We’re overdue here to discuss the big announcement this past week about how the government plans to sort out the “toxic assets” that have been preventing new lending and slowing down the economy.

Now, first things first: “toxic assets,” which were first referred to as “troubled assets,” will now be called “legacy assets.”

See? Things are better already. From troubled, to toxic, to legacy. Soon, perhaps, we can switch to calling them gardenias – so sweet that we kind of want to keep them around. No, that’s not true.

But this is the Troubled Assets Relief Program or “TARP” from the financial service bailout law finally being actually used for troubled assets – hurrah! (Recall that the first thing done with the TARP program was investing in financial services firms, not addressing troubled assets.)

What are these toxic/troubled/legacy assets again? (Realize throughout that you’re getting this from a non-expert – doing my best.) Some are just bad loans – nobody knows if they’ll be paid or what the value of the collateral behind them is going to be. Not knowing how much they’re on the hook for with these loans, banks aren’t doing new lending. These “legacy assets” are also things like mortgage-backed securities that don’t have any reliable value.

Mortgage-backed securities are mortgages that are packaged together. The package is then divided up into shares that can be traded like stocks. This allows more money to go into lending because lenders don’t have to hold the mortgages – after they’ve sold off the mortgage-backed securities to investors, the money they get can go back into lending for new mortgages.

But that system is frozen up because mortgage-backed securities don’t have any reliable value. What does that mean – “reliable value”?

Ordinarily in a securities market, everybody has a pretty good idea of what things are worth. They buy if they think the value of a security is going to rise or hold value and they sell if they think it’s not. But when the bottom dropped out of the housing market, the bottom dropped out of the market for mortgage-backed securities because nobody knows how many mortgages will be repaid, how many homes will go into foreclosure, and so on.

Now, making things a little worse, some of the holders of mortgage-backed securities had bought them with money they had borrowed, using the securities themselves as collateral. These investors had used loans as “leverage” to get more heavily invested without putting up as much capital.

Well, when the collateral on your loan loses its value, your lender either wants more collateral or it wants its money back. So the crisis in mortgage-backed securities has a bunch of “leveraged” investors selling just to get money out. This selling causes prices to drop yet more, causing yet more leveraged investors to get out, and so on until you’ve got a serious downward spiral.

These troubled assets, which have no reliable price, still have some value, of course – we just don’t know what it is. And they have less value just because of not knowing. People aren’t sure that they could sell them if they owned them.

Let’s say you were buying apples from a farmer to take to a farmer’s market and sell, but you heard that one of the roads to the market was washed out and the grounds where the farmer’s market was located was flooded. You’d give the farmer less for the apples because you’re not sure you can sell the apples you usually would at the market. The need for apples hasn’t changed a bit, but the price of apples has dropped just because of uncertainty in the market. Get it?

(Ugh – all this is just the set-up for what the feds are going to do to try to fix it. I predict this will be the longest, most boring post ever.)

The thing the feds are trying to do is jump-start a market for troubled/toxic/legacy assets, so they can get a reliable price again. Once there is a market for assets like mortgage-backed securities again, new mortgage-backed securities can be issued and lending starts again. The economy picks up again, and we can all go back to lighting cigars with $100 bills. (No, I think we’ll be a little more careful than that. Savings, people!)

A white paper the Treasury Department put out last week tells how they plan to fix all this. It’s basically by subsidies and loans to new investors in troubled – er, toxic – I mean, legacy investments.

So here’s how it is supposed to work for bad loans:

Let’s say a bank has a pool of residential mortgages it wants to unload. The bank would go to the Federal Deposit Insurance Corporation (the FDIC) which would auction the pool of mortgages to new private investors. But the new investors would only have to put up part of the money they had bid. Much of their bid would be funded by a loan that the FDIC would insure (meaning you, the taxpayer). Half of the remaining purchase price would be put up as a “co-investment” by the Treasury Department (meaning you, the taxpayer).

The private investor would manage the investment – but, oh, of course, with lots of government oversight. When the investor sold off the investment, it would pay off the loan, keep half of the remaining proceeds, and pay half to the Treasury (you).

In the example the Treasury Department put in its white paper, it talks about a pool of loans with a face value of $100. (”Face value” is just what’s printed on the face. What it’s really worth, again, depends on whether the loans are going to be paid off, what the value of the collateral is, and so on.) Based on its look at the pool of loans it’s auctioning, the FDIC decides that it will loan the buyer 5/6ths of the buyer’s bid.

Let’s say the highest bid for the $100 face-value pool of loans ends up being $84. The FDIC loans the winning bidder $72. The winning bidder and the Treasury each put up half of the remaining bid, or $6 each. The private bidder then does its best to get the most value out of the asset.

After the private investor has done everything it can to maximize the value, if it ends up at $80, everybody loses. The first $72 goes to pay off the loan, and the private investor and Treasury (you) get only $3 back, a loss of $3.

If the final value ends up at $120, though, everybody wins. The loan gets paid off, and the two investors (the private investor and the Treasury/you) get $24.

If the final value ends up at $40, everybody loses big time. The private investor and the Treasury/you are cleaned out, and the FDIC covers the part of the loan that the private investor couldn’t pay off: $32.

This system creates a chance for the private investors to make big money, and if there are winnings, taxpayers will share some of it. The chance of losses mostly falls on taxpayers. It’s the sweetness of that deal that is intended to entice the private investors in.

It’s valuable to have functioning credit markets and mortgage-backed securities markets and stuff, but we’ll have to see how well it works. If we see taxpayers making huge payouts while some investors get super-rich, that won’t be cool – and it won’t really be a surprise. It’s hard to design a system like this that can’t be gamed.

The Treasury’s white paper doesn’t give any detail on this, but the amounts we’re talking about are in the range of $500 billion to $1 trillion, which is about $5,000 to $10,000 per U.S. family. I haven’t seen any estimate of the “subsidy cost” for this plan. That’s the best estimate of what you’re statistically on the hook for as a taxpayer. But this is a big deal. If it works, that’s good. If it fails, that’s bad.

Now, did you enjoy this write-up? Find it useful? Did you actually read all the way to the end? (I wouldn’t if I hadn’t written it!)

If you did read all of this, I’m amazed. Be the first to comment (be sure to include your correct email address) and I will send you a Pez dispenser. Seriously! Might send Pez dispensers to later commenters, too, especially for comments that are both astute and random/odd.