HOW TO MAKE "TOXIC" ASSETS "NON-TOXIC"

Treasury Secretary Geithner's discussion of greater Federal control over the financial sector and his suggestion that the Feds should be able to seize any major financial group that is in danger of bringing down the entire economy is generating lots of controversy. As for seizing large financial institutions, the Feds have already done this by acquiring Fannie Mae and Freddie Mac,the insurance giant AIG, major stakes in GM and Chrysler and looking to take on more. Technically the Feds have not "seized" these key enterprises but bought them, or at least a major stake in them. How the Feds manage their new portfolio is open to discussion, but their ability to do this is no longer a question.

As for new rules for the financial sector, I have already outlined how the Feds will restart and manage the "securitized debt" market. We have come to learn that in order for our economy to operate at the level it achieved by 2007, it must have "securitized debt," as well as "traditional" sources of credit.

Until 2007 this market worked well as a private activity with no visible market or specific set of government rules. However, no one had a complete understanding of how large this source of credit had become, how it operated, who owned what and so on. In the absence of a visible market and a clear understanding of the total construct of securitized debt, valuations of the assets, the bundled loans that were sliced up and sold as "securitized debt," were done by "models" that used related or even tangential factors to make their valuations. I am given to calling these models, "electronic Ouija Boards," since they are no more reliable a device.

The securitized mortgages, which accounted for the largest part of all securitized debt, were valued against the property market. As soon as the property market started to falter, the securitized mortgage debt was devalued to whatever level the model used determined. Those using the models did not wait to see defaults and foreclosures due to non-payment of mortgages as the reason to employ the models, in fact the models in general do not even take these factors into consideration. They worked solely on the value of the property market.

I see those who point to greedy Wall Street mavens as the cause of the financial crisis, or aggressive mortgage brokers, or lax Federal regulators and other "bad guys." However, the decline in balance sheets of major lenders was caused by those using their imperfect models to drive down the value of mortgage based assets and thus leave the holders with "over leveraged" assets.

As contradictory as it may sound, the Feds are starting to revive the securitized debt market in order to restore our economic health. Many say this means using the same "toxic assets" again and this will lead to even more economic upheaval. However, they overlook the main issue. As a totally private sector activity we had no idea how large the securitized debt market was and how it operated. Under Fed leadership and control, the market will be visible and readily understood by all.

Leo Cecchini
March, 2009