The Treasury program rolled out yesterday seems to have been quite popular and should have an impact on markets. The question is, therefore, what impact? The program really is not a “toxic” asset program, per se, but really just an asset program. The program is a continuation of the TALF and others meant to relieve constraints on AAA-bond hypothecation in repurchase markets. It is not, therefore, a substantial means of relieving banks of truly toxic assets or resolving insolvent institutions. Hence, the system is not out of the woods yet.
To get an idea of the program and estimate its impact on markets and the economy, let’s take a look at the collateral that is acceptable for purchase under the program. The collateral is whole loans or structured finance (SF) bonds that were AAA at origination. These are two separate issues. Today I will focus, however, on the SF.
The program is limited to funding purchases of bonds that were AAA at origination. AAA, however, is still the most stable rating category. According to Fitch, 12.8% of AAA SF bonds were downgraded in 2008, compared to 3.7% in 2007 and 1.3% historically, 1991-2007. Of that 12.8%, 40% remained above investment grade (IG) (5.16% of total) and 60% fell below IG (7.62% of total).
One of the worst performing sectors was residential mortgage backed securities (RMBS), where 15.11% of AAA bonds were downgraded in 2008. Of that 15.11%, 35% remained above IG (5.34% of total) and 65% fell below IG (9.77% of total).
Historically, including 2008, 97.01% of AAA SF bonds remained AAA, with another 1.71% downgraded but remaining above IG and 1.09% falling below IG. So the problem assets targeted by the program, the previously AAA assets that are rated something lower now, amount to about 2.99% of AAA SF bonds ever issued, or more liberally interpreted, the 12.8% of AAA SF bonds downgraded last year (worth roughly $250 billion in face value).
Now here is the important part: while AAA bonds comprise the largest dollar value segment of securitization markets, they bear the least risk. So while a AAA bond downgrade may meantan increased possibility of loss for AAA investors, it means that lower-rated junior investors have already lost money. The AAA-rated bond is not toxic – the lower-rated bonds is horrendously so.
Those junior investors, who typically own, on average, just under 3% of the pool in recent securitizations (down from more than 4% in older vintages), are the first to bear losses. As a result, those junior assets have historically been difficult, if not impossible, for commercial and mortgage banks to sell into an efficient market. Hence, banks typically kept those assets on their books, so that while a majority of claims to positive cash flows left the bank in the form of AAA-rated bonds, the majority of losses remained. THOSE junior bonds are the really TOXIC assets that are causing bank losses.
Bear in mind, however, the arguments above represent clarification, not criticism, and do not obviate the need for the present program. The present program’s intent is not to resolve truly toxic bank assets, but rather to restore liquidity in repurchase markets. Over recent years, repurchase markets came to accept AAA-rated SF as acceptable collateral, only to get stuck with a lot of lower-grade assets when the AAA-rated SF was downgraded. Once, bitten, repurchase markets are loathe to accept such collateral today, creating a vital liquidity constraint to even sound banks’ growth.
Restoring repurchase markets is important to financial system functions and this program will help. But now is not the time for Treasury to sit back and relax. More such ambitious programs will be necessary to address the crisis. Problems of bank insolvency still need to be addressed soon if we are to avoid more crises.
So, Treasury, the program is a good start. Get back to work.