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Toxic Assets – Beginning of the End

by kraju

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In this article International Finance Magazine explains what is a toxic asset,fall of Lehman brothers, misuse of Repo 105 and its implications on the world.

An article from Bloomberg stated, Citigroup Inc., the third biggest U.S. bank by assets, reported that its first half costs at a unit holding some of the lender’s most toxic loans and securities multiplied by almost 10 times compared to the last year on account of higher legal expenses. The Special Asset Pool’s operating expenses climbed from $ 1.25 billion from the first six months of the year from $ 129 million in the same period last year.

“One of the legacy issues that we’ve got is continuing litigation coming out of our business in holdings,” said its Chief Financial Officer (CFO) John Gerspach. Private label mortgage backed securities are not guaranteed by government sponsored securities such as Fannie Mae or Freddie Mac. Investors can force banks to repurchase the underlying mortgages if they are faulty.  Many banks have managed to cut down their toxic assets, Citigroup for example, cordoned off its troubled assets in January 2009 with its creation of Citi Holdings. In the last two quarters the bank has managed to unload $ 56 billion in bad debt, including complex investment products like collateralized debt obligations, or CDO’s. Other banks have also taken the initiative of off loading their toxic assets by deploying teams of individuals called “special asset groups” who have been tasked with clearing out loans and other securities. AIG, the insurance giant which succumbed in the 2008 financial crisis has been given a fresh lease of life by the Federal Reserve which has bailed out the company by spending $ 31.5 billion and buying the troubled insurance company’s assets.

“The truth of the matter is many financial institutions are in much better shape than in February of March 2009” said Edwin Truman, senior research fellow at the Peterson Institute of International Economics.

Investopedia defines Toxic assets as “ An asset that becomes illiquid when its secondary market disappears. Toxic asset cannot be sold, as they are often guaranteed to lose money. The term “toxic asset” was coined in the financial crisis of 2008-09, in regards to mortgage backed securities, collateralized debt obligations and credit default swaps, all of which could not be sold after they exposed their holders to huge losses.

A toxic asset can be described by this example:

If Jonathan buys a house and takes out a $ 500,000 mortgage loan with a five percent interest rate through Bank “A”, the bank now holds an asset – a mortgage backed security. Bank “A” is now entitled to sell the asset to another party Bank “B” is entitled to the 5 percent mortgage interest paid by Jonathan. As long as the house prices go up and John continues to pay his mortgage, the asset is a good one. However, if Jonathan defaults on his mortgage, the owner of the mortgage (Bank “A” or Bank “B”) will no longer receive the payments to which he is entitled. The value of the house would have gone down and only a portion of the money can be recovered. As, a result the securities based on this mortgage would not sell in the market as no one would pay for an asset that is guaranteed to lose money. In this example, the mortgaged backed security becomes the Toxic Asset.

Collapse of Lehman Brothers

Founded in 1850 by three immigrants from Germany, Lehman Brothers had been a prominent investment bank in Wall Street for decades, it operated at a wholesale level, dealing with governments, companies and other financial institutions, employing 28,000 people worldwide, with 5,000 employees in the U.K. The scandalous part of the Lehman brothers collapse was uncovered when they tried to cover up their abysmal financial situation. The bank sold $ 50 billion worth of toxic assets (mortgage backed securities) to different banks in the Cayman Islands with the promise that they would buy them back within a short time,(which is legal) this promise to buy them back makes the transaction a loan, not a sale. But Lehman Brothers used a combination of illegal and sneaky accounting to make their companies cash balance appear to be $ 50 billion greater than it actually was and made their toxic asset balance lesser by $ 50 billion than they were actually. Therefore it appeared that the bank had made sales of $ 50 billion when in fact they had borrowed $ 50 billion from different banks in the Cayman Island and showing them as a Repo 105 transaction. A “Repo 105” (a kind of window dressing) is a short term loan that is classified as a sale.

For example: If Lehman owned a bond that was worth $ 105, it would sell it on the repo market for $ 100. The investment bank would then take the money it got from selling the bond and settle some of its debts. After it had issued the quarterly report, the company would borrow more money to repurchase the bond.

The bank which was dubbed as the “The Real Estate ATM” said in August 2007 that it would make write downs to the extent of $ 700 million to adjust the value of its investments in residential mortgages and commercial property, a year later the figure soared to $ 7.8 billion, it also admitted of having $ 54 billion worth of hard-to-value mortgaged backed securities. It’s over exposure to the U.S. real estate market, huge investments in subprime mortgages and innovative but risky investments such as collateralized debt obligations and credit default swaps also contributed to its downfall. Lehman which once employed more than 28,000 employees, 5,000 in U.K alone, traded at a value in the NASDAQ at $ 85 at its peak and with a 158 year history it failed because it traded on Toxic assets and taking too much risk on a booming market. Its share value had plummeted by 95 percent

On 15th September 2008, it was curtains for the bank as it filed for Chapter 11 bankruptcy protection, which allows a company to reorganise and devise a plan to pay back its creditors. The fall of the investment banking giant precipitated the financial crisis worldwide and a loss of confidence among major banks and a major financial crisis throughout the world. 

http://www.internationalfinancemagazine.com/article/Toxic-Assets-Beginning-of-the-End.html

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