Shattering the myth of 'toxic' assets

The picture presented these days regarding so-called toxic assets is one of a financial wasteland where investors do not see value at any price and the securities are left to rot on bank balance sheets. While some sellers don’t like the prices they’re seeing and call the assets “toxic” and “illiquid,” markets for many such assets are, in fact, alive.

Indeed, information gaps among policymakers and investors are clouding some of the key issues that need to be faced in the current financial crisis. These information gaps have allowed confusion to linger and sapped confidence from the markets, all despite recent well-intentioned efforts from the Treasury Department to move these assets off bank balance sheets. If allowed to continue, this unfortunate state of affairs will only further exacerbate the downturn.

The realities of the current market may be surprising, especially given that some misconceptions have become so pervasive as to be seen as virtual truisms. These realities help close the information gap and help us on the path to financial recovery.

There is a market for “toxic” mortgage assets. Ten major dealers and numerous smaller boutiques will commit their own or others’ capital to non-agency residential mortgage-backed securities. Daily volume in residential mortgage-backed securities runs into the hundreds of millions of dollars — which has been the case for most of the past two years.

There also are two actively traded indexes, both owned and administered by Markit Group Ltd. One is the Markit ABX.HE, a synthetic tradable group of indexes representing a basket of subprime mortgage-backed securities, a benchmark owned and administered by Markit Group. The other is the Markit CMBX, a synthetic tradable group of indexes representing a basket of commercial mortgage-backed securities.

Trading volume for these over-the-counter indexes has exceeded $1 billion on the recent active days, highs that are similar to historical peaks.

Mark-to-market accounting is blamed for forcing financial institutions to price their portfolios at ridiculously low valuations, leading to stock price declines, difficulty in funding and a negative feedback loop that has caused the demise of otherwise sound companies. The belief is that somehow market prices have stopped reflecting “intrinsic” or “fair” value.

This is like blaming thermometers for global warming. Mark-to-market accounting is a reflection of reality. Discerning market participants will always perform their own estimates of value based on multiple arm’s-length transactions, which are a more objective gauge of value than subjective estimates put forth by conflicted stakeholders. Mark-to-market accounting works.

What has truly exacerbated the crisis is lack of transparency. Instead of getting rid of mark-to-market accounting, financial institutions should instead make more granular disclosure of what they own and where they have it valued, which will increase confidence and speed the path to economic recovery.

For example, institutions could report the value of securities using mark-to-market accounting where markets exist, as well as their own estimates of value. Regulators could decide to base capital requirements on more flexible valuations, such as in guidance proposed in April by the Financial Accounting Standards Board for Statement 157. But let’s have more transparency, not less. This maximizes objective information, enabling market participants to form a more orderly consensus around valuations.

Credit default swaps are frequently characterized as tools for predatory market operators to manipulate prices and force calamity on companies by attacking their perceived credit quality. This perception is seen as hampering a company’s ability to source funding at fair levels. Moreover, some view CDS as a small, illiquid market with limited players, allowing traders to easily manipulate valuations.

The reality is CDS spreads reflect the opinions of scores of investors globally, all of whom are risking capital. Credit default swaps provide an accurate picture of risk.

CDS spreads proved to be accurate predictors of risk in the cases of Washington Mutual Inc. and Lehman Brothers Holdings Inc., and they have also reflected the credit risk of auto manufacturers, which sought federal assistance and whose viability remains in question. As with mark-to-market accounting, CDS prices are more a symptom of financial stress than the cause of it.

Even if CDS spreads were being pushed out unfairly by short sellers or others with manipulative agendas, the best defense would be increased transparency. A company under such an attack could simply give full disclosure of their holdings and valuation methodologies and allow market participants to objectively value the business. If the CDS prove to be unfairly priced, then investors can make money by selling protection. Opaque markets and limited disclosure create the most favorable environment for market manipulation.

Rather than being demonized, CDS should be seen as another tool for expressing a value judgment. As steps toward this goal, CDS contracts are already using standardized documents and settlement conventions. To further improve transparency and minimize systemic risk, a centralized clearinghouse is being developed to replace the current over-the-counter market and should be operational in the near future.

Reliable information and sound ideas are critical to enabling investors to make informed investment decisions, for lawmakers to craft sound policy and, most importantly, for taxpayers to have confidence in the economy and the policy decisions being made by their representatives. Closing the information gaps and dispelling misconceptions will go a long way toward putting this financial crisis behind us.

Anthony Lembke is managing member and co-chief investment officer, MKP Capital Management LLC, New York.