Remember all the hype about "toxic assets"?



















Recently, concerns have arisen over the prospect that the government may force banks that received TARP money to raise capital in order to pay their way out.

Doing so would cause the banks to have to issue more shares of common stock, thus diluting the value of the shares currently outstanding, a prospect which yesterday prompted a sharp sell-off in shares of the larger banks.

The irony of this situation, and with the current discussion over the health of the banks, is that nobody seems to be discussing the status of the original "toxic assets" that supposedly necessitated the entire TARP program in the first place.

We have long held the position that the so-called "toxic assets" were really a kind of bogeyman created in large part by the well-intentioned but misguided mark-to-market accounting rules instituted in 2007.

Those accounting regulations caused banks to have to write down the value of assets -- such as mortgage-backed securities -- to whatever the market said they were worth at the time, which during the financial panic was next to nothing. We previously linked to this report from former FDIC Chairman Bill Isaac which gave an illustration from an actual bank which had to write down assets with face value of a billion dollars by a massive loss of $913 million, even though actual losses on the assets were only $1.8 million, with projections of losses of no more than $100 million.

The irony is that now, more than a year later and after the removal of that ill-conceived accounting requirement, those supposedly "toxic assets" have not imploded. In fact, current data would suggest that the main source of bank losses are from straight loans, not from the financially-engineered debt products that (in conjunction with a toxic accounting rule) caused such panic and led to the government forcing banks to accept TARP.

This recent article from Bloomberg shows that the real losses at banks have been from non-current loans that they wrote and kept on their books. As Louisiana State banking professor Joseph Mason says in the article, "While these aren't your giant banks, they are the guys your local strip mall and commercial real estate investors get their funds from." They are local loans that weren't securitized and packaged up into exotic structured products, but the kind of local development loans that have been hung out to dry by the recession.

It is also important to note that, just as in any other business, some banks were less wise in their business practices than others, and are now suffering the consequences. This is yet another reason why we do not advocate investing by "the whole sector" (whatever sector it may be), but rather advise investors to do their due diligence on the individual companies, and commit capital only to individual companies that meet rigorous criteria.

All this is not to say that we take a positive view of the financial engineering that went into the creation of the complicated debt instruments that played a starring role in the devastation of Wall Street in 2008. We have written many times that we take a dim view of the belief that investment risk can be engineered away with complex academic algorithms and theories.

However, the fact that these assets did not contain the level of losses that mark-to-market accounting was forcing firms to value them at raises significant questions. It is entirely possible that these banks never should have been forced to take TARP in the first place, and that the shotgun wedding of B of A and Merrill Lynch (for example) need never have taken place*.

Unfortunately, the repercussions of the over-reaction to the toxic assets that really weren't will echo through the financial system for decades to come.

* The principals of Taylor Frigon Capital Management do not own shares of Bank of America (BAC).

For later posts dealing with this same subject, see also:

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