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Toxic assets
From CopperWiki
Sometimes the government steps in with the taxpayers money to bail out the afected company and stop a bigger crisis from occuring. Expersts say that toxic assets lead to privatization of profits and socialization of losses.
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[edit] Why should I be aware of this?
- Whenever products are mispriced and do not reflect the real costs and risks associated with their usage, people go to excess. That is exactly what happened in the financial marketplace.
- The big financial-services companies engaged in complex financial trading schemes that did not adequately price in the costs and risks of a market reversal.
- Toxic assets are nothing but loans or mortgage securities tied to the real estate boom. Huge quantities of such loans and mortgages are now sitting as figures on the balance sheets of banks as there are so few buyers in the market for these assets. As they are merely stuck on banks' books, they are eroding capital, constricting credit and undercutting confidence. If the economy has to be turned around, these toxic assets will have to be disposed of.
- As housing prices continue to drop the debt is becoming more toxic
- The longer the housing and banking crisis continues the deeper and more prolonged the recession will be, placing additional strains on financial markets
[edit] All about toxic assets
The crisis started with the mortgage crisis in the US — mortgages to buy houses and other forms of credit extended to underqualified consumers with less than solid credit histories. The loans were often repackaged and sold to banks and investors around the world.
[edit] “Mortgage-backed securities” are toxic assets
Toxic assets is another term for “mortgage-backed securities.” A mortgage-backed security starts with a bank issuing a mortgage loan to an individual who is buying a home on the condition that the new home owner will repay the loan, usually on a monthly basis, over an agreed period of time. The repayment is composed on principal and interest on the loan.
In earlier times getting a bank loan to build a home was a difficult process. Most home owners were required to put up 20 percent of the price of the house down before a mortgage loan could be granted. This requirement of down payment prevented many from owning a house. There also was additional requirement for paperwork listing your assets and liabilities and calculating your net worth. Your credit score, income, and employment were considered. Only once all the criteria were met mortgage loans were sanctioned.
In recent years a new practice was started to fulfill the dreams of all to own a dream home. Banks started putting together hundreds of loans and selling them to larger banks. The larger banks, in turn, packaged the mortgage loans together into what they call a mortgage-backed security.
[edit] Home loans made easy
This made easy for everyone who wanted to own a house to qualify for a mortgage loan. In the early part of the 21st century, when the U.S. housing market was booming, there was still high demand for these very profitable mortgage-backed securities. Banks started meeting these demands and began lending money for mortgage loans to people who did not have the level of income or credit that previous borrowers had. These were called sub-prime borrowers because they had a low credit rating.
These loans often started out at very low, affordable interest rates for a certain number of years but then they adjusted to a higher interest rate. Just like the conventional mortgages, they were packaged into mortgage-backed securities and sold to investors. Because the credit risk was higher for these sub-prime loans, the possible return on the mortgage-backed securities was even higher and was in great demand among investors. As these sub-prime mortgage interest rates began moving upwards, the homeowners couldn’t afford to make the payments, leading to an increase in home foreclosures. With the rise in foreclosures, the mortgage-backed securities lost their value and began to perform poorly for their investors.
[edit] Suddenly banks had no money to loan
In late 2006, foreclosures rose at an alarming rate and the value of mortgage-backed securities fell at an equally alarming rate. By 2008, it was clear that the big banks, those considered “too big to fail” had balance sheets full of mortgage-backed securities that were worthless because homeowners were not paying their mortgage payments and banks had foreclosed on their homes. As a result:
- Because of the huge mortgage-backed securities held by the banks, suddenly banks had no money to loan. They started posting huge losses.
- Consumers and businesses were unable to borrow, the companies unable to sell their products and services.
- The housing market was oversold and new houses didn’t sell.
- Existing houses up for sell didn’t sell because there were so many of them. *As companies were unable to sell their products and services their stock price dropped and they were forced to lay off workers.
- With rise in unemployment, consumers spend even less. It becomes a vicious circle and a recession happens.
This is how mortgage-backed securities, those “toxic assets,” brought down the “market” and the economy.
[edit] Corrective measures
Whenever there is a systemic banking crisis there is a need to recapitalize the banking/financial system. This is mostly done by buying the toxic assets of the banking system. However, such buyouts are carried out at a huge expense for the taxpayer - the common and preferred shareholders and even unsecured creditors of the banks.
- US plan to buy bad debts
The original plan of the US government was to buy up the bad debts - starting with the Citi Group - allowing cash-strapped banks to again make the consumer loans that are essential.
The Citigroup has got risky assets worth US$ 306 billion. This is equivalent to over half the total assets, nearly six times of market value as well as annual revenue, or about 50-times of full-year net profit of all Indian banks together.
The planned capital infusion of US$ 40 billion as part of a pact reached with the US Government's Treasury Department -- the central bank Federal Reserve and Federal Depository Insurance Corp, the government agency that is often appointed as receiver for failed banks, is one of the biggest rescue acts in the world's banking history, Under the deal, the government would also guarantee Citigroup's toxic or risky assets worth USD 306 billion, which are in the form of securities, loans and commitments backed by residential and commercial real estate and other assets.
[edit] CopperBytes
- All the Indian banks taken together have a current market capitalization as well as full-year revenue of a little over US$ 50 billion each
- Even the total assets of all the Indian banks, at about $ 580 billion, is estimated to be less than double the size of Citigroup's toxic assets.
- The total assets of all the private banks in India, at about US$ 150 billion, are only half the size of risky assets with Citi.
- The total full-year net profit of all the Indian banks together, at about US$ 6.5 billion, is just about two per cent of the toxic assets lying with Citi. [1]
[edit] References:
- Understanding the Bank Bailout
- Global EconoMonitor
- Toxic Assets: What They are and How They Brought Down the U.S. Economy
