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 Fannie Mae and Freddie Mac originally made mortgages available to millions of Americans by lowering mortgage risk through the process of bundling and selling mortgage debts.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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