Let Us Talk About The Details

For those few people that read MONEYTHOUGHTS, I am going to once again try and explain what happened and what it is going to take to correct the fraud and mistakes of the past as it pertains to banking and the securities industry and the credit rating agencies.

The use by the media of such words as “toxic assets” and “meltdown” do not clarify just what is at stake. I would like to use a term I remember President Nixon often used, “crystal clear”, because our inaccurate use of language, I think, can keep us from solving our problems. The words “toxic assets” and “meltdown” do not tell us very much about what really happened or what needs to be fixed. The word “bubble” is another word that needs to be examined too.

What is a toxic asset? One definition of a toxic asset is that it is a loan or a bond where a market value can not be determined because no one is making an active market in the security. In the case of a loan, it is often a non-performing asset. It does not pay interest on the loan. Someone owes some one and the loan or bond’s value is uncertain because there is a meltdown and no one is making an active market in the note or bond and so they say it is toxic. The Federal Government buying up these toxic assets from the banks will free up a lot of capital because the toxic assets must be marked at market value under current banking and accounting rules. But, if there is no one making a market in a note or a bond, how does the bank determine the value of that asset without a bid or asked price? If the asset is down in price from book value or the cost basis, how can the bank know for sure what the asset is worth?

The meltdown of the asset-backed bond market simply means that no one is making an active market in those securities and that it is not possible to determine the value of these assets.

The whole problem goes back to what caused the real estate bubble? What is a bubble? What causes a bubble to grow? What is a bubble filled with? If this was a science question, I think just about everyone would agree that air fills up a bubble and more air makes the bubble bigger. The air that expanded and prolonged the real estate bubble was money. Money flowed into asset-backed bonds because of a few reasons.

First, asset-backed bonds had higher rates and higher yields. Second, US Treasury notes and bonds were lower in rates and yields and investors were reaching for the higher returns. The AAA ratings that were given these asset-backed bonds by the major rating agencies acted like the valve on an inner tube and let the tube get bigger and bigger until the tube burst. Without the AAA ratings, money in the United States and around the world would not have been poured into this class of assets. Money permitted the bubble to grow and a faulty “valve” the rating agencies, that could have prevented the bubble from enlarging by giving these bonds their proper rating, but failed again in their mission.

Bad loans and bad asset-backed bonds have the country’s banking system in a mess. The mess is because investors, here and abroad, do not know what the Federal Government’s plan to deal with the failed banks is going to be. As a result of this uncertainty, the market for all bank stocks has gone to hell.

The Federal Government needs to make itself clear and speak with one strong voice about the plan of action to stabilize and resurrect our banking system. A significant part of that resurrection must be a new rating system where conflict of interest is eliminated from the process of rating all debt securities.

No one that I read or listen and see on TV news programs is talking about fixing these problems, but rather just keep repeating words like “toxic assets”, “meltdown” and “bubble”. It is time to start examining, in detail, the parts of the problem and take quick action to correct the inadequate parts of the capital markets process.

Stay tuned.