Why Toxic Assets are so Hard to Clean Up

John Taylor and Kenneth Scott argue that “sheer complexity” is at the heart of the financial crisis:

Why Toxic Assets Are So Hard to Clean Up, by Kenneth Scott and John Taylor, Commentary, WSJ: Despite trillions of dollars of new government programs, one of the original causes of the financial crisis — the toxic assets on bank balance sheets — still persists and remains a serious impediment to economic recovery. Why are these toxic assets so difficult to deal with? We believe their sheer complexity is the core problem and that only increased transparency will unleash the market mechanisms needed to clean them up.

The bulk of toxic assets are based on residential mortgage-backed securities (RMBS), in which thousands of mortgages were gathered into mortgage pools. The returns on these pools were then sliced into a hierarchy of “tranches” that were sold to investors as separate classes of securities. …

But the process didn’t stop there. Some of the tranches from one mortgage pool were combined with tranches from other mortgage pools, resulting in Collateralized Mortgage Obligations (CMO). Other tranches were combined with tranches from completely different types of pools, based on commercial mortgages, auto loans, student loans, credit card receivables, small business loans, and even corporate loans that had been combined into Collateralized Loan Obligations (CLO). The result was a highly heterogeneous mixture of debt securities called Collateralized Debt Obligations (CDO). The tranches of the CDOs could then be combined with other CDOs, resulting in CDO2.

Each time these tranches were mixed together with other tranches in a new pool, the securities became more complex. Assume a hypothetical CDO2 held 100 CLOs, each holding 250 corporate loans — then we would need information on 25,000 underlying loans to determine the value of the security. But assume the CDO2 held 100 CDOs each holding 100 RMBS comprising a mere 2,000 mortgages — the number now rises to 20 million!

Complexity is not the only problem. Many of the underlying mortgages were highly risky, involving little or no down payments and initial rates so low they could never amortize the loan. …

With so much complexity, and uncertainty about future performance, it is not surprising that the securities are difficult to price and that trading dried up. Without market prices, valuation on the books of banks is suspect and counterparties are reluctant to deal with each other. …

The latest disposal scheme is the Public-Private Investment Program (PPIP). … But the pricing difficulty remains and this program too may amount to little. The fundamental problem has remained untouched: insufficient information to permit estimated prices that both buyers and sellers find credible. Why is the information so hard to obtain? … CDOs were sold in private placements with confidentiality agreements. …

This account makes it clear why transparency is so important. To deal with the problem, issuers of asset-backed securities should provide extensive detail in a uniform format about the composition of the original pools and their subsequent structure and performance, whether they were sold as SEC-registered offerings or private placements. By creating a centralized database with this information, the pricing process for the toxic assets becomes possible. Making such a database a reality will restart private securitization markets and will do more for the recovery of the economy than yet another redesign of administrative agency structures. …

I am becoming convinced, after reading articles like this and from other research on this issue, that forcing these transactions through organized exchanges that monitor and mitigate counterparty risk is a good idea. Here’s a discussion of the issues:

On the derivatives side, the administration had already indicated that it would push for all standardized derivatives to be traded through an organized exchange or cleared through a clearing house. … Exchanges bring a real benefit from transparency about the pricing and volume of trades, as well as making it easier for regulators to track trading positions of major parties. In contrast, much of the trading volume in derivatives now takes place “over the counter,” between two counterparties who are not generally required to report details of the trade and who take each other’s credit risk in regard to the transaction. This credit risk is often mitigated by requiring collateral, but it is clear in retrospect that this process was not well-managed in many cases, leaving a large number of institutions very exposed to the credit risk of AIG, for example.

The major exchanges dealing in derivatives use central clearing houses that act as the counterparty to both sides. …

It should be noted that using a clearing house does not eliminate counterparty risk altogether. The clearing house could become insolvent itself if enough of its counterparties fail to meet their obligations. This should still represent a diminution of the total credit risk in the system, since clearing houses are well-capitalized and operate in a clearly defined business…, but there could be extreme circumstances where a government rescue would be required.

The big controversy with derivatives is what to do about customized derivatives. The use of derivatives to manage risk by sophisticated corporations is pervasive. Sometimes those derivatives are significantly cheaper or more effective if they cover the exact risk rather than using one or more standard derivatives to approximate the desired protection. It would be a great shame to lose those efficiencies altogether by banishing customized derivatives, but there is also a fear that financial firms will deliberately sell slightly non-standard derivatives in order to avoid the tougher rules on standardized ones.

This is another area where the devil is in the details. The trick will be to provide incentives or requirements to use standard derivatives where possible, while leaving the ability to use customized ones where they serve a genuine need. The administration’s proposal attempts to strike this balance. It will be interesting to see what comes out the other end of the legislative process…

One solution is to subject transactions for customized derivatives (which have their uses) that cannot go through organized exchanges or clearinghouses to discouragingly strict margin and capital requirements.


Originally published at Economist’s View and reproduced here with the author’s permission.

3 Responses to "Why Toxic Assets are so Hard to Clean Up"

  1. Anonymous   July 20, 2009 at 10:18 am

    Like most articles dealing with the aftermath of the burst housing bubble, this one presents a particular view of a serious problem, then proceeds to tell readers that the problem can be solved relatively easily if done properly. As is typical, the reader ends up believing that the problem isn’t really that difficult to solve. In this instance, in early March, the “toxic assets” were detoxified by a relatively simple and quick change of the accounting rules which formerly required owners of the toxic assets to value them at the fair market value. The rule change enabled the banks to place their own marked-up value on the assets and that was the spark that ignited the big stock market rally that’s in progress now. Now detoxified, the assets are rarely mentioned in the media except when the experts have come up with a new way to “dispose” of them, or “clean them up.” A new way to dispose of the toxic assets is necessary soon in order to maintain the stock market rally, and that is why we’re likely to be seeing more articles about how that will be accomplished. Most people, however, know that someone is going to have to take big losses in order for the assets to be “cleaned up,” and the loser will be the taxpayer, once again, as the losses will be socialized, one way or another. The real problem is how to get the public to accept responsibility for taking the loss.

    • Anonymous   July 20, 2009 at 5:48 pm

      Bingo, anonymous, and when they can no longer talk, they will run.

    • Richard Ginnold   July 24, 2009 at 4:38 am

      Great point on negative effects on stock market if we go back to mark to market. Why is level of market used to define prosperity. Let us go back to requiring banks to hold all or most of their loans in house, have high reserves and eliminate CDOs because of the impossibility of proper valuation of large bundles. Also borrowers should have to make large downpayments, stock investors should have high margin requirements and credit cards and other consumer loans should be reined in. What would this do. It would certainly reduce the size of the financial sector, would increase savings rates, would decentralize net worth and wealth to midsize markets and would probably result in increased US economic net worth, growth and productivity. Income inequality would start moving back to the l970s level and we could start repairing our education system and our health care system and social security on a pay as you go basis. Deficits could be gradually phased out. Oh, for fiscal sanity, how about removing the tax benefits for hedge funds and more strictly regulating both banks and hedge funds. Finally, go back to taxing home profits unless the sale proceeds are rolled over into a new property. These latter changes, lobbied through by the rich for the rich, simply benefit the top 2 or 3 percent of taxpayers. How does this happen, politically? I guess by more public information and education of the masses on true finance by the RGE Monitor and other responsible business journalists. Let´s clean up our house and get some of the capital and jobs back into the US.