark-down in the value of credit-sensitive assets are likely to only delay – and perhaps even worsen – the day of reckoning."In short, the government cannot save the banks by improving liquidity orchanging mark to market rules because the problem isn't illiquidity oraccounting. The problem is that highly leveraged financial firms own assetsthat are worth far less than they thought they would be, and the firms areinsolvent as a result. This is why the latest bailout plans secretly givehuge subsidies to banks--because the only way to keep the insolvent zombiesafloat is to transfer billions of dollars to banks, bank stockholders, andbank creditors. The alternative--allowing the insolvent banks to fail,seizing the assets, wiping our shareholders, giving bond holders a serioushaircut--is still not on the official agenda.