Toxic asset
Encyclopedia
Toxic asset is a popular term for certain financial assets whose value has fallen significantly and for which there is no longer a functioning market, so that such assets cannot be sold at a price satisfactory to the holder. The term became common during the financial crisis of 2007–2011, in which they continue to play a major role.
When the market for toxic assets ceases to function, it is described as "frozen." Markets for some toxic assets froze in 2007, and the problem grew much worse in the second half of 2008. Several factors contributed to the freezing of toxic asset markets. The value of the assets were very sensitive to economic conditions, and increased uncertainty in these conditions made it difficult to estimate the value of the assets. Banks and other major financial institutions were unwilling to sell the assets at significantly reduced prices, since lower prices would force them to reduce significantly their stated assets, making them, at least on paper, insolvent.
, founder of Countrywide Financial
, who used the term "toxic" to describe certain mortgage products in emails in spring of 2006, as revealed in SEC filings:
Regarding Countrywide's subprime 80/20 loans:
of a good equal each other, so buyers and sellers are matched, one says that the "market clears
".
Classical economics
and neoclassical economics
posit that market clearing happens by the price adjusting—upwards if demand exceeds supply and downwards if supply exceeds demand. Therefore, it reaches equilibrium
at a price that both buyers and sellers will accept, and, in the absence of outside interference (in a free market), this will happen.
This has not happened for many types of financial assets during the financial crisis that began in 2007, hence one speaks of "the market breaking down".
One can explain this alternately as the price not adjusting down—the price is too high, with supply being too high, or alternatively demand being too low, or by the theory of an equilibrium price not holding—the price at which sellers will sell is higher than the price at which buyers will buy.
Prior to the crisis, banks and other financial institutions had invested significant amounts of money in complicated financial assets, such as collateralized debt obligations and credit default swaps. The value of these assets was very sensitive to economic factors, such as housing prices, default rates, and financial-market liquidity. Prior to the crisis, the value of these assets had been estimated, using the prevailing economic data.
When it became clear that such conditions would not continue, it was no longer clear how much revenue the assets were likely to generate and, hence, how much the assets were worth. Since the assets were typically very sensitive to economic conditions, even relatively small uncertainties in the economic conditions could lead to large uncertainties in the value of the assets, which made it difficult for buyers and sellers in the market to agree on prices.
Furthermore, banks and other large financial institutions were reluctant to accept lower prices for these assets, since lower prices would force them to recalculate the total value of their assets, and, if the loss was sufficiently large, force them to declare a negative total value. Several banks in the autumn of 2008 were forced to accept buy-outs or mergers because it was believed that they were in this situation. This re-evaluation of total assets based on prevailing market prices is known as mark-to-market pricing. The term zombie bank
was introduced to describe banks, which would have become bankrupt if their assets had been revalued at realistic levels. Toxic assets, by increasing the variance of banks' assets, can turn otherwise healthy institutions into zombies. Potentially solvent banks will make too few good loans. This is the debt overhang
problem. Alternatively, potentially insolvent banks with toxic assets will seek out very risky speculative loans to shift risk onto their depositors and other creditors.
Further, insolvent banks with toxic assets are unwilling to accept significant reductions in the price of the toxic assets, but potential buyers were unwilling to pay prices anywhere near the loans's face value. With potential sellers and buyers unable to agree on prices, the markets froze with no transactions occurring. In some cases, markets remained frozen for several months.
(FDIC)] will provide non-recourse loan guarantees for up to 85 percent of the purchase price of legacy loans. Private sector asset managers and the U.S. Treasury will provide the remaining assets. The second program is called the legacy securities program, which will buy mortgage backed securities (RMBS) that were originally rated AAA and commercial mortgage-backed securities (CMBS) and asset-backed securities (ABS) which are rated AAA. The funds will come in many instances in equal parts from the U.S. Treasury's Troubled Asset Relief Program (TARP) monies, private investors, and from loans from the Federal Reserve's Term Asset Lending Facility (TALF). The initial size of the Public Private Investment Partnership is projected to be $500 billion. Economist and Nobel Prize winner Paul Krugman
has been very critical of this program, arguing that the non-recourse loans lead to a hidden subsidy that will be split by asset managers, bank shareholders, and creditors. Banking analyst Meridith Whitney argues that banks will not sell bad assets at fair market values because they are reluctant to take asset write downs. Removing toxic assets would also reduce the upward volatility of banks' stock prices. Because stock is a call option
on a firm's assets, this lost volatility
will hurt the stock price of distressed banks. Therefore, such banks will only sell toxic assets at above market prices.
However, that argument ignores the possibility of simultaneously adjusting bank liabilities by legislation or regulation, as requested in the September, 2009, $24 billion plan proposed by FDIC chair Sheila Bair, which would have shielded shareholders but could have led to non-astronomical management bonuses. Bair's plan was never implemented. Because the number of commercial bankruptcy filings continues to increase, there is evidence for negative feedback pressure indicating that toxic assets still need to be addressed.
coined by Robert Gibbs
as an attempted re-branding of toxic assets.
When the market for toxic assets ceases to function, it is described as "frozen." Markets for some toxic assets froze in 2007, and the problem grew much worse in the second half of 2008. Several factors contributed to the freezing of toxic asset markets. The value of the assets were very sensitive to economic conditions, and increased uncertainty in these conditions made it difficult to estimate the value of the assets. Banks and other major financial institutions were unwilling to sell the assets at significantly reduced prices, since lower prices would force them to reduce significantly their stated assets, making them, at least on paper, insolvent.
Origin
The term was in limited use at least as early as 2006, and may have been coined by or popularized by Angelo MoziloAngelo Mozilo
Angelo R. Mozilo was the chairman of the board and chief executive officer of Countrywide Financial until July 1, 2008. Condé Nast Portfolio ranked Mozilo second on their list of "Worst American CEOs of All Time".-Life and career:...
, founder of Countrywide Financial
Countrywide Financial
Bank of America Home Loans is the mortgage unit of Bank of America. Bank of America Home Loans is composed of:*Mortgage Banking, which originates purchases, securitizes, and services mortgages. In 2008, Bank of America purchased the failing Countrywide Financial for $4.1 billion...
, who used the term "toxic" to describe certain mortgage products in emails in spring of 2006, as revealed in SEC filings:
- "[The 100% loan-to-value subprime loan is] the most dangerous product in existence and there can be nothing more toxic..." (March 28, 2006)
Regarding Countrywide's subprime 80/20 loans:
- "In all my years in the business I have never seen a more toxic prduct [sic]. It's not only subordinated to the first, but the first is subprime. In addition, the FICOs are below 600, below 500 and some below 400[.] With real estate values coming down ... the product will become increasingly worse." (April 17, 2006)
Market freeze
When the supply and demandSupply and demand
Supply and demand is an economic model of price determination in a market. It concludes that in a competitive market, the unit price for a particular good will vary until it settles at a point where the quantity demanded by consumers will equal the quantity supplied by producers , resulting in an...
of a good equal each other, so buyers and sellers are matched, one says that the "market clears
Market clearing
In economics, market clearing refers to either# a simplifying assumption made by the new classical school that markets always go to where the quantity supplied equals the quantity demanded; or# the process of getting there via price adjustment....
".
Classical economics
Classical economics
Classical economics is widely regarded as the first modern school of economic thought. Its major developers include Adam Smith, Jean-Baptiste Say, David Ricardo, Thomas Malthus and John Stuart Mill....
and neoclassical economics
Neoclassical economics
Neoclassical economics is a term variously used for approaches to economics focusing on the determination of prices, outputs, and income distributions in markets through supply and demand, often mediated through a hypothesized maximization of utility by income-constrained individuals and of profits...
posit that market clearing happens by the price adjusting—upwards if demand exceeds supply and downwards if supply exceeds demand. Therefore, it reaches equilibrium
Economic equilibrium
In economics, economic equilibrium is a state of the world where economic forces are balanced and in the absence of external influences the values of economic variables will not change. It is the point at which quantity demanded and quantity supplied are equal...
at a price that both buyers and sellers will accept, and, in the absence of outside interference (in a free market), this will happen.
This has not happened for many types of financial assets during the financial crisis that began in 2007, hence one speaks of "the market breaking down".
One can explain this alternately as the price not adjusting down—the price is too high, with supply being too high, or alternatively demand being too low, or by the theory of an equilibrium price not holding—the price at which sellers will sell is higher than the price at which buyers will buy.
Prior to the crisis, banks and other financial institutions had invested significant amounts of money in complicated financial assets, such as collateralized debt obligations and credit default swaps. The value of these assets was very sensitive to economic factors, such as housing prices, default rates, and financial-market liquidity. Prior to the crisis, the value of these assets had been estimated, using the prevailing economic data.
When it became clear that such conditions would not continue, it was no longer clear how much revenue the assets were likely to generate and, hence, how much the assets were worth. Since the assets were typically very sensitive to economic conditions, even relatively small uncertainties in the economic conditions could lead to large uncertainties in the value of the assets, which made it difficult for buyers and sellers in the market to agree on prices.
Furthermore, banks and other large financial institutions were reluctant to accept lower prices for these assets, since lower prices would force them to recalculate the total value of their assets, and, if the loss was sufficiently large, force them to declare a negative total value. Several banks in the autumn of 2008 were forced to accept buy-outs or mergers because it was believed that they were in this situation. This re-evaluation of total assets based on prevailing market prices is known as mark-to-market pricing. The term zombie bank
Zombie bank
A zombie bank is a financial institution that has an economic net worth less than zero but continues to operate because its ability to repay its debts is shored up by implicit or explicit government credit support...
was introduced to describe banks, which would have become bankrupt if their assets had been revalued at realistic levels. Toxic assets, by increasing the variance of banks' assets, can turn otherwise healthy institutions into zombies. Potentially solvent banks will make too few good loans. This is the debt overhang
Debt overhang
Debt overhang is when an organization has existing debt so great that it cannot easily borrow more money, even when that new borrowing is actually a good investment that would more than pay for itself....
problem. Alternatively, potentially insolvent banks with toxic assets will seek out very risky speculative loans to shift risk onto their depositors and other creditors.
Further, insolvent banks with toxic assets are unwilling to accept significant reductions in the price of the toxic assets, but potential buyers were unwilling to pay prices anywhere near the loans's face value. With potential sellers and buyers unable to agree on prices, the markets froze with no transactions occurring. In some cases, markets remained frozen for several months.
Geithner attempt at bail-out
On March 23, 2009, U.S. Treasury Secretary Timothy Geithner announced a Public-Private Investment Partnership (PPIP) to buy toxic assets from banks. The major stock market indexes in the United States rallied on the day of the announcement, rising by over six percent with the shares of bank stocks leading the way. PPIP has two primary programs. The Legacy Loans Program will attempt to buy residential loans from bank's balance sheets. The Federal Deposit Insurance CorporationFederal Deposit Insurance Corporation
The Federal Deposit Insurance Corporation is a United States government corporation created by the Glass–Steagall Act of 1933. It provides deposit insurance, which guarantees the safety of deposits in member banks, currently up to $250,000 per depositor per bank. , the FDIC insures deposits at...
(FDIC)] will provide non-recourse loan guarantees for up to 85 percent of the purchase price of legacy loans. Private sector asset managers and the U.S. Treasury will provide the remaining assets. The second program is called the legacy securities program, which will buy mortgage backed securities (RMBS) that were originally rated AAA and commercial mortgage-backed securities (CMBS) and asset-backed securities (ABS) which are rated AAA. The funds will come in many instances in equal parts from the U.S. Treasury's Troubled Asset Relief Program (TARP) monies, private investors, and from loans from the Federal Reserve's Term Asset Lending Facility (TALF). The initial size of the Public Private Investment Partnership is projected to be $500 billion. Economist and Nobel Prize winner Paul Krugman
Paul Krugman
Paul Robin Krugman is an American economist, professor of Economics and International Affairs at the Woodrow Wilson School of Public and International Affairs at Princeton University, Centenary Professor at the London School of Economics, and an op-ed columnist for The New York Times...
has been very critical of this program, arguing that the non-recourse loans lead to a hidden subsidy that will be split by asset managers, bank shareholders, and creditors. Banking analyst Meridith Whitney argues that banks will not sell bad assets at fair market values because they are reluctant to take asset write downs. Removing toxic assets would also reduce the upward volatility of banks' stock prices. Because stock is a call option
Call option
A call option, often simply labeled a "call", is a financial contract between two parties, the buyer and the seller of this type of option. The buyer of the call option has the right, but not the obligation to buy an agreed quantity of a particular commodity or financial instrument from the seller...
on a firm's assets, this lost volatility
Volatility (finance)
In finance, volatility is a measure for variation of price of a financial instrument over time. Historic volatility is derived from time series of past market prices...
will hurt the stock price of distressed banks. Therefore, such banks will only sell toxic assets at above market prices.
However, that argument ignores the possibility of simultaneously adjusting bank liabilities by legislation or regulation, as requested in the September, 2009, $24 billion plan proposed by FDIC chair Sheila Bair, which would have shielded shareholders but could have led to non-astronomical management bonuses. Bair's plan was never implemented. Because the number of commercial bankruptcy filings continues to increase, there is evidence for negative feedback pressure indicating that toxic assets still need to be addressed.
Types of assets
An example of a market which froze is the Canadian ABCP ("asset-backed credit paper") market. The term "toxic asset" is generally associated with financial instruments like CDOs ("collatoralized debt obligations", assets generated from the resale of portions of a banks mortgages), CDS ("credit default swaps"), and the subprime mortgage market -particular the lower tranches-, but the term does not have a precise definition.Related terms
Prior to the start of the financial crisis, the term "toxic waste" was used to describe the lowest tranch of the subprime mortgage market. Legacy assets is a euphemismEuphemism
A euphemism is the substitution of a mild, inoffensive, relatively uncontroversial phrase for another more frank expression that might offend or otherwise suggest something unpleasant to the audience...
coined by Robert Gibbs
Robert Gibbs
Robert Lane Gibbs was the 28th White House Press Secretary. Gibbs was the communications director for then-U.S. Senator Barack Obama and Obama's 2008 presidential campaign...
as an attempted re-branding of toxic assets.
External Links
- This American Life: Toxie (5 November 2010), episode 418, retrieved 13 February 2011.