Working Title: Tracking Down Toxic Assets

Here's the first page of an article looking at how we figure out what's in those "toxic assets" which everyone wants to throw into a "bad bank."

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Introduction - We're not moving fast enough.

While there has been much handwringing by financial market observers, regulators, elected officials and others as our banking industry sways back and forth on the edge of a precipice, it appears that there is little understanding (but much fear) of the magnitude of the collapse of the credit markets on our banks and other financial institutions, and exactly where, and with whom, the problem lies. The consensus is that the collapse of the subprime mortgage market was a major cause of the current crisis. Asset-backed securities (ABS) and securitized assets created from the subprime mortgages originated in the now collapsed housing market make up the bulk of the so-called “toxic assets” now found in the portfolios of troubled banks. By identifying these assets and their owners, and establishing values (or a lack thereof) for them, the federal government and others will be better able to make informed judgments about what to do next, whether to absorb the assets of these institutions, or recapitalize those banks that need it.

Identifying the assets and establishing values for them is not an impossible task. There are threads to untangle, relationships to understand, and documents to review, all of which in the end will help us answer the question “how much?” But time is of the essence.

Make no mistake, this is a mess. The securitization market is complex, and was made more so as it burgeoned throughout 2006 and 2007. There are no central sources of unbiased, normalized information. Further, the picture of those who participated in this market is a moving target. The financial services industry has evolved faster in this decade than ever before, by any consensus description shared among knowledgeable participants, and new sub-sectors are emerging annually. The evolution of sub-prime mortgage origination mechanisms was only one of those feeding the explosion in types and volumes of derivative instruments. Importantly, it was also one at the center of the least regulated (and, hence, least documented) growth areas for structured financial instruments. Many of the originators of subprime loans are no longer in business; many of the institutions that bought and sold these products are no longer, or have been bought up or split up. Individuals who sold or structured the deals have disappeared. Put simply, the landscape has radically changed since the market exploded in 2006.

To unwind these securities, one must go back in time to re-create connections and transactions. Hindsight in this case is not likely to be flattering, but an accurate postmortem is critical if we are to learn from our mistakes. We are living through a significant, if not the most significant ever, credit crisis. This is not the first time, however, that markets have shown themselves to be inherently unstable in a given set of circumstances. Fortunately, we are living in a time where history itself is changing – we have audit trails and methods for deducing and analyzing recent past transactions and relationships that did not exist in prior crises.

There are three layers to understand as we begin the process of dissecting the asset-backed security/securitization market:

• The Participants – Sources of Investment Capital, Intermediaries, or Product Providers, those operating in and around what we call the “Trading Zone”
• The Instruments – Securitized assets, including their valuation components, and
• The Relationships between the Participants and the Instruments.

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