What ARE the Toxic Assets Everyone Is Talking About?

Paul Krugman has already eviscerated Geithner’s toxic asset plan in the New York Times (see this, this and this). So have Yves Smith, Mish and many others.

But very few are taking a step back and addressing a more basic question: what are the toxic assets that Geithner is throwing taxpayer money at?

The answer is that the toxic assets include:

  • Credit default swaps (CDS)
  • Collateral debt obligations (CDOs)
  • Mortgage backed securities

In fact, these different classes of toxic assets are related.

Some CDOs are bundles of subprime and other mortgages sold in “tranches” (when you use a fancy word which sounds French, people assume it must be good). The rating agencies like Moody’s, S&P and Fitch’s gave crazily high AAA ratings to many of the tranches on the assumption that real estate prices wouldn’t fall nationwide.

They did, and so the CDOs plummeted in value and became “toxic”.

Other CDOs – called “structured finance CDOs” – are bundles of mortgage-backed securities and other asset backed securities.

Moreover, some CDOs – called “synthetic CDOs” – are bundles of CDS and other credit derivatives.

Similarly, there were huge CDS bets made that the companies buying or selling CDOs would stay solvent. When those companies started becoming insolvent, the CDS became toxic.

Can you see the relationship between all of the toxic assets?

What Should We Do With the Toxic Assets?

I obviously agree with Krugman, Smith, Mish and everyone else who is not directly making money off of this scam that it is a horrible plan which will probably fail and end up sticking it to the taxpayer.

But what people should be discussing is cancelling the toxic CDS and CDOs. As I have written repeatedly over many months in different ways, the American people should demand that the government rescind the CDS and CDOs.

The government has that power. Indeed, the same arguments which have been made for the government’s authority to cancel AIG’s bonus contracts can be used to cancel CDS and CDO contracts. In order to receive any more bailout money (or to keep the money they already received), the CDS counterparties and CDO holders need to cancel their contracts. And for foreign CDS counterparties and CDO holders, the government could simply say “we will not loan your central banks any more money unless you cancel the contracts”.

Do you think this is extreme?

Well, this is a much better plan that throwing trillions upon trillions of taxpayer dollars at banks (foreign and domestic), hedge funds, etc. And unlike Geithner’s plan, this could actually work.

And this is a national emergency. Rescinding CDS and CDOs is is a much better plan than seizing gold or using governmental emergency powers in other ways.

The government can do something productive and force a rescission of all of the toxic assets (or at least the CDS and CDOs).

At the very least, the government must give the counterparties and CDO holders a haircut and cram the dollar value of those contracts down to a very small amount.

If Obama fails to do this, the economy will be poisoned for years to come and may not recover for a decade.

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  • http://www.blogger.com/profile/13156080225918567393 The Grey Tiger

    Exactly, watching the circus the last few months it has become painfully obvious that all the derivative classes need to be blown away. I know this will wipe out a whole class of investors most of whom were rich to begin with and of course pension and retirement plans will suffer big losses. Better some investors than a nation. The statement in your post that said the rating companies rated these securities AAA because they believed real estate would always go up says they were spending their huge salaries on high grade dope is obvious. No thinking human being could possibly believe that when wages were falling and mortgages were as big as 10 times your annual salary. Stringent regulation and some serious jail time might keep this from happening again.

  • http://www.blogger.com/profile/17268676589486921213 Eric Vaughan

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