Toxic Assets and Insolvency

It has become axiomatic that the major players in finance are insolvent. Insolvent can mean different things, depending on how you define it. Let's be absolutely clear about one thing: none of the major banks are insolvent -- except from one perspective.

Insolvency is a statement reflecting data on an institution's balance sheet, on which are listed assets, liabilities, and cash reserves. Thanks to the FDIC, all banks in the US have more than enough cash reserves. Where banks are weak is in the assets category. This will remain true even with the easing of the mark-2-market rules, all thanks to toxic assets. Here's why.

In our era, toxic assets are derivatives, the value of which ultimately reflecting the performance of various loans, including the dreaded subprime mortgages. As those loans go sour, the bundles of loans (MBS, ABS), take a hit. Now, a bundle of loans has a diminishing value over time anyway, resulting from the fact that as people pay down their loans there is a diminished future cash stream associated with the bundle. Think of it this way, a bundle of 100 separate $300k mortgages (each with the same interest rate) is worth 300k plus 30 years of compounded interest. Fifteen years later, the bundle has lost half of its total value (from a creditor's perspective).

But, these toxic assets are mostly full of relatively recent loans, so pay down over time is not a material factor in the reduction of bank assets. What about foreclosure and delinquency? Yes, this is certainly a factor in some of the MBS and ABS -- especially those underwritten with a lot of 2005 to 2007 mortgages originated in CA, FL, NV, and AZ. But, this amounts to a reduction in value in the 10-40% range, not a total wipeout.

Back to basics, then: the vast majority of mortgages and commercial loans are performing. Therefore the bonds created by bundling them (and the subsequent derivatives created in relation to that bond) should be maintaining 60-90% of their value. Why, then, are they not?

First. Consider fear. Not fear of blank-eyed zombies with blood smeared down their shredded French cuff shirts. Rather, consider fear of 10% unemployment and bottomless foreclosures. Consider plunging home values due to lack of demand (and lack of liquidity) for mortgages. Consider fear that major institutions currently dragging the corpses of subprime lenders may not make it through the year. Most importantly (from the perspective of toxic assets), consider the fact that the ratings on all MBS and ABS are suddenly deemed meaningless. Consider the political fear of zombie banks.

Now, couple that fear with the real failures of IndyMac and Bear Stearns. And the stupidity of AIG being a net seller of CDS without holding a cash reserve like it does for its properly regulated insurance products. The result is WaMu. WaMu was crushed because depositors left unprotected (at that time) by FDIC insurance pulled out their money because of rumors of WaMu's imminent demise. WaMu overnight became the first and only insolvent commercial bank during this crisis. Failure came to it.

Now, in that climate, what do you think WaMu's and IndyMac's ABS and MBS would fetch on the secondary market? I have heard the going rate was 5 cents on the dollar. With mark-to-market rules in place, everyone holding similar assets has to mark down the value of those assets to reflect the going rate. In an instant, the top 20 banks in the country, the top 100 banks in the world, have shrunk the assets on their balance sheet by a considerable margin.

Basic accounting: Equity = Assets - Liabilities.

If you listen to Goldman, you might think that there's no problem at all because CDS and the CDOs they spawn should cancel out the risk created by underperforming MBS and ABS. In the abstract, that's true, and I believe that most of the remaining banks will pull through, despite the recklessness and hubris of the liquidity bubble.

In reality, however, problems remain. All those derivatives have other uses than sale, resale, and hold to maturity. They are also collateral.

Picture yourself owning a pawnshop. Uriah comes in looking for some cash to borrow. He's going to take that cash and make a bunch of smaller loans to some dudes he knows, at a higher interest rate than the pawn shop is charging him. Everyone wins. He tells you he can pledge his 60" plasma TV and a crate of canned tuna to secure the loan. You knows plasmas are good and will resell at a good price if Uriah defaults. And you can always eat the tuna.

Just after Uriah leaves, you turn on the TV and watch a news report telling you that new research shows that plasma TVs cause eye cancer. Sales are expected to plummet. By the time you get ahold of Uriah on his cell phone to tell him he's either gotta pledge more collateral or return a big bunch of money pronto, he's already loaned the cash out. You know one thing, the next guy coming in with a TV for collateral is getting kicked to the curb.

The funny thing is, a couple of Uriah's dudes were using the cash to buy smaller plasma TVs, with the idea being that Uriah would take the TVs off their hands if they fail to pay him back.

As a pawnbroker, what do you do? Wait to see if Uriah pays you back? If he pays you back all, or most, then the crisis is averted. If he only pays you back ten percent, then you're stuck with a plasma TV that you can't resell, plus you're out the cash you loaned to Uriah. You better hope you have enough cash in reserve to pay the rent on your commercial real estate lease.

What does Uriah do? Some of his friends pay up. Some are late. Some don't pay at all and Uriah can take possession of the TVs they bought. No matter what, he's burned. He'll either go out of business altogether, or only lend out money under stricter conditions in the future. Uriah has become risk averse.

You have a sister who specializes in eye cancer. It is clear to her that Plasma TVs do not in fact cause eye cancer, or if they do, the risk posed is minimal. Yet, you are still stuck with a TV that has no market value because there is no demand for them. The intrinsic worth of the TV still holds: you can watch the hockey playoffs in hi-def; PS3 blows your mind, etc. Knowing that the health threat is overblown, you want your business partners and creditors to let you keep the asset value of the TV up near what you paid for it (the amount originally loaned to Uriah).

That's where the banks are today, which is why the m2m rules have been eased. It's the equivalent of you, the pawnbroker, placing a $500 dollar price tag on the TV in your store, but no one would pay more than $10 today for it.

A month goes by and Uriah hears on the radio (not watching TV, of course, because he doesn't want eye cancer) that there is actually only a small chance of plasma TVs causing eye cancer. Suddenly the market for plasma TVs rebounds. Not robust like it had been (everyone's still wary, wondering what if the next news will be bad news), but product is moving again. He has already sold most of the repossessed TVs at a huge loss. He recoups a little bit by selling the remaining repossessed TVs are the lifted market price, but he'll never get back to where he thought he would be. His friends are out cash and have no TV (yes, people who have lost their homes to foreclosure).

Meanwhile, you learn of the improved market conditions. You get a bunch of bidders on the TV, some are even willing to pay $700 for it. Things are looking up, right?

Well, here's where the problem is. What if you learn that the TV is health-friendly, but by this time the eye cancer scare has led to dramatic increase in layoffs in the TV and TV-related industries. Those layoffs lead to decreased spending, which leads to other business failures completely unrelated to plasma TVs. Soon, unemployment is up, spending is down, and everyone's looking at everyone else with extreme suspicion (hence the run up in corporate bond yields). Okay, great, go ahead and try to sell that TV, buddy.

That's where the banks will be. That's why Goldman's reassurances are to be taken as a best-case scenario. That's why the government needs to do only one thing right now: cure the ills of unemployment (either with benefits or job creation, or both). That is all that matters in our current era. Every other problem can wait.

The intrinsic value of the reference entities of the toxic asset is still good. Therefore the banks are still solvent, except from a regulatory perspective that requires banks to maintain certain capital requirements (of which these assets play a part in determining). But, without a leveling off of unemployment or a means to ease the pain of unemployment, the economy will continue to deteriorate, and more people will fail to pay their debts (diminish the values of reference entities in derivatives), further deteriorating the value of the toxic assets.