(CedricMuhammad.com) Last I checked, this is what the word toxic meant: ‘of, affected by, or caused by a toxin, or poison; acting as a poison; poisonous. Poison, in case any of us forgot means: a substance causing illness or death when eaten, drunk, or absorbed even in relatively small quantities; anything harmful or destructive to happiness or welfare, such as an idea, emotion, etc.’
Alright, now that we have established that you are thinking what I’m thinking when you hear the word ‘toxic’ casually and formally thrown around by reporters, economists, analysts, and yes, government officials (I will not acknowledge this new term the Obama administration coined yesterday – ‘legacy’ assets!) we can get down to the business of confronting the reality that there is nothing anyone can do in the short term to turn these ‘assets’ into attractive investments or engines for economic growth.
What Timothy Geithner unveiled yesterday is a thoughtful plan, but one that is more about creating a new set of books for financial companies than it is about growing the economy aka encouraging the flow of capital and credit to entrepreneurs, business owners, students, consumers, and the majority of investors.
We’ve just defined toxic, but the real word that folks are playing games with is ‘assets.’ Unlike how most of us would normally think, the liabilities of a bank are its deposits, because banks are liable or obligated to pay interest on them, plus reserves – the amount of money banks must not touch and cannot collect interest on. A bank’s assets, strange as it may seem on the surface, are its loans, because it can make money on them - primarily by collecting interest on them.
So an asset is a bank loan.
A toxic asset is a bad bank loan (or bundle of them that the bank owns) that so greatly harms or heavily weighs down a bank’s profitability or balance sheet that a depositor or an investor believes the bank is not a safe place to store money or in which to invest.
At this stage the question becomes is the bank insolvent? In other words is it unable to pay debts as they become due? Is it effectively bankrupt?
If the impression grows (or reality becomes) that a bank is insolvent, then a run on the bank and capital flight can occur – when depositors pull their money out of banks en masse, and when investors sell the equity they own in banks, or refuse to make any new investments in the bank, respectively.
While the government for the most part has been successful at preventing runs on the nation’s banks, it has not been as successful at preventing capital flight, and as a result, banks, they argue, are not healthy enough to make loans.
They blame the toxic assets for this problem and suggest that if these assets could be taken off of the books of the banks – the banks would look healthy enough to attract investments, and then, would be in a good position to make the loans the economy thrives upon.
To see where this logic breaks down, please read my “Securitization as Satan,” (http://www.cedricmuhammad.com/securitization-as-satan/) from February 19th.
Aside from the reality that over $2 trillion in credit and loans comes from the non- commercial bank or shadow banking community through securitization, and banks increasingly originate loans (in a primary market) only when they know they can sell them (in a secondary market), there is another problem that Secretary Geithner is not facing up to, when he indicates how successful this latest program can be.
Trying to repair the balance sheets of banks by subsidizing the purchase of toxic assets does not make the assets (remember these assets are bad loans or securities based upon bad loans) anything other than poison. It only makes them more affordable poison.
So, to make a hyperbolic analogy, the Geithner plan is the equivalent of a community that is dependent upon its informal or illegal economy, deciding to allow drug dealers (or I should call them street pharmacists) from out of town (O.T.) to purchase the crack, crystal meth, ‘wet,’ and weed that isn’t moving, and is depressed in price, from their local competition - the community’s indigenous dealers. The bet, the out of town dealers are making is that the drugs will rise in value and that they will be able to sell them elsewhere. The community’s gamble is that its local drug dealers will be able to survive with the new cash infusion (from the OT dealers) and will be able to once again finance new inventory and resume the loans and philanthropy that the community depends upon.
[Anyone not in appreciation of the importance of the informal or illegal economy, may not be familiar with the realities of communities that because of discrimination or segregation have been cut off from the three primary sources of capital : inheritance, savings, and financial markets; and therefore turn to the two remaining sources: crime and government. Often the leaders of 'organized crime,' become beloved, due to the access to capital that they provide to the poor. See Harlem, 1920 to 1940.]
So how were the toxic assets created and how bad was the poison being peddled?
First, subprime mortgage loans, stated income loans (’liar loans’), and alt-A mortgage loans were made by banks when they shouldn’t have been*. This is where the toxicity emerged:
- Subprime mortgages are loans originated by a lender that are A- to D in quality. Consumers who have the best credit ratings with th ehighest FICO scores are considered “A” credit quality. Subprime borowers usually have several blemishes on their credit histories, including missed payments on mortgages and other types of installment debt such as credit cards.
- Stated Income Loans a.k.a ‘Liar Loans’ are a mortgage obtained when the consumer states his/her income without the lender asking for documentation of the salary stated. The lender accepts the income stated as if the borrower has a FICO score north of 700, which is considered “A” paper or prime quality. There are variations on this loan, including “low-doc”" (maybe a bank statement with no W-2) and “no-doc” (no income or asset documentation or verification).
- alt-A mortgage loans are nonconforming mortgage where the borrower has a higher than subprime credit score. Alt-A is short for alternative A. alt-A loans were made to home buyers with good credit but who despite having good credit also had run up a lot of credit card or auto loan debt.
Second, these bad assets (remember loans are assets) were then securitized, meaning, a bond was issued backed by this risky pool of mortgages. These mortgage backed securities contained anywhere from 1,000 to 25,000 of these horrible mortgages in one bundle.
Third, these bad pools of securitized assets which should have received some of the worst grades for quality available instead received the highest ratings possible from the respected ratings agencies – Moody’s, Standard & Poor’s, and Fitch (in the case of mortgage backed securities bought by large Wall Street firms from a non bank, it was the outsourcing firms like Clayton Holdings, The Bohan Group and Opus Mortgage who were supposed to re-underwrite the loans to make sure they were good enough quality, to keep the garbage from being underwritten at all or passed along in their current form.)
Fourth, collateralized debt obligations (CDOs) were created from slices or ‘tranches’ of other bonds. A CDO is a security made out of other securities. This in effect compounds the problem by concentrating more of the poison in one group. These CDOs were then sold to investors around the world, including large banks.
To understand the maze and how systemically the poison was passed along, one must remember that even when commercial banks did not originate bad real estate loans, they would often buy them, in their bundled or securitized form as investors. And even when they were not making subprime loans themselves they were purchasing subprime lenders who were. The best example of this, of course, is Bank of America’s purchase of Countrywide.
It should also be noted that many of the sub prime loans were made by non-banks (who received loans from Wall St. firms that wanted more loans originated in order for them to securitize and re-sell them), but many of these banks were purchased by commercial banks or had their loans held by major banks. An example of this is the relationship that existed between New Century and Citigroup.
The result today of this maze of madness is that there are an estimated $2 trillion in toxic assets on the books of banks.
The Geithner plan (yes it’s his plan as his op-ed in yesterday’s Wall Street Journal makes clear, ‘My Plan For Bad Bank Assets,’) although very thoughtful does not make these toxic assets healthy. It does not affect, negate or improve what underlies these loans and securities – lies, greed, false income statements, job losses, a weak economy, poor due dilligence, and no regulatory structures.
Subsidizing pension funds and hedge funds in their purchase of something that is fundamentally flawed and which they normally would not consider as a viable investment does not represent an economic activity, it is a continuation of the kind of accounting gymnastics which created toxic assets in the first place.
Finally, what the Geithner plan further reveals is the dependence that the U.S. government and the American economy grew to have this past decade and continues to have on the shadow banking industry – hedge funds, private equity firms, investment banks, mortgage finance companies, non-bank lenders, structured investment vehicles – which are responsible for providing $14 trillion in credit.
That many of them are underwater, out-of-business, or keeping their powder dry means that the Fed through its TALF (Term Asset-Backed Securities Loan Facility) program (which seeks to securitize new and now existing student loans, small business loans, credit card loans, auto loans and corporate loans) and the Treasury Department now through this officially titled, Public-Private Investment Program (PPIP) are totally dependent upon pension funds, hedge fund managers, mutual funds and private equity investors to prop up the commercial banking system.
While the terms the government and Fed are providing are generous [under TALF investors have as much as 85% of their investments subsidized or protected from losses; under the PPIP, the government and Fed provide the investors with up to 6 times their own investment in financing (this means things have gotten so bad that the government and Fed are now providing leverage to firms like the old Wall St. houses used to) while allowing the investor to share in 50% of the profits] there is a serious question as to whether they will attract enough capital from the sidelines to unfreeze credit markets and encourage lending as advertised.
Remember, over $4 trillion in ‘missing assets’ ($2 trillion in toxic assets and $2 trillion in non bank securitized lending) have to be addressed.
Perhaps the only positive sign in all of this is, is that change is on the way - if Sec. Geithner cannot get his plan to work, President Obama will finally be ‘free’ to move past the too-Wall St. friendly group of advisers that accompanies every financial crisis. Mr. Geithner, a former President of the shadowy Federal Reserve Bank of New York does not have the worldview that an eclectic and talented mixture of progressive, conservative, and libertarian economists would, working in tandem with monetary historians, and practitioners like financial analysts and engineers (even former derivatives traders who seek to repent) who understand the instruments and assets that computers and mathmeticians created in recent years.
It appears that only a motley crew like this has the courage, intellectual freedom, insight, foresight and common sense to tell President Obama that there is no tonic that can create economic vitamins out toxic assets.
In other words - sugar ain’t made from $^!+…
Cedric Muhammad
March 24, 2009
* drawn from definitions provided by Paul Muolo and Matthew Padilla in their book ‘Chain of Blame.’
Greetings,
I’ve found your articles always clear, timely and informative.
As-salaam Alaikum
This is brilliant.
Great Article! Thanks for taking the time to put this topic in a more digestible form; it reviled some missing elements for me. Perfect closing! LOL.
As always my brother, you made this complex mess very plain for our community. If I could add the following:
1. The major flaw in the plan Presidnet Obama is allowing to Geithner to use, is that is based on a false set of assumptions about what the real financial crisis and the recession in the real economy are all about. Like you said, you can’t make sugar from *#$&@ and at best this is the right plan, for the wrong problems.
2. Some analysts note that regardless of the success or failure of the Geithner plan to make a significant impact on the real economy, (at best it might create a temporary boost) if the shadow banking system companies use it up to 1 trillion dollars, the details on how the deals will be structured could result in an additional net $500 billion transfer of capital from taxpayers to the banks selling the toxic assets. of course not only does $500 billion still fail to cover the holes in their balance sheets, it becomes even more pathetic when you know that the banks have some bigger holes coming later this year as some of their commercial real estate, credit cards, car loans, and even prime mortgage assets (like you said loans) get transformed into TOXIC assets.
3. And of course for playing this role, the shadow banking system collects fees and gets help re-starting their securitization business model. They need both to compensate for their own losses and because the first federal reserve backed $200 billion securitization re-starting program launched a few months ago has only produced 5 billion in new securitization.
4. In the end, the biggest problem I see is that President Obama thus far has not accepted the fact that saving the banks as a prerequisite for saving the real economy, represents a false logic and world view. The only thing that logic will produce after the crisis, is a return to the status quo of the financial industry being both seperate from the real economy, but also having power over the real economy, which is actually THE problem. It is unsustainable as an economy which can support the society and fosters repeated systemic risks. The logic Obama may have to come to is one where the solution is not to save the banks, but to transform the role and position that banks are supposed to play in a society. The finance industry is not supposed to dominate the real economy like a parasite, it is supposed to “support” the real economy.
Thanks for taking the time to enlighten us cousin. I agree that throwing good money after bad is not good public policy. The concern for me is the alternative. The notion of ‘too big to fail’ is real and problematic but I don’t think that this particular plan was conceived to address that. I take it for what it is. A plan that tries to a) prevent bank runs or systemic failure and b) lure private money back into the system while mitigating the risk to taxpayers as much as feasible. The potential losses are still TREMENDOUS but I look at this risk similar to alcohol poisoning (think 120lbs woman vs 300lbs man in a drinking contest). The more pressing concern that I have is the endemic wealth transfer that Marc mentions above. But again, I go back to the alternative. Politically, I think it would be much more difficult for the Administration to secure receivership powers (which I think they ultimately will in a limited capacity) over non-bank institutions without first trying the Geithner plan. For the ’shadow banking industry’ as described by Nouriel Roubini and others, there is no government instrument that could orderly liquidate the assets of non-bank institutions which pose a systemic to the larger economy. This stands in stark contrast to the FDIC which has such powers for banks in certain instances. Part of this plan calls for an entity similar to RTC during the S&L scandal but resolution authorities have historically done a poor job of valuation. If the auction model works and there is sufficient incentive and/or willingness on the part of the banks and the hedge funds and others to participate, then I am at least optimistic that the Geithner plan represents one of the best of a few VERY BAD options. Securitization has driven our economy over the last few decades. I question whether the political and economic climate is actually shifting to the point where greater regulation will be imposed upon the financial sector and thereby shrink its size and influence. Obama’s gamble is that big bets on education, health care, and energy will pay off over the long term through bottom up prosperity that “could” be created. Solving the ‘too big to fail’ problem won’t happen overnight and both Geithner and Obama have hinted that a new regulatory framework is under works. But even if they do change the relationship between capital and the government (to strike a better balance between efficiency and stability), I doubt that it will result in any drastic structural changes to our system. Even if securitization was the problem (which I do not think it is), the political will won’t be there until there is a viable replacement. That’s why I have resisted looking at the toxic asset plan independent of his recovery plan and long-term agenda. But what do I know? I’m just a young twenty-something.
The answer lies in the fundamentals of Islam. More later. On my way to court.
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