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Curing Toxic Assets - And Why We're Doing it Wrong

Peruvian economist and staunch defender of individual property rights Hernando de Soto has written a very good opinion piece for the Wall Street Journal that examines the "toxic assets" whose collapse precipitated the current worldwide economic crisis:

Today's global crisis -- a loss on paper of more than $50 trillion in stocks, real estate, commodities and operational earnings within 15 months -- cannot be explained only by the default on a meager 7% of subprime mortgages (worth probably no more than $1 trillion) that triggered it. The real villain is the lack of trust in the paper on which they -- and all other assets -- are printed. If we don't restore trust in paper, the next default -- on credit cards or student loans -- will trigger another collapse in paper and bring the world economy to its knees.

If you think about it, everything of value we own travels on property paper. At the beginning of the decade there was about $100 trillion worth of property paper representing tangible goods such as land, buildings, and patents world-wide, and some $170 trillion representing ownership over such semiliquid assets as mortgages, stocks and bonds. Since then, however, aggressive financiers have manufactured what the Bank for International Settlements estimates to be $1 quadrillion worth of new derivatives (mortgage-backed securities, collateralized debt obligations, and credit default swaps) that have flooded the market.

A quadrillion is one thousand trillion. So de Soto is saying that at their peak, the world's derivatives were valued at roughly four times the value of the world's property paper circa 2001, which was then valued at approximately $270 trillion.

How did we get into this mess? By definition, a derivative is "a financial instrument whose characteristics and value depend upon the characteristics and value of an underlier, typically a commodity, bond, equity or currency." Fannie Mae and Freddie Mac originally made mortgages available to millions of Americans by lowering mortgage risk through the process of bundling and selling mortgage debts. Their mortgage-backed derivatives were tied closely to the value of the underlying mortgages and were guaranteed by the US government. This process worked well until recently, when Fannie Mae and Freddie Mac greatly expanded their mortgage derivatives to include sub-prime mortgages and other high risk debts.

American banks also began selling credit derivatives based on mortgage debt bundled with debt incurred through other types of loans and credit services. These derivatives were sold to investors as low-risk investments under the assumption that perpetually rising real property equity values and securities values guaranteed that the value of their underlying assets would never decrease. Financial institutions even set up a kind of insurance plan for these risky derivatives called a "credit default swap," which was a contract arrangement through which the buyer paid a premium to the seller, in exchange for a guaranteed cash settlement from the seller if an underlying financial instrument defaulted. Executives at insurance giant AIG thought they were making a killing by selling hundreds of billions of dollars worth of credit default swaps on "low-risk" derivatives.

But these new credit derivatives were poorly regulated, and, unfortunately, greatly overpriced. de Soto continues:

Unlike all other property paper, derivatives are not required by law to be recorded, continually tracked and tied to the assets they represent. Nobody knows precisely how many there are, where they are, and who is finally accountable for them. Thus, there is widespread fear that potential borrowers and recipients of capital with too many nonperforming derivatives will be unable to repay their loans. As trust in property paper breaks down it sets off a chain reaction, paralyzing credit and investment, which shrinks transactions and leads to a catastrophic drop in employment and in the value of everyone's property ... The only paper representing an asset that is not centrally recorded, standardized and easily tracked are derivatives.

About two years ago, as an increasing number of American homeowners began to default on sub-prime mortgage payments, which in turn began to drive down the value of real estate, investors became worried that bundled credit derivatives might be fundamentally unsound. Panicked investors sold them in a frenzy. Trillions of dollars in assets were wiped off the books of banks and other financial institutions as the value of their derivatives plummeted. AIG faced financial ruin because there was no way that it could meet its credit default swap obligations. Suddenly, mortgage-backed securities and credit derivatives became "toxic."

de Soto argues that the solution to the problem lies in stricter regulation of credit derivatives that forces them to be tied directly to underlying assets. Unfortunately, the plan to "detoxify" mortgage and debt-backed derivatives announced by Secretary of the Treasury Timothy Geithner comes up short in this area. As my fellow blogger HughS has painstakingly explained, Geithner's TALF plan allows banks to trade "toxic" derivative assets on their books at market value (which is currently very low) while the government covers the difference between the current market value and the original declared equity value of those assets.

No wonder the markets jumped when the plan's details were finally announced -- banks (who got us into this mess in the first place) would be spared most of the risk, thus escaping responsibility without having to restructure their derivatives in such a way that would tie them directly back to underlying asset values, or truly reveal the value of the bank's assets. This would allow banks to push the value of their derivatives upward and possibly create yet another bubble based on overvalued assets. On the other hand, the government would assume great risk, only making money on these deals if the market value of toxic derivative assets eventually climbed back above their original declared equity value -- which (as I just explained) carries with it the risk that the derivatives will once again be overvalued.

And all of this will be done with money created by the Treasury and Federal Reserve essentially out of thin air. This week's attempts by the US and UK to auction treasury bonds (essentially selling their debts to other suckers buyers overseas) did not go well, which suggests that we are taking on too much debt load. So if the economy fails to grow and proportionally raise the value of bank equity holdings, then the losses absorbed by our government as it covers these toxic derivative assets (potentially up to $700 billion) will certainly spur rampant inflation. Right now I'm a little worried about all of this. Are you as well?
________________________________

One more thing - it remains to be seen how Geithner's new plans to expand government regulatory power over all entities "trading in financial derivatives and to companies including large hedge funds and major insurers" will affect TALF and the derivatives market. But when it comes to big government regulation, it's difficult for me to get my hopes up very high.


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Comments (15)

"Right now I'm a little wor... (Below threshold)
GarandFan:

"Right now I'm a little worried about all of this. Are you as well?"

Worried doesn't begin to cover it. And throw in The Obamassiah's grandiose spending plans for good measure. Inflation? We haven't seen anything yet. We seem to be perpetually reinventing the wheel when it comes to regulation of businesses. We're more 'sophisticated' nowadays. Our grandparents learned the hard way. Guess we will to. While the fundamentals of the economy are sound (it's okay to say that now), we need to reinstall safeguards so that the few can't game the system to the detriment of everyone else. One thing I'll credit FDR with; in regulating Wall St after the crash of 1929, he went to the most successful thief there and had him write the laws that would have prevented him from making a killing on the backs of others. That thief was Joseph Kennedy. Go figure.

I inherently distrust any a... (Below threshold)
Bob:

I inherently distrust any alleged solution that relies on greater federal regulation of the market. Regulation brings only a false sense of security. We need to get the government out of the market not farther into it. Every step taken to involve the government in the economic crisis - whether through massive spending, billion dollar bailouts or new regulations - will deepen and lengthen our financial problems.

Worried? You bet. What to d... (Below threshold)

Worried? You bet. What to do? Prepare for the worst, expect the best.

Now is the time to finish s... (Below threshold)
Adrian Browne:

Now is the time to finish stocking up the bunker and move in.

120 cartons of Cheetos √

600 cartons of Yoo-Hoo √

1 fine weapon

Adrian will be whining the ... (Below threshold)
epador:

Adrian will be whining the loudest when the ACORN Brownshirts come to drag him away.

Pass the Beer and Popcorn.

A couple of obvious points.... (Below threshold)
Mac Lorry:

A couple of obvious points.

•  The "Financial" industry can be lucrative, and thus, it attracts lots of bright and ambitious people looking to make their fortune.

•  The way to make big money in a mature system is to do or invent something new, such as hostile takeovers, junk bonds, and more recently, derivatives.

•  Bright and ambitious people looking to make their fortune can invent new ways of making money far faster that government can regulate them.

•  Wealth created by the financial industry is fragile in general and particularly so if it's based on speculation. In other words, it's unreliable and can vanish into the thin air from where it came with little warning or provocation.

One solution would be for the government agencies that regulate the financial industry to adopt the strategy that was devised to stop bright and ambitious people from making their fortune selling snake oil. That is, a drug has to be tested and approved before it can be sold. The idea is for the government to maintain an enumerated list of approved investment and insurance instruments.

Anyone selling something not on the approved list would have to tell the investor that it's not approved and the law would allow investors to claw back loses from those selling such investments including their personal property or anyone they gave money to or paid at higher than market rates.

Such a change would go a long way toward killing off most of the financial snake oil without damaging the traditional financial markets. If someone does come up with a new investment or insurance instrument that's sound they can submit it to the government for approved.

So way can't we just let the free market run it's course. Well, for the same reason you can't let the free market run it's course in medicine. The buyer simply can't know if the seller is telling them the truth, nor does the buyer have a reliable means of testing the seller's claims. When the seller can't determine the true nature of what they are buying the free market doesn't work. Here's proof.

Good article, Michael, but ... (Below threshold)
bryanD:

Good article, Michael, but *ugh!*: "toxic assets" is such jargon.

This is the WHOLE thing in parable form:

I steal a bike from Joe Citizen and ride it to my haunt in Brooklyn, say. I take it to a storefront swag shop owned by some old Columbo wiseguys who don't require ID to sell. And they say, "No, thanks. We ain't buyin'."

Now, that's absurd because a penny is profit and the mob is greedy. But the backstory is, that these goombahs have seen me around and my habit of spending whole days in the Irish dive across the street. They figure I'll follow my routine and bring the bike, to try to sell or not, but likely leaving the bike outside. At which time they'll saunter over and take it. And they don't care if I catch them red-handed because what an I going to do about it.

That's the situation so far. I'm the Federal Reserve System, Joe Citizen is the US taxpayer, the bike is the US Dollar "backed" by "toxic assets", etc, and the guys in the swag shop are China and Germany. The Irish bar is the import-dependent U.S.Service Economy.

Now here's the point: in the midst of all this gritty realism, behold! a fairy godmother alights (let's call her "marc") and offers to trade "my" bike for one invisible, un(re)stealable, and that also produces daily living expenses from the end of its handelbars. Just remove hand grip in the morning, and voila!

The fairy godmother is the Call (in the form of "Questions") for a new world currency to supplant the dollar. And we all know what they say about "angels of light".

The new and improved *magical* bike is the new currency itself.

PS. Fairy Godmother is a "mob associate".

Ach!!! Cryptic!!! VOTE HIM ... (Below threshold)
hyperbolist:

Ach!!! Cryptic!!! VOTE HIM DOWN!!!

Bob,Do you actuall... (Below threshold)
Rance:

Bob,

Do you actually think the stock market should be totally self regulating, or is your sarcasm too subtle for my poor little brain?

Bob preaches voodoo economi... (Below threshold)
hyperbolist:

Bob preaches voodoo economics and worships the free market fairies. There's nothing they can't fix! Party like it's 1928!

Free range cattle are not f... (Below threshold)
SCSIwuzzy:

Free range cattle are not free of the rancher.

Nicely done, Michael.... (Below threshold)
Baron Von Ottomatic:

Nicely done, Michael.

The US Treasury debt is the... (Below threshold)
Ron:

The US Treasury debt is the problem.
The Campaign to Cancel the Washington National Debt by 12/21/2012 through constitutional amendment begins. See our facebook page at http://www.facebook.com/group.php?gid=67594690498&ref=ts

We are also planning to have a booth at FreedomFest 2009, the world's largest gathering of free minds! July 9-11 www.freedomfest.com in Las Vegas. Ron

I thought the world's large... (Below threshold)
hyperbolist:

I thought the world's largest gathering of "free minds" was the big porn convention in Las Vegas.

Part of the issue with the ... (Below threshold)

Part of the issue with the recordation of derivatives is that technology (e-mail, text message and so on) has made the formation of legally-binding contracts very cheap and easy. Efforts to promote better documenation on derivatives will provoke massive campaigns to capture, archive and comprehend electronic financial records. See Details --Ben




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