The put problem with buying toxic assets

Abstract

This article uses the option pricing arguments of Merton (1974 Merton, RC. 1974. On the pricing of corporate debt: the risk structure of interest rates. Journal of Finance, 29: 449–70. [Crossref], [Web of Science ®] , [Google Scholar]) to demonstrate that even solvent banks will be reluctant to sell volatile, toxic assets at market prices. Banks’ shareholders have insolvency puts that give them limited liability in the event of default. The insolvency puts are more valuable when the banks’ assets are more volatile. Shareholders in banks will require any buyer to pay for the lost volatility as well as the market price of the toxic assets. Thus, taxpayers must be ready to richly overpay if they want banks to voluntarily part with their toxic assets.

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