Suppose that as a result of a housing price decline, the value of the bank\'s se

Question

Suppose that as a result of a housing price decline, the value of the bank's securitized assets falls by an uncertain amount, so that these assets are now worth somewhere between 25 and 45. Call the securitized assets "troubled assets." The value of the other assets remains at 50. As a result of the uncertainty about the value of the bank's assets, lenders are reluctant to provide any short-term credit to the bank. Suppose instead of buying the troubled assets, the government provides capital to the bank by buying ownership shares with the intention of selling the shares again when the markets stabilize. (This is what the TARP uitimately became.) The government exchanges treasury bonds (which become assets for the bank) for ownership shares. To keep capital positive and the bank solvent, suppose the government exchanges 25 of Treasury bonds for ownership shares. Assuming the worst case scenario (so that the troubled assets are worth only 25), set up the new balance sheet of the bank. (Remember that the firm now has three assets: 50 of untroubled assets, 25 of troubled assets, and 25 of treasury bonds) Assets Liabilites Securitized assetsShort-term credit Short-term credit $ Other assets $ Treasury Bonds Net Worth Captial Given the answers above and the material in the text, why might recapitalization be a better policy than buying the troubled assets? O A. Unless the government is willing to buy assets at above market prices, buying assets does not mean bank capital will remain positive. O B. The direct infusion of capital improves the solvency of the bank. ° C. Buying trouble assets will at best provide a bank liquidity but not necessarily positive capital. O D. All of the Above

Explanation / Answer

Securitised assets will be now 50-25= 25

Other assets will remain at 50

Treasury bonds will be 50-25=25

Short term credit will remain at 80

Capital will be 20 now

Securitised assets. 25. Short term credit 80

Other assets. 50. capital. 20

Treasury bonds. 25

D. All of the above is correct

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