Are Toxic Assets Still a Threat to Financial Stability?

Remember those toxic assets that President Bush explained during a special evening address had posed a threat to the entire U.S. economy back in the fall of 2008? The bailout was originally designed to relieve banks of those assets, with the government planning to buy a $700 billion chunk of them. Once Treasury Secretary Henry Paulson realized how difficult that would be, however, he decided it would just be easier to give banks lots of money instead. The big banks have now mostly recovered, but many of those toxic assets remain on their balance sheets. Do they still pose a threat?

A Wall Street Journal Article today by Michael Rapoport examines the toxic assets still outstanding. First, there are some unrealized losses banks have already associated with such assets:

In part due to those bad assets, the top 10 U.S.-owned banks had $13.8 billion in "unrealized losses" that have lasted at least a year in their investment portfolios as of Sept. 30, according to a Wall Street Journal analysis. Such losses are baked into banks' book value, but don't get counted against earnings as long as the banks believe the investments will later rebound. If those losses were assessed against earnings, it would have reduced the banks' pretax income for the first nine months of 2010 by 21%, according to the Journal analysis.

In reality, however, this isn't a lot of money for the big banks. It would boil down to an average of $1.4 billion each. That's a lot of money, but not really for these banks. For example, JP Morgan made $17.4 billion in profit last year. If it realized an additional $1.4 billion loss, that would hurt the bank, but it certainly wouldn't endanger its existence. It's also important to remember that these unrealized losses haven't been declared in part because they could decline if assets increase in value as the economy improves.

But the unrealized losses only capture one aspect of the toxic asset exposure of these banks. Rapoport also writes:

One problem centers largely on "Level 3" securities, illiquid investments that can't be easily valued using market prices. According to the Journal analysis, as of Sept. 30, the top 10 banks had $360.7 billion in "Level 3" securities. That amounts to 42.6% of the banks' shareholder equity, a pile of assets whose value is hard to verify.

Now we're talking about some real money. This would average out to $36 billion per bank. Surely, banks would have some trouble withstanding a loss of this size. But there's no realistic possibility that banks would have to endure a loss of this magnitude, and particularly not all at once.

First, these assets are not all worthless. Let's say their value declined by a huge amount -- by 50% on average. Then the loss would only be $18 billion per bank. That's still a lot, but it's far more manageable than what the total size of these assets implies.

And in a recovering economy, a loss of that magnitude doesn't seem particularly likely. A large share of these assets are likely mortgage-related. The housing market is still hurting, but the vast majority of Americans continue to pay their mortgages. As those payments come in, potential mortgage-related losses shrink. If banks hold these assets to maturity, then the losses they will face should be relatively small and limited to the interest and principal lost as foreclosed properties are auctioned off.

It's also important to remember how long of a time horizon that would be. In some cases these assets won't mature for more than a decade, or indefinitely in some other cases. So even if big losses are in these banks' future, they will be spaced over the span of quite a few years. This won't make them any less painful, but it will make them less fatal.

The reason why these assets were so toxic in 2008 was due to panic. The market freaked out when it realized banks had huge portfolios of mortgage-related assets. Investors didn't know how many of these assets banks held or how deep their losses would be. As a result, the financial industry seized. Unless panic strikes again, banks can slowly endure the losses that result from these assets over time and avoid another crisis.