In this article we will talk about the toxic assets in the belly of banks. What they are and why they are in your bank’s balance sheets.
Banks have various assets within their balance sheets. among these we can find bonds, shares, loans and then various derivatives such as MBS mortagage backed securities, CDO and CDS (Credit default swaps).
The part that could be toxic almost all of the time are the last 3 elements, which are derivatives. These derivatives are created through securitisations.
Securitization is a financial technique specially designed to transform non-transferable financial instruments into other transferable financial instruments.
These transactions can generate cash flows, such as bank loans, and are “transformed” into divided and salable assets into bonds called Asset Backed Securities (ABS).
This financial activity is carried out to drain additional monetary resources from the market. Its popularity as a tool for raising loans has grown considerably in recent years, which has allowed banks to feed into the subprime mortgage granting mechanism.
Based on the securitized underlying, we can speak of securities like:
MBS (mortgage backed securities, the underlying of which are mortgages),
CDO (collateralized debt obligation, the underlying of which are public or private bonds),
ABCP (asset backed commercial paper, which are short-term credits).
To give you an example of real securitization, you have to think of a bank that has a number of real estate loans among its activities; if the bank decides to securitize these assets then it will issue securities, which have home loans as collateral, which will be sold to private or institutional investors.
Our bank sells this group of mortgages to a Special Purpose Vehicle (SPV for short), created specifically for the purpose, which issues bonds (in the specific case of mortgages, Mortgage Backed Securities) which sells to investors like Pension Funds.
The risk is transferred by the bank to the final subscribers of the bonds,the payment of interest of the bonds are linked to the effective collection of the interests of the loans themselves.
Understand that if these mortgages go unpaid, investors will see the value of their bonds go to zero. In the years before the subprime mortgage crisis there was a very sustained growth in securitisations all over the world, reaching a peak of approximately $ 11 trillion in the United States and € 2 trillion in Europe.
Understanding what a securitisations is, let’s get back to our toxic assets.
Sometimes banks don’t really know what’s in their belly as the rating agencies haven’t done a real due diligence, so the risk is masked or hidden and in the end the banks have bought assets whose problem only comes to the surface at the worst moment , like when debts are not paid.
Let’s show another example, let’s assume that all these assets are placed in a box and divide it into 3 parts.
We would find truly toxic assets, like financial products based on loans that will never be paid such as car mortgages, credit cards, home mortgages and personal loans.
Unfortunately, we all know someone who lives far beyond their possibilities. That someone is our toxic asset creator.
So these assets, which the bank paid at 100, are actually worth almost zero.
A second type of asset that we could find are long-term assets, or assets that today may seem toxic but which in the long term can be of excellent quality.
Think of a credit given to a company, like your neighbor who works seven days a week in his engineering company, which despite being small is an excellent shop, which has just modernized all its machinery. This company will be burdened with a large debt but with new machinery and its good management, within a few years it will pay off the loan and be profitable.
If the economy starts to grow again this kind of debt will all be repaid, so they are good in the long run but are also potentially toxic if the economy stalls or worse collapses
The third part, on the other hand, is made up of good payers, the couple who lives in the apartment next to yours and who have just changed the car for a bigger one because they want to expand their family. They are both employees, so they have a stable job and this potentially puts them in the category of debts that are paid consistently and always on time. These are great assets. They are owners of credit cards that pay their debts, mortgages that are regularly paid off, etc.
Now let’s look at everything in terms of the economy. At a time when the economy is in dire straits and slows down
The first group, toxic assets, actually has zero value.
The second group, the potential assets that the banks have paid at full price, begin to lose value.
The loss of value is not given by the payment problems by the debtors but because these assets are poured into the market because the banks have to cover their expenses and then sell them to make cash but the large amount of assets on the market causes the price to drop to a tenth of the initial value.
The second group would be an asset to be held but the banks need cash. Fast.
And the problem worsens as banks will have to account for these assets with their market price, no matter if the bank believes the value is 100. If the market prices at 50, this will be the value to be accounted for
The more pressure there is on the bank and other banks, the more they will have to sell these assets. Assets that are not toxic to payers, but toxic to the bank
As the economy continues to deteriorate, it is likely that the bank will also have to sell the assets of the third group, the best of the lot. This unfortunately in turn leads to a fall in the price of top quality assets and this means that even these become potentially toxic for the bank.
As you can see, everything is originated from the initial toxic assets.