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August 26th, 2009

A Market-Based Solution for Toxic Assets?

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First there was TARP — the troubled asset relief program — then there was PPIP — the Public-Private Investment Program. Both ideas unsuccessfully attempted to remove the failed investments (or toxic assets) off the books of investment firms. These bad loans continue to clog up the financial system, making it harder for banks to make new loans and extend credit to consumers.

Toxic assets: they’re a problem that no one has quite figured out how to solve;  they’re “the stubborn stain on our economic recovery.” Why are they the “stubborn stain?” Simply put, it’s because no one, no plan, has been properly able to price the bad loans so they can be resold.

Well, the latest strategy to sell the toxic assets come from Wall Street itself, but the idea is striking fearful images of deja vu into many:

In recent months investment banks have been repackaging old mortgage securities and offering to sell them as new products, a plan that’s nearly identical to the complicated investment packages at the heart of the market’s collapse.

In recent months, banks have tiptoed toward a possible solution [of dealing with the toxic assets], one in which the really good bonds get bundled with some not-quite-so-good bonds. Banks sweeten the deal for investors and, voila, the newly repackaged bonds receive AAA ratings, a stamp of approval that means they’re the safest investment you can buy.

Despite the deceptively high rating (AAA), proponents of the strategy say, unlike before the financial crisis occurred, this time investors know what they’re getting into. As we understand it, the investments, or bonds, will be broken into two separate investments — one with greater risk than the other:

[Arizona State University economics professor Herbert] Kaufman said he’s optimistic about the recent string of deals because, unlike during the real estate boom, investors in these new bonds know what they’re buying.

The sweetener at the heart of the deal is a guarantee: Investors who buy into the really risky pool agree to also take some of the risk away from those who buy into the safer pool. The safe investors get paid first. The risk-taking investors lose money first.

“It actually makes a lot of fundamental sense,” said Brian Bowes, the head of mortgage trading at Hexagon Securities in New York. “It’s taking a bond that doesn’t necessarily have a natural buyer and creating two bonds that might have a natural buyer for each.”

However, this strategy isn’t absent of risk. Ironically, and perhaps most worrisome, is that the investments rely both on steadily improving financial markets and accurate ratings. These are the same bets that investors took on similar risky investments before the crisis, the exact reason why critics are calling Wall Street’s idea deja vu:

The risk is, if the housing market slips even more, even the AAA-rated investments may not prove safe. The deal also relies on the rating agencies, which misread the risk at the heart of the subprime mortgage crisis, to get it right.

There have been several proposed solutions designed to tackle the market’s stockpile of toxic assets. There was TARP, PPIP, the central database idea proposed by professors and authors Kenneth Scott and John Taylor, and now this latest idea being kicked around by Wall Street. With this latest solution, it seems as though the markets have developed their own response to dealing with these toxic assets, which frankly, is a very healthy sign.

Whether this strategy will work or not is unknown, but it’s encouraging since the plan isn’t coming from Washington, it’s coming from the private sector. The broad, far-looking outcome of getting these toxic assets moving again, means healthier banks and happier consumers.

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About the HSH Blog

HSH.com's daily blog focuses on the latest developments in the mortgage and housing markets. Our mission is to relate how changes in mortgage rates and housing policy, as well as the latest financial news, impacts consumers, homebuyers and industry insiders alike. Our 30-plus years of experience in the mortgage industry gives us an edge as we break down the latest changes in an ever-changing market.

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Tim Manni

Tim Manni is the Managing Editor of HSH.com and the author of their daily blog, which concentrates on the latest developments in the mortgage and housing markets.

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