Are Toxic Assets Out of The Banking System?

Investors haven’t heard the last of toxic assets by a long shot.

Despite surging stock markets and record quarterly earnings for Wall Street’s top banks an alarming amount of hard-to-value financial instruments still remain in the banking system.

“I think banks are less than 50 percent of the way through recognizing all the loan losses that they need to recognize,” Tanya Azarchs, banking credit ratings analyst at Standard & Poor’s, said. “Under accrual accounting, loan losses will take a while to develop. Until the borrowers actually do default, you can’t write it off.”

The label “toxic,” tossed around like a Frisbee over the past couple of years, has been loosely applied to assets that are highly risky, difficult to value, and nearly impossible to sell.

In a nutshell, a toxic asset is a product that makes buyers cringe. In 2007 to 2009, that was most of the collateralized debt obligations, credit default swaps, or mortgage-backed securities that the banks were desperately trying to shed.

Exact figures on how much of those assets remain on banks’ balance are hard to come by, but John Lonski, chief economist for Moody’s Investor Services, estimates that banks (including investment banks) are currently holding about $1.2 trillion, insurance companies are holding $250 billion, and US government sponsored enterprises have $240 billion.

Other estimates are lower.

Jim Eckenrode, banking and payments research executive at Tower Group, estimates that as of Dec 31, 2009 (the last date for which Federal Depositary Insurance Corporation numbers are available), total loans that are “nonperforming” across all US banks come in at about $530 billion, up from $396.5 billion in the year-ago period.

But in an indication that banks are still wary about the size of nonperforming assets, total loan loss provisions (the amount that banks reserve against future loan losses, based on their analysis of their loan portfolios), is $61.1billion, down only slightly from $71.1billion a year ago.

And while Fed holdings of agency MBS are generally non-toxic, a paper published by the New York Fed entitled “Large Scale Asset Purchases by the Federal Reserve: Did They Work?” asserted that $1.3 trillion in agency debt and MBS still remained on the Federal Reserve’s balance sheet as of February 2010.

“Many people assume that these assets will improve in the 5 to 10 year horizon – an assumption that could prove incorrect,” Bob McDowell, director of European banking at Tower Group, said. “There are assets that will come into deeper scrutiny in the next few years.”

Finding Gold in Toxic Assets

Despite the amount of such assets on balance sheets, toxic assets don’t appear to be clogging the banking system. And that’s good news for the many investors that have dived into financials, pushing exchange traded funds like the Dow Financial Sector Index Fund up 10 percent since the start of the year.

The Fed was quick to take the most toxic of these assets off the balance sheets of the banks that were too big to fail, engaging in large-scale asset purchases, bailouts and liquidity injections.

“Banks are trying to lend,” Azarchs said. “Corporations are flush with cash. They’re not hiring people or taking loans. Banks are willing to extend credit, but they can’t force companies. As the saying goes: you can take a horse to water …”

And some are even looking at these toxic assets as new investment opportunities.

“At one point during the crisis, high yield bonds were also thought to be toxic… but they have performed very well over the past year, generating returns of 50% or more. Toxic assets could follow suit,” Lonski said.

Anything Still Lurking off the Balance Sheet?

A more critical question may be not whether banks are holding toxic assets, but whether they are hiding them. Recent evidence suggests that Repo 105-type book-cooking and balance sheet manipulation has been a prevalent phenomenon among a lot of Wall Street banks.

But Lonski remained skeptical.

“In this type of environment, where regulators and investors are increasingly sensitive to risk appetite, it’s less likely that banks would want to be seen as understating risk,” he said

And while more unsellable instruments could prove another burden for the recovering banking system, it is possible that the current crop of toxic assets has hit the bottom.

“It depends,” said Azarchs. “Are we through the housing decline or not?  If there’s a wave of foreclosures, there could be downward pressure on prices. But the Case-Shiller index is already down 30%.  That’s significant. How much lower can it really go?”

“I don’t think the major financial institutions are inclined to gamble (more),” Lonski said. “They’ve been burned once before. These investments are, with a bit of luck, thoroughly researched.”