Saturday, April 4, 2009

Of toxic assets and accounting

Disclaimer: I'm not an accountant, I have no particular insights into the accounting that went on during the housing bubble, and my observations are entirely based on my reading and personal analysis. Naturally, they conflict with those of most of the other talking heads and respected prognosticators. ... and I don't care.

Recently, I was reading the fascinating article written by the software developer who helped write the applications which were used to create CDO's (sorry no link). In it, he talked about how he created the software, the small amount of guilt he felt for being indirectly a part of the housing bubble and collapse, and what his software essentially allowed the banks to do. The last part was the most interesting, as it kinda shed some light, for me at least, on what the so-called "toxic assets" actually are.

See, most people think the assets are bad home loans, but that's not really true. As far as I can tell, what the banks did was take a home loan, a break it into two parts (conceptually): a bond paying a fixed return slightly under what the mortgage holder was supposed to be paying, and another financial instrument which was essentially an insurance policy that would pay out the value of the first bond if the actual mortgage holder defaulted. For this, a small part of the mortgage interest was diverted to the second financial instrument, kinda like an insurance payment. Then, because the first bond was insured, it could be rated AAA (the highest rating), and sold as an investment grade asset.

Now, the banks knew some loans would be expected to fail, and obviously if the loan failed both bonds would lose value. However, the bank could mitigate that risk by simply standing behind the second bond: by holding it on their books and guaranteeing it with the bank's assets, it was a solid insurance policy, which made the first bond good even if the loan failed. Which, in turn, allowed those bonds to be traded everywhere, held as investment collateral, etc. The other secondary bonds were held by the big banks, because they couldn't really sell them (nobody wanted the risk exposure), and they were well-paying assets while the bubble was going (they paid a fixed return with no immediate cost, like insurance policies). Which brings us to today...

The secondary bonds, essentially insurance policies backed by the bank, which are now looking like they will almost certainly need to be redeemed, are now called "toxic assets". Assets, because they are still paying a little bit of return from the underlying loans which have not yet failed. Toxic, because they can't be sold at face value (for obvious reasons, as they are not returning very much and their expected future returns is declining every day), and because they represent potential huge liability. The banks' accounting is based on them having future value, the pessimistic view is if they all default, the banks will be liable for trillions, and nobody knows where the real value will be (because nobody knows how the housing market will change in the future). Meanwhile, the banks have been holding them as "illiquid" assets, with mark-to-fantasy accounting valuations based on a bubble housing market, because if they mark them to actual market they would be insolvent.

When Lehman Brothers was allowed to fail, the government immediately realized the scope and magnitude of the problem, and it scared them so much that they have been blackmailed into handling out trillions of taxpayer dollars to the remaining banks ever since. When Lehman failed, the CDO's it held became value-less (because the bank had no more assets to back them which were not already claimed by secured creditors). That immediately caused all the primary bonds backed by those secondary bonds to drop in market value, because they were immediately backed only by the underlying mortgages and not by insurance any more. Since the underlying housing market was already bad, they immediately lost huge value. Since they were investment grade assets while Lehman was solvent, they had been purchased and were held by "safe" investment funds, such as money markets, pension funds, etc. These all realized the immediate loss in value, "breaking the buck" on several money markets, prompting the Treasury to offer an insurance program for the remaining money markets to save the market, etc. It was a wake up alarm for the industry.

The reverberations were huge, too. The regulators look a look at how much potential liability there was in the system, and took a fat dump in their collective pants. Treasury scrambled to figure out how to best funnel taxpayer money to the remaining banks to prevent a cascading failure of everyone (which would wipe out most people's savings, due to the AAA ratings for the primary bonds). The Fed "printed" $10 Trillion in direct injections and guarantees, the government started bailing out banks, the GSE's did everything they could to keep the housing bubble inflated and fight the natural market correction, and everything else is current events.

As a footnote to the ongoing catastrophe (which has been and continues to be not the market correction, but rather the government's abject and complete failure in dealing with it, before and after the bubble popped), the FASB just relaxed the accounting standards to allow banks to fantasize a little more with their valuations for the toxic assets they can't sell. This inexplicably caused their valuations to increase, because somehow being allowed to lie more about the asset valuations makes the banks worth more money. It's a crazy world we're living in.


  1. That is the clearest explanation of the problem of so-called “toxic assets” I’ve heard. (I have no idea whether it’s correct, but it rings true.) Why can’t the MSM be that clear?

    I am still unclear about the insurance (aka credit default swaps). Does the institution who collects the premium and is responsible to pay in case of default try to consider its position as an “asset”? Or does the institution paying for the insurance call the instrument and asset?

    If I write an option on stock, which is a lot like me offering insurance, I consider that an liability b/c I would have to spend money to close the position prior to expiration. If I buy an option, even one way out of the money, I consider it an asset. This mortgage insurance is a bit different b/c there’s a stream of payments to the insurer. It’s more like my term life insurance, which for estate planning purposes is an “asset”. It seems to me like this insurance policy asset should have increased in value, b/c of the increased risk of loan default, minus the counterparty risk (i.e. the risk that the insurer can’t make good on its promise to pay if the loan defaults). So if my understanding is right, the “toxic assets” really are just bad loans, made worse by the fact that the insurer (counterparties) can’t make good on their agreements.

    If my understanding is right, we should just call them bad debt”. We should say this financial institution has a lot of bad debts, instead of it has holds “toxic assets”.

  2. My understanding is that the holder of the bond which is itself kinda like an insurance policy considers it an "asset", since it is paying a fixed return. There's no institution paying for the "insurance" per se, since a percentage of the original mortgage interest is just being diverted to the secondary bond. It's an interest-paying asset, right up until the point where the original debt holder stops paying on the original debt, at which point it becomes a liability.

    If you think about it, that's why the banks are having so much consternation about the mark-to-market rules. Nobody wants to buy the toxic assets at anywhere close to the banks' book values, since they're such huge liabilities and everybody knows the junk mortgages are going to default. However, at the moment they are still paying returns, so the bank wants to continue to value them at fantasy prices for asset valuation purposes (since they will claim you cannot be certain the junk mortgages will fail, and if by some unforeseen miracle they don't, then the assets will be worth their fantasy values, and be salable). Mark-to-market forces them to be valued at what others would pay for them currently, which is next to nothing.

    The government (and by extension the news media, with a Democrat majority) calls them "toxic assets" to minimize the negative perceptions about using taxpayer money to buy them or otherwise bail out the banks holding them. I have suggested they be called "reckless gambling debts left over from when the banks made billions gambling during the bubble they created, while paying out billions to their executives" or something similar, but I have a feeling it would be less feasible to sell the public on spending Trillions to bail them out if they called them something more accurate. It's like so many other misnomers in the current economic wave ("bailout", "stimulus", "government help", etc.).