The Times has an interesting piece about how one goes about valuing the "toxic" mortgage-backed securities a lot of banks are sitting on, which makes a point you often hear about the risks involved:
Determining the right price for these assets is crucial to success. Placing too low a value would force institutions selling and others holding similar investments to register crushing losses that could deplete their capital and make it harder for them to increase lending.
But inflated values would bail out the companies, their shareholders and executives at the expense of taxpayers, who would swallow the losses if the government could not recoup what it had paid.
But is determining the right price really so crucial? As I understand it, the problem isn't so much that we don't know the right price (there's some uncertainty here, but not that much*). The problem is that the right price is much lower than the price the banks are claiming on their balance sheets, and that forcing them to price the assets accurately would reveal many of them to be insolvent.
Suppose a bank paid $100 billion for its portfolio of mortgage-backed securities, which it says are worth 90 cents on the dollar. Almost no one thinks they're worth that much. But if we price them closer to what people think they're worth (let's say 30 cents on the dollar), we've just wiped out $60 billion in stated assets. If the difference between the bank's assets and liabilities was less than $60 billion, it's now insolvent.
The reason banks aren't lending is that, even though they say their portfolio is worth $90 billion, they know it's actually worth closer to $30 billion, so they don't have enough capital to support new loans. Which is to say, they know they're insolvent (or close to it). They're just not admitting it.
Now, under this scenario, the trick isn't getting the value of the toxic assets right, as the Times says. If we get the valuation right, we've still got an insolvent bank on our hands. (That's the whole reason we're doing this bailout thing. If the banks could sell their toxic assets for prices that would keep them safely in the black, we wouldn't have a problem.) The trick is to figure out what how we want to fix our insolvency problem. We could simply overpay for the assets, which, as the Times notes, would be a sop to shareholders. Or we could demand that the government get an equity stake for every dollar we pay banks above what their bad assets are really worth, which would effectively nationalize the banks in many cases.
Put simply: The whole point is to overpay, because without overpayment the banks would be deep in the red. The question is what we get in return for that overpayment.
--Noam Scheiber
*Think of it the valution question this way: The size of our likely error in valuing the assets--maybe five to ten cents on the dollar--will be far, far smaller than the difference between what the banks say the assets are worth and what they're actually worth, which would be more like 50-60 cents on the dollar.