Toxic Assets

I have been puzzled by all of this talk about “toxic assets.” Primarily over exactly what one is. I found a pretty good explanation on YouTube:

(http://www.youtube.com/watch?v=06PwMyJY1vA).

One of the issues I have been troubled with is why there is such a problem. To hear everyone talk, it is those pesky folks that overbought and are now defaulting. OK, but, according to Time (3/9/09 pg 30) “just 7% of all borrowers are behind on their loans.”

So, how can 7% make that big of a deal for banks? Banks get money to lend from folks like us, depositors. But it is not enough to keep a steady flow of money coming in for which they can lend. So they sell and buy assets from other banks and lending institutes. These, along with their collateral from the loans they make and deposits, give the bank its “worth.”

The trouble with some of these assets, well, a lot of them actually, is that they were poor investments to buy in the first place. They were credit card debt, sub-prime debt, debt of debt, and on and on. They were not normal home loans secured by a down payment for a loan of 80% of the market value. Because of how they were structured the rating companies did not understand them and rated them high – an indication of to all investors (banks & insurers) that there was less risk. AIG then offered to insure the investor for any losses which made them “safe.” (AIG baked this insurance up with...you guessed it... the same type of assets which were valued "high" which made them "worth" more" which means they could back up more and more of these investments.)

The value was the value all these institutions placed on these assets. Everybody was enamored with the high rate of return on these Collateralized Debt Bonds and invested more and more into them, which drove up the demand for more and more debt. It all worked well until…….the chickens came home to roost.

So these assets that gave the banks their worth - for which they used as collateral to make more loan and buy more investments - suddenly start losing their value. Dump them! Which they did, which drove the price for these “assets” even lower. So now the banks worth is lower because the value of the assets are lower. Low demand lowers the value, this lowers the value of the marginal assets causing them to go toxic, and then – since everyone owns toxic assets which have no value (because no one wants to buy them), no one can really move money back and forth. Banking grinds to a halt.

Enter the government. Since no one wants to buy these assets, and the banks need money, we the people will secure them with taxpayer monies because there is, in any situation, always someone out there with money to invest. These super heroes will swoop down and buy them from the banks. The bank will get them off the books – plus – they will get paid for them. Banks will be happy, the wheels will start turning, and commerce will flow again. If the toxic assets over time lose their toxicity the investor wins!, If they stay toxic, the Investor turns it back to the government – the investor wins! Win-win for banks and investors! And the tax payer……..?

Why don’t these investors just buy it directly from the bank? Fire sale baby! Supply and demand has driven the price so low that the banks would probably get the same benefit if they just “zero” the balance sheet. By the government backing them they become more desirable – well in theory anyway. More desirable should raise the price.

Value is in the eye of the beholder. I’ll wait and see how it all comes out.