Toxic debt and subprime crisis

Rattlesnake in the balance sheet?

Cyanide in the bank account?

 What it is about

What are usually called "toxic debts" or "toxic assets" (sa seen from the creditors side) or "illiquid assets" are mostly American investment instruments (securities and related derivatives) which have been backed by subprime mortgage loans.

The appelation is now extended to other "junk bonds",

even some sovereign debts are becoming toxic.

Also the monetary system is in trouble.

We are still not out of the risk of a "systemic crisis"

This knol addresses mostly the US subprime episode.

But it gives also some hints and links about those new "toxicities".

* The (rotten) loans themselves

The subprime loans were granted.

=> to buy overpriced houses

=> with no or little downpayments,

=> to people with too low incomes

=> and usually at progressive interest rates.

Those overleveraged loans, to people incited to believe that they could own a house at nearly no cost,  were actually speculations on a continuous rise of US real estate prices.

But that rise was actually a speculative bubble. It reverted into a crash in 2007, when many of those purported "owners" found themselves unable to bear the interest payments and faced foreclosure.

 (*) actually.

* The (toxic) financial instruments based on those loans

OK, but how those fragile operations were funded, as real estate developers asked for good money, even if they knew, or because they knew, the dark side of those tricks?

The financial deception used for that purpose was based on various - far from transparent - techniques:

Those assets were repackaged (securitization) by the lenders in order to look like bona fide securities.

Highly fragile, if not completely phoney, investment institutions (shadow banking), called "vehicles", "conduits"..., were created to bear and transmit thoses securities,

Derivative contracts, such as CDS / credit default swaps, were also sold, without any guarantee of market liquidity in case the covered (and highly probable) risks materialize.

All those financial instruments, which became at the end "toxic debt"" or "toxic assets", according to the side of the balance sheet from which to look at them, were bought and traded extensively by banks, funds, insurance companies and other institutions.

Their total amount (at their issuing price) was said to have reached at least 3 trillion US dollars, by taking into account those generated in the United States for real estate only, therefore not including

Other non performing US individual and business debts.

Bad mortgage debts outside the US (Ireland, Spain...).

And more recently highly risky sovereign bonds of countries on the verge of default

The effects (the real estate and banking crash)

* Incidences on real estate economics

Needless to say, such practices fuelled a real estate bubble with overbuilding and extremely high prices. The ensuing crash emptied entire housing development areas and led to personal bankrupties.

* Incidences on the financial sector

The value of those financial instruments is seen since the crash as highly dubious if not fully worthless, and therefore destructive for their holders (whence the "toxic" appelation). Those assets became illiquid as no investor or financial institution wanted to buy them anymore, even at a large discount.

This was akin to the fall of a pyramid scheme, in which the first investors are paid by the next ones' subscription until nobody anymore brings money because the fraud has become blatant.

Those toxic instruments have been the main damaging factor in the now famous 2007 - 2010 "Subprime crisis" and the related "credit crunch".

They have put in danger various prominent investment banks and other institutions which carry them in their portfolio. The damage was not limited to US based-institutions.

Many institutions had to write-off / write-down those assets in their books, and launch huge recapitalization operations. Some went bankrupt (Bear Stearns, AIG, Lehman Brothers...) or taken over (Fannie Mae, Freddy Mac, Merril Lynch, Royal Bank of Scotland, Dexia...).

* Was the economic recession a direct result?

Those impacts on financial institutions dried the financing sources. This contributed to the global economic recession that started in the end of 2007. Various other economic imbalances were also at play, but the credit crunch was an accelerator.

The 2007 -Â .... recession has been attributed nearly exclusively by many pundits to the subprime financial crisis.

That was a reductive view, a kind of availability heuristic that was ignoring other factors:

 * Unsustainable consumer overspending signaled by

    negative household savings in the US,

 * Commodity / energy price bubbles, as symptoms of economic overheating,

 * Foreign trade imbalances, public budget deficits,

 * Foreign exchange volatility...

The financial crisis might have sparked or accelerated the economic recession but there might be deeper causes behind as well the economic crisis as the financial crisis.

It seems for example that a lax US monetary policy played a crucial part in both.

Since then, the recession gave some sign of stabilization. By a slow recovery or a second dip cannot be excluded as

 * Some of the economic and financial imbalances mentioned above persist,

 * Some got more "problematic" (see the " "Will the second shoe fall?" chapter).

 * New ones appeared (high level of unemployment) or are seen as menacing (inflation?)

 * New speculative practices and near-bubbles appeared, fuelled by the new money created.

 * New sources of potential crises (sovereign bonds, currencies...)

Rescue plans by governments

The fist emergency moves were taken by the leading central banks to alleviate the immediate liquidity problems by offering huge amounts of new money on a short term basis to commercial banks.

But that "fire brigade" action needed to be completed by more fundamental actions by governments.

* In the US

A first 700 hundred billion US dollar plan devised by the US Treasury chief, Henri Paulson, was enacted in September 2008 with the objective to buy those debts to those institutions so as to avoid a world financial "systemic crisis". Those assets are bought, held and managed by a specific US Government-owned federal fund. Also that fund buy shares of some of the banks involved.

This was soon considered insufficient and a second "stimulus" plan nearing a 800 hundred dollar has been launched in the first months of 2009.

At the end of 2009 some banks have repaid the support they received and at the start of 2010 the US administration plan to send an invoice of 117 gigadollars to the largest US banks for part of its costs .

* In Europe

The European Union countries decided similar measures, completed by government guarantees on bank customer deposits. and even some bank nationalizations, considered as temporary.

But those countries went only slightly further with budgetary measures to boost the economy. They were generally wary that it would just increase the public debt while creating a "liquidity trap" as consumer would prefer, out of precaution against further economic trouble, to keep the money, or use it to refund debts (deleveraging), instead of spending it or investing it in productive assets.

There are some worries also about heavy financing done by various Western European banks to Eastern European businesses and states which financial situations are degraded. Even some countries from the Eurozone, like Greece, Ireland or Portugal are crippled financially and economically.

* Globally

The G20 (an informal organization of the 20 richest countries in the World) met several times since the start of the crisis, at the Heads of State / Heads of Government level, to coordinate the various moves initiated by those countries.

Also, they granted more financial means as well as monitoring powers to the International Monetary Fund.

The need of further global financial and monetary governance, and as one of its possible tools a global monetary instrument, was not tackled (see democratic globalization). That undealt issue might emerge later under market pressure (foreign exchange, sovereign bonds...) as seen in the following chapter or fhis knol.

* Will the second shoe fall? Is a second crisis in the making?

     Shoes or dominoes?

This section was launched in May 2009, nearly one year between the Greek crisis broke out and pundits and markets started to hint at a sovereign debt domino crisis possibility.

The transfer of debts and risks to public budgets has created a new problem:

There are doubts about the capacity of many goverments to reduce such huge debts even when the economy picks up.

Nobody is certain that highly indebted countries will find enough lenders in the coming years and at a reasonable cost.

Some alerts in that respect, that needed bailout measures; have already reached countries such as Iceland, Greece, Ireland, Portugal... But what about bigger countries? Are they really immune?

Some "unorthodox" schemes has been put in place, such as financing country public debts with money created by central banks ("quantitative easing"), creating a monetary danger that would have impacts on inflation, foreign exchange rates.

More generally, those central banks injected a massive volume of liquidity, instead of detering speculations by banks incited them instead to enter new ones. To take one aspect, the bank's trader's bonus issue stays largely unsolved

As stated above, no preparation seems to have been done at the global level to tackle a possible new crisis that would involve:

Money markets (interest rates) and foreign exchange markets (the US dollar issue, temporarily hidden by the Euro issue).

Government bonds (the next toxic debt?) and all bond markets more generally. Here, more details in the 2010 -... sovereign debt turmoil knol

Banks ...again, as among the main lenders to governments (together with other governments via central banks buying treasury securities).

Anyway, acting in parallel but with different approaches, the US and UE lawmakers decided in July 2010 stricter rules on bank activities and their capital adequacy.

The world monetary system (actually the lack of such a system), which experiences a nascent distrust towards most currencies, including the one which was the old reference and pivot, the US dollar.Advanced symptoms of global monetary troubles seems already at play, such as a relentless gold price rise and a general forex volativity. Is a global monetary collapse in sight?

To understand better: what is a "systemic crisis"?

A financial "systemic crisis" is when the collapse of an institution brings the fall or another one, then of another one still, and so on until most of them sink.

This cascade of failures is a "domino effect" due to:

Either emotional contagion. The clients, depositors or holders, consider that other institutions are as risky as the one that failed and take their money back (the typical example is a "bank run").

And/or a mechanical effet due to cross-interests between financial institutions. Some institutions with money deposited in a failing one suffer a heavy loss and become ruined on their turn. This brings the collapse of other ones for the same reason, and so on...

Also no institutions wants to lend money to other ones and prefer to keep it in safe assets. All of them are also reluctant to dig into those reserves to give loans to customers. We have here a "credit crunch".

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