The Future of Toxic Assets

Once again, a Facebook discussion inspired me to think further. The banking idustry will face many challenges ahead, as outlined in last week's Special Report in The Economist. The culprint behind it all are "toxic assets". It's not as toxic when viewed in the long run, but for now bankers and regulators are still trying to find a place for it. The US went through this, and is slowly recovering with cleaner balance sheets. Europe is starting to experience similar troubles, especially Spain with its housing bubble. The question remains, what's next for these troubled assets (troubled is a better term than toxic).
In general, it is still too early to forecast the future of the banking system. The US, the source of the financial crisis, is still in the idea phase. The Dodd-Frank Bill is essentially a long list of proposals on what regulators intend to accomplish. Once a specific action plan full of regulations is introduced, analysts will surely weigh the pros and cons. We are starting to see the plans leak out, begining with consumer protection, and regulations on small things such as debit card transaction fees. The industry as a whole will be tightened, with higher capital and reserve requirements, cutting into profits. This might also force banks to venture into new exotic investments, and spill over risk from the shadow banking system - financial dealings with investment banks and other non-deposit institutions.

The initial plan, and what remains to be the first resort, is to set up a bad bank. The government purchases troubled assets and places them in a 'bad bank' where they sit and wait to be bought at a higher value. The government also collects payments in the form of a core capital ratio from the banks. The tricky part is valuing these assets and figuring out book values. The market for troubled derivatives is essentially dead, and there is little transparency, no source of ownership, and no demand pressure to set an actual price. The government has actuaries who assume the price, and we have some faith in this value. I think that the cost of the lump sum of purchases should equal to the amount of cash desperately needed to free up the bank's balance sheet.

The underlying asset that sets the value of these derivatives such as credit default swaps and mortgage baked securities are mainly consumer debt and homes, respectively. Currently, the US housing market is sluggish, as many homes remain vacant, foreclosed, and on a tightrope amidst mortgage loan restructuring. Some banks are desperately extending loan terms to help buyers by decreasing mortgage payments, in hopes to hold on to income producing properties. Other banks have lost hope and started a wave of short-sales, accepting small losses, but still face low demand from buyers. An empty home is...an empty home, and the derivatives that are fueled through the payments of borrowers are empty too, dead, or as some like to call it - toxic.

Fast forward a decade into the future. By this time, these troubled assets will be worth something. Governments can sell them off for profit, but I feel like there is a better way for banks to deal with this on their own. Consider this:

Banks establish a bad bank of their own and bear the costs involved in doing so (no initial sale, no cash). The government is artifically valuing the assets, when given some time, these instruments can arrive at a fair market value. These bank owned 'bad banks' will be managed by a team in charge of re-structuring the assets for a gradual launch throughout the recovery years. The assets are already structured for a good economy with cash flows from income generating properties and debt accumulation. The problem that caused systemic collapse was when the economy went sour, these instruments became toxic because they were not created to yield positive results during default. No matter how many parties insured the risk of default, the process of capital payment to borrowers and faulty ratings trumped all other pre-cautionary measures. Also, the web of insurers grew to large, that a collapse was inevitable, because no one could pinpoint the source of risk.

When these assets are structured, they need boundries. These derivatives should perform similar to options. It must come with a start date, and most important, maturity. The maturity period should arrive when the economy gives signals of exhaustion. Next, the assets should be split into groups of investors so that transparancy can flow easily. This is a better alternative because it is re-structured to be sustainable. Sitting on the government's books does nothing, and will only leave the new investors in more pain.