Toxic assets – A taste.

Here’s a question for you. How do toxic assets keep making money?

Another way of asking the same thing is why do banks want to keep some toxic assets on their books rather than get rid of them?Now first-off, some assets are so toxic the banks have written them off (though sadly very few) and many more they have unloaded onto the central banks when those banks agreed to pay a hugely inflated price for them using your tax money to do it. (Generally Central banks agreed to pay full face value or very close to it even though at the time and even now, they are not worth anything like what they paid)Answering this question gives a little insight into how securities work, what the governments and banks are playing at and what is going on in the housing markets.

These securities are based on underlying debts/loans. Instead of a bank keeping a loan on its books getting a little income each month, the banks sell them on. By selling them on the bank replenishes its coffers, can make more loans and the over all market grows more quickly than it would doing it the old fashioned way.

The banks may create the securities themselves or sell them to someone else who makes the security. The security is made of many mortgages all sliced up. The reason to do this is to spread the risks of any given mortgage defaulting.

It is a certainty that some percentage of mortgages will default. A certain percentage of any group will have a heart attack, get run over, get divorced, fall in love with a Llama and emigrate to Peru. If companies bought whole single mortgages then someone would get stuck with a complete loss on one of those unlucky mortgages. By slicing them up and recombining the pieces, those losses are absorbed into a larger flow of people who are still paying.

So now we have our security made of lots of bits of mortgages. Each time a mortgage in our security stops paying, for whatever reason, the flow of money into the security lessens by a little bit. But, so long as most keep paying then the flow of cash coming in stays healthy. Even if many people default on their mortgages there will still be some paying and therefore still some money coming in. This is why even toxic assets have some cash coming in.

Now imagine you bought your security when it was first made, when everything was on the up. You paid $50,000 for it. It purported to make you at least that much back. But as the crunch happened and mortgages started to default the cash flow started to dry up. What do you do as the investor/owner? Do you hang on and accept a dwindling income or do you sell the whole thing for less than you paid for it? If you sell you might avoid a larger loss if the crisis gets worse and more people default, and you might be able to recoup your loss by investing what you sell it for, in a more lucrative way. So you find someone who thinks things are going to stabilise who therefore thinks you are selling a bargain that is going to regain its value. Or you sell at such a discount (there are securities that when created sold for $70K or more and are now bought for 1K) that the buyer recovers what he paid even with the reduced cash flow.

You sell and take the money (accepting that over all you sold at a loss) and now invest in, for example, a CDS betting that the very security you just sold is going to go down. It turns out you are right this time, It does decline further. You get paid by the CDS issuer and you have made your money back. Lucky you.

Of course it could have gone the other way. People trade in distressed debts trying to figure out those which are actually going to recoup a little of their value. You buy from someone who wants/needs out. Perhaps they are just desperate for immediate cash and have to sell, and you buy at the bottom and perhaps re-sell on the way up. In/out shake that profit all about.

Now lets look at the banks and others who hold these securities. It is obvious that how much one of these securities is worth can be worked out by looking at how much cash is still flowing in. A buyer tries to work this out in order to decide what it’s worth buying it for. This would be called marking the value to what the market will pay for it – ‘mark to market’. This accounting method gives an accurate day to day value of the asset. It also means, however, that the banks holding these assets have to keep showing how their investments are going down and the bank is worth a little less. As the bank is worth less and less it is seen to have less capital standing behind its other loans. At some point the assets of the banks become too low to support their remaining liabilities and the bank collapses into insolvency.

So how did those banks keep trading wile they were obviously insolvent and why did they then collapse? In a word, CASH-FLOW.

Which brings us to the last stop on our sorry journey. The banks have NOT been foreclosing in the US and in may European markets ( I strongly suspect Spain in this respect), or if they have they have been buying the properties themselves (via a specially set up off-balance sheet investment vehicle SIV) at almost face value. Both actions stop the real value (market value) of the asset becoming apparent.

This might seem a bit crackers. And it is. But it does allow the banks to maintain the lie of who much capital they have. And remember it is instant death if their capital requirement is seen to be too low. They have to raise capital, get another bail out or face a bank run. So better to lie and put off any day of reckoning. The banks can maintain this lie as long as there is some cash flow coming in. For the banks can survive as long as there is just enough cash flowing in to pay off its creditors at some agreed fraction. The creditors may agree to a lower return rather than face the liquidation of the bank and then get nothing at all, themselves.

The banks would rather have toxic assets about whose value they can lie. Their creditors would often prefer them to lie because they often own the same assets themselves and wouldn’t like theirs revealed as worthless. They may also prefer so as to keep a even a small cash flow coming in and hope that the economy ‘recovers’ so restoring the value of their assets. The banks lies are often what stands between them and their own demise.

Of course the more toxic the assets get the lower the cash flow from them and the more difficult it is to keep everyone in the game. Someone might need OUT no matter what, to deal with their own cash crisis, for example. Which is where bail-out become necessary. Fresh cash injected from a willing or unwilling donor (Consent? who needs it. Just strap them down, jam in that needle and bleed them till the bankers are feeling in the pink again). Public cash has been what has helped keep cash flows from drying up.

The bail-outs are what has kept the whole lie going. That cash plugs the gaps where the lies run thin.

So you can see from the banks perspective and that of their large creditors who often own the same worthless paper ( sold to them by the banks) lying and pretending is the best, in fact only policy. Certainly the only one that protects their wealth. That is why they have all advised our governments that this is the ONLY policy that can be talked about. Do you remember ANY debate at all, then or since?

There is only one little problem with this whole thing. Someone has to pay for the bail out. Someone has to borrow and print all that cash so the banks can pretend. That person is you and me of course. We borrow. We pay the interest all the time they are waiting and pretending.

Now the IMF and the banks themselves are all agreed, that all nations must reign in their deficits and convince the markets of their fiscal measures for tightening spending. Banker speak for cut spending on everyone and everything not essential to bankers.

Bankers don’t need state schools. Their children go to Public schools. Bankers don’t need the NHS, they go to private hospitals. Bankers don’t need social services or unemployment benefits. They have bonuses to cover all that. SO cut it all.

Cut it in Greece, in Ireland, in Iceland, In Latvia, in Portugal and Spain. Cut it in Britain.

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