20 April 2010

Toxic Assets

With health care seemingly out of the way, congress is turning its attention to finance reform. Last fall I posted my summary of the crash of 2008. I think there's little doubt that reforms need to be made in the financial markets. However, I've been wondering if those reforms need to be brought about through legislation or if there might be another way.

Most of the blame for the financial crisis has been leveled at investment banks and other institutions that hid risky investments behind complicated financial instruments. However, Credit Rating Agencies like Moody's and Standard and Poor's were complicit in creating the problem because, like the banks, they ignored the possibility of market-wide problems.

So, just as the cooperation of Credit Rating Agencies helped create the problem, CRA's could likewise drive much of the reform. Unfortunately, there continue to be allegations of inflated ratings and the agencies have avoided liability for past mistakes. Despite this I have hope that reform can come from this sector without legislative pressure.

The term "Toxic Asset" was invented in 2008 to describe the financial derivatives for which a value cannot be determined with confidence. The presence of large quantities of toxic assets on corporate and bank balance sheets froze the financial markets. There's are markets for high and low-risk securities. But when a risk or value cannot be determined with confidence, that's when markets freeze up. "Toxic Asset" is very descriptive term for such things.

What I would like to see is an agency that would report on the portion of a security -- stock, bond, or derivative -- that is composed of questionable derivatives. To do so with accuracy would require cascading fractions through the network of ownership. For example, if 15% of a bank's balance sheet is composed of toxic assets and 20% of a mutual fund is invested in that bank then the mutual fund would be rated 3% toxic (15% * 20% = 3%). Of course, some portion of other stocks in the mutual fund might also be considered toxic so the total toxicity of the mutual fund might be higher.

Creating a database that tracks the network of ownership would be complicated but not impossible. The information required is all in the public record. There would have to be a objective way of determining whether a fundamental asset is toxic. However, once the system is in place, it could also be used to rate cascading ownership in many other types of assets. Fractional ownership in business sectors such as manufacturing, education or hospitality could be measured through the cascading layers. Involvement in totalitarian regimes, conflict assets or vice business could also be tracked.

I suppose this is another of my Business Concepts. It would take a considerable up-front investment and a continuing investment to maintain the database but the ability to analyze cascading ownership would be a potent investment tool.

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