Gros recalls that many assets have gone from being bad investments to toxic ones as a result of the financial crisis.
Recapitalising bad investments is manageable, he says, as it is based on the "assumption that most losses would arise from residential mortgage-backed securities".
But given an "unprecedented drop in housing prices" and losses that have been made from "credit card and auto loans," bad investments have become toxic as "creditworthiness has suddenly become much more difficult to assess," the CEPS director explains.
This "uncertainty is the key reason why markets have broken down," he argues.
As a result, the bank lending market is characterised by perpetual doubt, with investors assuming that "anyone who tries to sell a securitised credit portfolio is selling the worst risk, even if the true motive is just the need to de-leverage," Gros observes. Moreover, the "judgement of rating agencies has become worthless and most banks have little reputation to lose," he adds.
Such doubt is "at the heart of toxicity" as there is "simply no price that will clear the market as long as there is such uncertainty about the value of the securities offered for sale," the CEPS director says.
Thus Gros calls for public intervention to create a so-called "bad bank" institution to take over toxic assets.
The move would resemble a "bankruptcy procedure" with the aim of saving the "good parts of a firm and shutting down the bad parts, writing down the firm's debt so that the good parts can continue producing profit," he says.
Gros claims this process would help kickstart the economy by "reducing losses to creditors" and "allowing banks to restart normal lending".
Whether US and European governments go for this approach depends on whether they choose to muddle "through with partial recapitalisation schemes that leave banks alive but too weak to lend or a big-bang approach that clears balance sheets and allows survivors to resume lending without looking back," Gros concludes.
