Where's the toxic waste?

Where's the toxic waste?

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I noticed that William Isaacs mentioned a 20% default rate in a denunciation of Mark-to-Market accounting which was published in the WSJ on 9-19-08 (four days after Lehman failed). He commented about the anticipated default rate at that time: "...The dark cloud on the horizon was about $1.2 trillion of subprime mortgage-backed securities, about $200 billion to $300 billion of which was estimated to be held by FDIC-insured banks and thrifts. The rest were spread among investors throughout the world.

The likely losses on these assets were estimated by regulators to be roughly 20%. Losses of this magnitude would have caused pain for institutions that held these assets, but would have been quite manageable..." (See Note 1.)

Subsequently, Kenneth Scott and John Taylor (of Stanford University) discussed a complex "CDO2" derivative contract in the WSJ on 7-21-09. They reported that the rate of delinquency on that contract was about 20%: "...About 1,800 of the 7,000 mortgages still remain in the pool, with a current delinquency rate of about 20%..." (See Note 2).

Are you saying that **100%** of the "fat" on banks' balance sheets is derived from such "minor" percentages of bad assets which "floated to the top of the gravy jug" from *VARIOUS* derivative contracts? Are you saying that "the fat" in your example is *ALL* bad? Would you agree that it might constitute only about 20% of the total content of the "gravy jug," but would you say that, even though non-performing assets may only constitute 20% of any one derivative contract or even though they may only constitute 20% of *ALL* of any one bank's portfolio of such contracts, those twenty per cent are still worth nothing, so they should be marked down?

Does the apparent agreement of Isaacs, Scott, and Taylor about a default rate of about 20% on all of banks' derivatives help to explain why many banks may insist that their derivative instruments are doing well if those securities are "only" 20% in default, because 80% of the underlying contracts are performing as they were expected to perform? Does this explain why those banks believe they should hold those derivatives to maturity, possibly taking 20% losses, rather than try to sell the instruments at extremely low prices in a non-existent "after market" or mark them down to zero simply because no such after market exists? I may have this all wrong, and I admit I have neither training in these topics nor professional experience of them, but I think Isaacs' denunciation of M-t-M accounting is cogent. I've often thought that these complex securities were never intended for resale and were expected to be held by their initial purchasers to maturity. I therefore think it might only be appropriate to evaluate these securities by some type of actuarial "present value of money" calculations based on how well they're performing, not on what type of price they could claim in an after market which doesn't even exist. I notice that the FASB modified the Fair Value accounting rules shortly after the 3-10-09 US equities rally began...

Your presentations are wonderful. Are transcripts available?

Jeff Hook


1. William Isaacs' commentary is "How to Save the Financial System," at:


2. The Scott and Taylor Op-Ed text is "Why Toxic Assets Are So Hard to Clean Up" from:


Nice work. A great source of information. Thanks


Paddy Old Lad!
Another great presentation!What really great work you do!
Astonished and interested!What a
great education you are providing me.
Cheers to you old bean!
Bob Braithwaite

great education you are providing me!
Cheers to you old bean

Forgive me on my memory of current events, but werent the mark to market rules recently changed so the banks can value the 'fat' at their perceived fair value?

Also, doesn't the amount of fat on the books restrict lending, pressuring credit markets?

Hi Steve
Yes, the truly toxic stuff is indeed non-performing. As such, it should be marked to market. And the market for the truly toxic stuff is probably zero. The problem is twofold. Firstly, some banks would argue that there is no real market for the toxic stuff - because no-one wants to buy it, there is no bid, which means marking it would be guesswork. Secondly, some banks are still kidding themselves that the securities might recover someday and be worth something. So they're saying they're going to hold the paper to maturity, meaning they don't have to mark to market. If they were honest abut it, they would be marked down, but marking them all down at once, to their real levels, well, that could break them.

You draw the money as if it's there on the balance sheet "countering"the toxic stuff. But some that poured-out-gravy money was used for bonuses. Some was used to buy other banks. So drawing your picture as if it's all there to balance the toxic (and thus an excuse for banks not lending more) was not quite honest. I'm sure the bankers thank you but, Tsk tsk.

this was fantastic - thanks so much!


Your talent for explaining complex concepts is legendary. Any chance you could tackle the potential problems that a proposed Own-to-Rent plan (whereby once-homeowners get to stay in their homes but give up equity and rent from then on) would create for the housing market, securities holders, and banks?

Fantastic. Very illuminating. Keep up the good work!

Regarding "Where is the toxic waste" aren't these assets in the "fat" section "non-performing"? And as such, aren't they already marked down dramatically?

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