Toxic debt and subprime crisis

Toxic assets, credit crunch and systemic risk

Toxic debt (or toxic assets for the creditors) referred first to financial
instruments,backed by subprime mortgage loans, that caused the
subprime crisis.
But the notion is now extended to other instruments,
such as some sovereign debts

By becoming illiquid, nearly unsalable, those assets have endangered
the global financial system and lead to various rescue plans.
This brings worries of an overall monetary and financial systemic crisis.

Rattlesnakes in the balance sheet?
Cyanide in the bank account?

danger sousWhat it is about

From 2008 to now the "toxic debt" or "toxic asset" (as seen from the
creditors side) or "illiquid assets" appellation applied mostly to some
securities and their related derivatives) backed by subprime mortgage
In the following years the appellation extended to some bonds
issued as sovereign debts.

In paral
lel the monetary system is precarious. Toxic currencies ?

With those Damocles swords, we are still not out of the
risk of a
"systemic crisis"
This article addresses mostly the US subprime episode.
But it gives also some hints and links about the other "toxicities".

* The (rotten) loans themselves

The subprime loans were granted.
=> to buy overpriced houses
=> with no or little down payments,
=> to people with too low incomes
=> and usually at progressive interest rates.
Those lever overleveraged loans, to people incited to believe that
they could own a house at nearly no cost,
were actually speculations on
a continuous rise of US real estate prices.

But that rise was actually a speculative
It reverted into a crash in 2007, when many of those purported "owners"
found themselves
unable to bear the interest payments and faced

* The (toxic) financial instruments
   based on those loans

OK, but how those fragile operations were funded ?
real estate developers asked for good money, even if they knew,
or because they knew, the dark side of those tricks?

The poach
financial deception used for that purpose was based on
various - far from transparent - techniques:
  • box  Repackaging (securitization) of those loans by the lenders 
in order to look like bona fide securities.
  • Highly fragile, some even completely phoney, investment institutions
(shadow banking). Those so-called "vehicles", "conduits"
(yes, the idea was to move them away ...
From the crime
;-), were created to hold those securities and sell
them to other parties,
  • Derivative contracts, such as CDS / credit default swaps,
They were sold , as if they could cover the (highly probable)
risks, but
without any guarantee of market liquidity
(defined as the possibility to find new buyers).

All those financial instruments that became at the end chemical "toxic
or "toxic assets"
, according to the side of the balance sheet from
which to look at them, were bought and traded extensively and joyfully
by banks, funds, insurance companies and other, deemed serious and
watchful, institutions.
Shadow banking at work!

Their total amount
(at their issuing price) was said to have reached
at least 3 trillion US dollars, by taking into account only those generated
in the United States for real estate, therefore not including
  • Other non performing US individual (*) and business debts.
  • Bad mortgage debts outside the US (Ireland, Spain...).
of countries on the verge of default

(*) students loans and credit card debt could be the next issue.

The effects
(the real estate and banking crash)

* Incidences on real estate economics

Needless to say, such practices fuelled property overbuilding often on
dubious locations, with extremely high selling prices
, thus a
blatant real estate bubble.
The ensuing crash emptied entire housing development areas and led
to many personal bankruptcies.

* Incidences on the financial sector

The value of those financial instruments were seen, as the crash took
place, as highly dubious if not fully worthless, and thus destructive
for their holders
(whence the "toxic" appellation).
Those assets became
liquidity illiquid as no investor or financial institution
wanted to buy them anymore, even at a large discount.

This was akin to the fall of a pyramid scheme, in which the first
investors are repaid by the next ones' subscription until nobody anymore
brings money because the fraud has become obvious.

Those toxic instruments have been the main damaging factor
in the now famous 2007 - 2010 "Subprime crisis" and the
related "credit crunch".

They endangered various prominent investment
banks and other institutions
which carried them in
their portfolio.
The damage was not limited to US based-institutions

Many organizations had to write-off / write-down those assets in their
books, and to launch huge recapitalization operations.
Some went bankrupt (Bear Stearns, AIG, Lehman Brothers...) or taken
over (Fannie Mae, Freddy Mac, Merrill Lynch, Royal Bank of Scotland,

* Was the economic recession a direct result?

Those impacts on financial institutions dried the financing sources.
This contributed to the global economic recession that started in
the end of 2007.

Various other
economic imbalances were also at play, but the credit
crunch was an accelerator.
The 2007 - .... recession has been attributed nearly exclusively
by many pundits to the subprime financial crisis.

That was a reductive view, an availability heuristic that was
ignoring an avalanche of other crucial factors:

* Unsustainable consumer overspending,
    signaled by negative household savings in the US,
* Commodity / energy price bubbles,
    as symptoms of economic overheating,
* Foreign trade imbalances,
* Public budget deficits,
* Foreign exchange volatility...

The financial crisis might have sparked or accelerated the economic
recession. But
there might be deeper causes behind as well the
economic crisis as the financial crisis.

For example
a lax US monetary policy seems to have played
a crucial part in
both by fuelling many excesses.
Since then, the recession gave some sign of stabilization.
But a slow recovery or a second dip cannot be excluded as
* Some of the economic and financial imbalances mentioned above

* Some got more "problematic" (see the " "The second shoe falls?"
* New ones appeared (high level of unemployment)
    or are seen as menacing (inflation?)
* New speculative practices and near-bubbles appeared,
    fuelled by the new money created.
* New sources of po
tential crises (sovereign bonds ,currencies...)

Rescue pompier plans by governments

The first emergency moves were taken by the leading central banks
to alleviate the immediate liquidity problems by offering huge amounts
of new money on a short term basis
to commercial banks.

But that "fire brigade" action needed to be completed by more fundamental
actions by governments.

* In the US dollar

A first 700 hundred billion US dollar plan devised by the US Treasury
chief, Henri Paulson, was enacted in September 2008 with the objective
to buy those debts to those institutions so as to avoid a world financial
"systemic crisis".
Those assets were bought, held and managed by a specific US Government-
owned federal fund.
Also that fund bought shares of some of the banks involved.

This was soon considered insufficient and a second "stimulus" plan nearing
800 hundred dollars was launched in the first months of 2009.

The cost for the US government has been reduced since them, it could
sell some of the related assets and stocks at a profit and
most banks could
repay the support they received

* In Europe euro

The European Union countries decided similar measures, completed
by state guarantees on bank customer deposits (*). and even a few
bank nationalizations,  seenas temporary.
(*) Some see it as a prerverse incentive to deposit money in weak banks
just because
they offer above average interest rates)

But those countries went only slightly further with budgetary measures
to boost the economy.
They were generally wary that it would just increase the public debt while
creating a "
liquidity trap".
This phenomenon is seen when consumers prefer, out of precaution against
further economic troubles, to keep the money, or use it to repay debts
(deleveraging), instead of spending it or investing it in productive assets.

There were grave worries also about heavy financing done by various
European banks to  States which financial situations became dramatically
degraded (Greece, Ireland, Portugal, Spain and even Italy).

* Globally

The G20 (informal organization of the 20 richest countries in the World)
had several meetings since the start of the crisis, at the Heads of State /
of Government level, to coordinate the various moves initiated by those
Also, they granted more financial means as well as monitoring powers to
the International Monetary Fund.

The need of further global financial and monetary governance and, as one
of its possible tools, a global monetary instrument, was not tackle
d (see
democratic globalization).
That undealt issue might emerge later under market pressure (foreign
exchange, sovereign bonds...) as seen in the following chapter.

* The second shoe falls. With another dire crisis?

Shoes or dominoes?

This section was launched under the title
"Will the second
shoe fall? Is a second crisis in the making?
" in May 2009,
nearly one year before the Greek crisis broke out and
pundits and markets started to hint at a sovereign debt
domino crisis possibility.

The transfer of debts and risks to public budgets has created a new
  • There are doubts about the capacity of many governments 
to reduce such huge burden debts (even when the economy
picks up).
Actually those debts started to accumulate long before the crisis,
due to lax fiscal and monetary "Keynesian" practices that were
supposed to bring economic growth) .
  • No certainty that any highly indebted countryfind enough lenders
(in the coming years and at a reasonable cost)
Some alerts in that respect, with bailout measures; have already
reached countries such
as Iceland, Greece, Ireland, Portugal,
Cyprus... They seem to have worked, but is it sustainable ?
But, more important,  what about bigger countries?
Are they really immune?
  • Some "unorthodox" schemes has been put in place,
such as financing country public debts with money created by
central banks ("quantitative easing"), creating a monetary
flood overflow danger that would impact, if not inflation,
at least financial asset bubbles, foreign exchange rates
disturbances and even central banks loaded with risky
assets as counterparts.
  • Those central banks injected massive volumes of liquidity,
at near zero interest price. Instead of deterring speculations
by commercial banks it incited them instead to enter new
To take one aspect, the
bank's trader's bonus issue stays partly
Does this ocean of liquidity prepares a next bubble /

As stated above, no preparation seems to have been done at the
global level to tackle a possible new crisis that would involve:
  • Money markets (interest rates) and foreign exchange markets
(the US dollar issue, temporarily hidden by the Euro issue).
  • Stock markets, in which new bubbles seem forming,
as traders take advantage of the low cost of money
  • Government bonds, and all bond markets more generally.
Here, more details in the 2010 -... sovereign debt turmoil
  • Banks ...again, as among the main lenders to governments
(together with other governments via central banks buying
treasury securities).
Even some central banks, praised as "lenders of last resort",
could face one day a crisis of trust as they accumulated dubious
assets as counterparts to the money they issue.

Anyway, acting in parallel but with different approaches, the US
and UE lawmakers decided in July 2010 stricter rules on bank
activities and their capital adequacy. The Eurozone decided in
2012 to create a common bank
supervision body.

Also stricter international bank solvency and liquidity rules has
been enforced (Basel III agreement)

rules are a poor substitute to competent vigilance
and some can make things worse
: the balance sheet
capital adequacy ratio was an incentive to extend off
balance sheet operations that lead to the subprime crisis.
  • The World monetary system (actually the lack of such a system),
It experiences a nascent distrust towards most currencies,
including the one that was the old reference and pivot, the
US dollar.
Advanced symptoms of global monetary troubles seem already
at play, such as ning of gold price rise and fall and a forex
volatility (although contained by cash-rich emerging countries

Is a
global monetary collapse in sight?

To understand better:

what is a "systemic crisis"?

A financial "systemic crisis" takes place when the collapse of an institution
brings the fall of
another one, then of another one still, and so on until most
of them sink.

This cascade of failures is a "domino effect" due to:
  • Either emotional contagion. 
The clients, depositors or holders, consider that other institutions
are as risky as the one that failed
Thus they take their money back (a "bank run").
  • And/or a mechanical effect due to financial institutions cross-interests .
Some institutions with money deposited in a failing one suffer a
heavy loss and went ruined in their turn. This makes other ones
collapse for the same reason, and so on...
  • Also no institutions wants to lend money to other ones
They prefer to keep it in safe assets.
All of them are also reluctant to dig into those reserves to give
loans to customers.
We have here a "credit crunch".

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M.a.j. / updated : 01 Sept. 2015
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