What are the Toxic Assets Actually Worth?

As reported, FASB changed the mark-to-market pricing rules last Thursday, giving banks more discretion in reporting the value of mortgage-backed securities. Bankers bitterly complained that the current market prices were the result of distressed sales and that they should be allowed to ignore those prices and value the securities instead at their value in a normal market. But even in a "normal" market, what are the alleged toxic assets actually worth?

Treasury Secretary Timothy Geithner seems to think that these assets may actually be valuable one day, and has implemented a plan to provide “nonrecourse” loans to institutions that buy up the unwanted assets.

University of Illinois College of Law Professor Larry Ribstein, on the other hand, has declared Geithner's plan an elaborate "shell game." The government subsidizes private equity companies to buy the assets at inflated values. Instead of just giving them wheelbarrows of money, they get non-recourse loans for most of the purchase price. When we find out that the assets are actually worth what the banks really think they’re worth (as opposed to how they’re currently booked) the taxpayers, who provided most of the money, will bear most of the loss.

Unfortunately, he may be right. USC Business School has released a preliminary report, titled The Pricing of Investment Grade Credit Risk during the Financial Crisis, written by Joshua Coval and Erik Stafford (Harvard) and Jakub Jurek (Princeton). An overview of the paper can be found here. The paper presents three uneasy conclusions:

1. 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."
2. 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."
3. 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."

So, what is the solution? Profesoor Ribstein says we should let the banks sell the assets for what they're worth but not make them reduce their capital for regulatory purposes.

What do you think we should do?