Toxic Assets Research Articles

Market and Public Liquidity

As the record of Federal Reserve interventions over the past year, from December 2007 to December 2008, makes abundantly clear, a foremost concern of monetary authorities in responding to the financial crisis has been to avoid a repeat of the Great Depression, and especially a repeat of the monetary contraction that Milton Friedman and Anna Schwartz (1963) have claimed as the major cause of the 1930s Depression. The Fed has shown tremendous resourcefulness and inventiveness in its liquidity injections, considerably widening the collateral eligible under the discount window and the term auction facility, and setting up new programs targeted at primary dealers, the commercial paper market, and money market funds. At the same time it has stepped in to offer guarantees on assets held by some financial institutions (e.g., Citigroup) to avoid their bankruptcy (see David Enrich et al. 2008). This unprecedented intervention has had the intended effect of averting a major systemic financial meltdown and it has kept some critical financial institutions afloat. Yet, until now, banks have mostly responded by cutting new lending and hoarding liquidity, so that the ultimate goal of forestalling a credit crunch has not been achieved. For the most part, banks also are still holding most of the toxic assets that Monetary Policy, liquidity, and Financial crises †

Monetized Government Spending Instead of Elimination of Toxic Assets Can Solve Current Economic Problems

While most commentators seem pessimistic about solving current economic problems exhibiting gloom and doom, I argue that concerted monetized government spending (without any debt or taxes to match) by Euro-zone, US and Japan can quickly help reduce many of current imbalances in world macro economy. Apart from fraud and some abuses by financial executives, reasons for current malaise include excess supply of savings on world market (mostly by Asians leading to what Keynes called the paradox of thrift), and bursting of asset price bubbles. My solution has a clear-cut objective of artificially creating an inflation in US of about 5% in overall price level for next few years. I show that it is politically easy to sell and is low cost, due to market-based efficiencies. I explain sense in which it is easy to turn off almost overnight when market expectations respond with appropriate confidence, and hence as temporary as policy makers wish it to be. I show how Obama's stimulus package can be modified to be consistent with our proposal. A dose of inflation can make many of 'toxic assets' become benign and allow markets to determine price of assets, instead of 'stress testers' appointed by Fed.

The Put Problem with Buying Toxic Assets

This paper uses the option pricing arguments of Merton (1974) to demonstrate that even solvent banks will be reluctant to sell volatile, toxic assets at market prices. Banks' shareholders have insolvency puts that give them limited liability in the event of default. The insolvency puts are more valuable when the banks' assets are more volatile. Shareholders in banks will require any buyer to pay for the lost volatility as well as the market price of the toxic assets. Thus, taxpayers must be ready to richly overpay if they want banks to voluntarily part with their toxic assets.

The Housing-Asset Relief Program: A Plan for Stabilizing the Housing and Securities Markets

As many as six million U.S. homeowners are facing foreclosure during 2009 and beyond. Delinquent residential mortgages are at the heart of the ongoing financial crisis, as they have been packaged into mortgage-related securities originally worth trillions of dollars, but now valued at substantial discounts. I propose to address this crisis by striking at the heart of the problem - by refinancing delinquent mortgages. Approximately $300 billion in TARP or stimulus funds would be used to write down the principal on these mortgages so that new mortgages would meet underwriting guidelines for debt-to-income ratios. Delinquent mortgages would be repaid in the refinancing, eliminating approximately $1.5 trillion in toxic assets from the balance sheets of lenders and the asset pools underlying mortgage-related securities. This proposal is designed to achieve three goals: (1) to enable as many as six million families to avoid eviction and stay in their homes; (2) to recapitalize the banking system; and (3) to detoxify mortgage-related securities by eliminating delinquent mortgages from the underlying pool of assets, thereby avoiding the need for complex “price discovery” plans for pricing these toxic securities. This program deals with a number of practical problems that have dogged other proposals, including how to provide for significant principal reduction, how prevent ruthless defaults by healthy but underwater borrowers, how to deal with second-lien holders, how to deal with mortgages in pools of securitized assets, and how to properly price toxic mortgage-related securities.

Debt Overhang and Bank Bailouts

When a bank is deemed too-big-to-fail by regulators, it may be tempted to buy risky assets. This paper analyzes bank bailouts involving the purchases of toxic assets, preferred stock, and common stock when the government wants to encourage efficient lending. It finds that preferred stock recapitalizations are the least efficient in correcting debt overhang problems from both an ex post and ex ante perspective. In contrast, efficient lending and voluntary participation can be best achieved without subsidy by purchasing either toxic assets or common stock. Nevertheless, troubled banks must be subsidized if they will voluntarily participate in any recapitalization.

Toxic Tests

Lucian Bebchuk of Harvard argues that the U.S. stress test for banks was deeply flawed and other countries should at least try to gauge the long term losses on toxic assets.

Das Bilanzproblem der Banken – Ein Lösungsvorschlag / The bank‘s balance sheet problems: a proposal for a solution

Zusammenfassung In dem Aufsatz wird ein Vorschlag für eine Rettung des Bankensystems gemacht, der nicht zu Lasten der Steuerzahler geht. Dies geschieht durch die Anwendung des Instrument der Ausgleichsforderungen. Bereits zweimal, zum einen nach dem Ende des Dritten Reiches und zum anderen nach der deutschen Wiedervereinigung, wurden den Banken Ausgleichsforderungen zugeteilt, da die Aktiva durch Krieg bzw. friedliche Revolution zum größten Teil entwertet worden waren. Die Ausgleichsforderungen waren zum Bilanzausgleich gedacht, der aufgrund der asymmetrischen Umstellung von Forderungen und Verbindlichkeiten im Zuge der Währungsreform notwendig wurde. Diese Staatspapiere waren nicht fungibel, verzinslich und wurden im Laufe der Zeit langsam durch den Staat getilgt. Im Gegensatz zum damaligen Ansatz, schlagen wir vor, dass in der aktuellen Krise die toxischen Papiere, statt gegen verzinsliche, gegen unverzinsliche Staatspapiere ausgetauscht werden. Die Idee ist, die in den Bilanzen versteckten Risiken über die Zeit zu strecken und so dass die Banken die Zeche selber zahlen, ohne dass sie durch die Krise in die Insolvenz getrieben werden. Wie wir zeigen werden, ist diese Vorgehensweise aus ordoliberaler Sicht existierenden Lösungsansätzen vorzuziehen. Unverzinsliche Staatspapiere würden nicht nur den Steuerzahler schonen, sondern auch das Haftungsprinzip stärken und somit keine Anreize für ineffiziente Risikobereitschaft während der nächsten Blase schaffen.

Financial Firm Bankruptcy and Systemic Risk

Policymakers justify bailing out major financial firms by saying those firms are 'too big to fail.' They argue that such failure would subject the market to 'counterparty contagion' as the failed firms default on their obligations to other firms. But empirical evidence indicates that counterparty contagion is rarely at work in the financial world, as investors diversify their risks. On the other hand, the current crisis does appear to reflect 'information contagion,' where the failure of one firm reveals the instability of similarly positioned firms. Information contagion cannot be contained by a bailout of 'too big to fail' firms, but instead requires a broad government bailout of the broader financial industry. Such a bailout would only reward the least successful companies and prevent the better-run firms from gaining market share. Policymakers should abandon the notion that the major financial firms are 'too big to fail' and let them unwind their toxic assets through the orderly bankruptcy process.

Letter: Another Take on "Why Paulson is Wrong"

Paulson proposes a top-down solution to the financial crisis by government purchase of bad loans from the lenders to "clean" their balance sheets. But, Barton suggests, a bottom-up solution would be a subsidy to borrowers to ensure full payments, restoring the value of the "toxic assets," thereby cleaning up.

We Need to Guard Against Destructive Creation

We Need to Guard Against Destructive Creation* Jagdish Bhagwati (bio) It seems clear that the current financial crisis, terrifying though it is in its dimensions, will not be allowed to turn into the Great Crash of 2008. However, the larger lessons of the crisis, and its commonalities with previous calamities, must still be learnt if a new financial architecture is to be designed that can reduce the prospect of something similar happening again. We can be optimistic about the effective handling of this crisis based on several factors. The Great Crash of 1929 has taught everyone lessons in what to do and, more importantly, in what not to do. Monetary policy is being loosened, not tightened: we can thank Milton Friedman’s influential analyses for that. Fiscal policy will be expansionary, not deflationary: we all live in the age of John Maynard Keynes, whose fiscal prescriptions were unavailable in 1929 and grew out of the mistaken doctrines and policies of that time. The Smoot-Hawley tariff of 1930, which led to “competitive” increases in protectionism by all, accentuated the Crash. No one is willing to repeat that error. Neither Ben Bernanke, the Federal Reserve chairman, nor Hank Paulson, the Treasury secretary – nor for that matter, President George W. Bush, who must take ultimate responsibility – wants to go down in history as another President Herbert Hoover, who presided over the Great Crash. Besides, the ideology of the US is a lack of ideology. Where Nicolas Sarkozy, the French president, could not resist being photographed reading Marx’s Das Kapital and announcing the death of “capitalism”, the Americans settled down to fix the problem. They will do everything required to stem the crisis: for evidence of this, witness the shift of the $700bn (€515bn, £401bn) bail-out fund from buying toxic assets to recapitalizing banks. When the dust has settled, we must ask the question: why did this crisis occur? There are specifics that are not applicable everywhere. The crisis was, for example, kicked off by highly leveraged lending for uncreditworthy mortgages by the quasi-governmental Freddie Mac and Fannie Mae. But the problems became huge because “policy innovations” had been racing ahead of comprehension. The securitization of mortgages was an innovation that led unwittingly to what Wall Street calls “betting the company”. Creditdefault swaps allowed AIG to bring in huge returns but at high risk if things went wrong, which they did. The Long Term Capital Management crisis had a similar problem. At its heart were derivatives that no one quite understood. The Asian financial crisis was a result of a different [End Page 1026] innovation: the spread of capital account convertibility to economies that had registered miraculous growth for three decades, based on trade, but which were felled by their shift to financial convertibility. The downside had not been anticipated. In each case, the assumption was that financial innovation was like non-financial innovation. When the personal computer was invented, the economy profited without upheaval. The typewriter became obsolete – an example of what Joseph Schumpeter famously called “creative destruction”. But with financial innovation, the downside can be lethal – it is “destructive creation”. We have to work hard at defining the downside scenarios. The failure to think about the downside results from what I call the “Wall Street-Treasury Complex”. Robert Rubin went from Goldman Sachs to the Treasury and back to Citigroup. Hank Paulson went from Goldman Sachs to the Treasury and will doubtless return also to Wall Street. This network shares the optimistic scenarios that Wall Street spins. Mr. Rubin was in charge of the Treasury during the Asian financial crisis, whereas Mr. Paulson was among the five major investment banking chief executives who persuaded the Securities and Exchange Commission not to extend prudential reserve requirements to their companies. We therefore need a truly independent commission of experts to look closely at each financial innovation and work out its potential downside. Keynes once wrote that the inevitable never happens, it is always the unexpected. This commission would be charged with trying to narrow the range of the unexpected. We do not have to be blindsided by downsides just because we lazily surrender to the euphoria of the Complex. [End...