A Story About Assets That Weren’t Toxic

Though we are almost a decade removed from 2008, memories from the Financial Crisis still linger in the media's narrative. From oil crashes to subprime in the auto industry, folks are constantly on guard for a 2008 redux. On the flipside, we see stories heralding the individual brilliance of investors who "turned toxic assets into gold" or succeeded in a market that "everyone left for dead" during that period. In our view, this indicates investors still don't have a great grasp on what actually drove that 2008 crisis and bear market. Understanding the Financial Crisis's root causes can help banish those media-conjured ghosts.

One of the frequently cited causes for the 2008 Financial Crisis was the proliferation of "toxic assets," which broadly refer to mortgage-backed securities (MBS) and other securitized loans (e.g., collateralized debt obligations, or CDOs)-a bunch of loans bundled together, then sliced up into interest-bearing securities. These complex assets, beloved of banks and hedge funds, didn't trade often, making it difficult to assess their value on the spot. Conventional wisdom argues the credit ratings agencies wrongly deemed them investment-grade, ignoring the often sloppy quality of the underlying loans, and overleveraged banks gobbled them up while ignoring risks they should have seen. When the housing bubble burst, the house of cards collapsed as borrowers defaulted en masse, exposing MBS as toxic filth, taking the entire financial system and economy down with them as banks fell victim to their own creativity and avarice.

However, what if the assets themselves weren't really toxic, but were infected by a poisonous accounting rule instead? Consider: The beginning of the bear (October 2007) started not long before the implementation of FAS 157-mark-to-market accounting-in November. The bear didn't end until March 2009, right around the time Fed chair Ben Bernanke spoke of revising the rule and a congressional hearing on the subject demanded the Financial Accounting Standards Board (FASB) take action (they suspended the rule on April 2). The evidence suggests this isn't simply a matter of conflating coincidence with causation, either.

To summarize, mark-to-market accounting required banks to mark assets on their balance sheet to their current market value. For illiquid, thinly traded assets like MBS and CDOs, that meant valuing them at the most recent sale price. Banks intended to hold these securities to maturity, collecting the interest along the way, but FAS 157 forced them to act as if they intended to sell. The result: a destructive feedback loop. As the housing sector sputtered and subprime mortgage defaults escalated, investors started fearing for hedge funds with leveraged exposure-particularly two at Bear Stearns. To meet redemption requests and margin calls, the hedgies were forced to sell these securities on the cheap. Before mark-to-market, this wouldn't have hurt investors who intended to own these securities forever. If they didn't intend to sell, they didn't have to account for them as if they would-they could just hold them, collect the interest and go about their merry way.

But FAS 157 forced any financial institution holding comparable assets to write down the value to those fire sale prices-or, what they'd get if they sold tomorrow. Those paper losses hit earnings and capital, spooking investors and drying up interbank funding. Bear Stearns was the first to fall, when mounting questions about its balance sheet and collateral quality locked it out of credit markets, and it ran out of cash to cover day-to-day operations. Though it had a wealth of long-term assets, illiquidity made it functionally bankrupt, so the Fed arranged for JPMorganChase to buy it out. That calmed markets for a while, but then Merrill Lynch fire-sold $31 billion in MBS in July, causing another round of writedowns. And another round of firesales. And another round of writedowns, all of which dinged earnings and capital, making short-term bank funding ever-more scarce. Freddie Mac and Fannie Mae fell in September and were nationalized by the government, wiping out shareholders. Later that same month Lehman Brothers fell into the same predicament as Bear Stearns, but as transcripts show, the Fed decided to make Lehman an example and let it fail. The vortex then sucked in AIG, one of Lehman's main counterparties, so the Feds nationalized it. If this series of events makes you dizzy, imagine it playing out in real time: The uncertainty and chaos roiled markets and liquidity dried up. All stemming from one costly accounting rule!

In a telling example, former FDIC chair William Isaac showed how mark-to-market accounting horribly distorted values. Based on a case study of a tranche securities owned by Wells Fargo, one MBS' maximum expected losses was $100 million, and it held $172 million in subordinated collateral. Yet FAS 157 forced the bank to record losses as $913 million-more than 800% of the highest projected losses. This needless destruction of capital forced some firms-e.g., Bear Stearns and Lehman Brothers-under as they couldn't access cash to meet daily needs, and, coupled with the government's haphazard and inconsistent response, turned the episode into a full-fledged panic, decimating investor confidence.

Ours is one of many hypotheses about 2008, and in the years since, the evidence supporting it has steadily built up. If the assets themselves were toxic, rather than the accounting rule, time would prove them to be failures. Yet that doesn't appear to be the case. Those securities came back-and even became profitable-years afterwards. CWABS 2006-7, for example, went from presumed dead to nearly recovering its value by 2013. There are also individual stories of investors who bought low and reaped the rewards. A team at Citigroup bid on a portfolio of CDOs in 2012-paying $6.3 billion, an average of 38 cents on the dollar-which has paid off tremendously. The bank has a firm hold on the CDO market and has pulled in almost $2 billion in revenue over the past three years. Similarly, across the pond, two individuals' big bet in the mortgage-backed bonds of failed UK bank Northern Rock worked out in a big way, as the debt regained almost all its face value by the time it was redeemed. Though Northern Rock wasn't subject to FAS 157, mark-to-market accounting had a global ripple effect since it decimated the mortgage-backed securities market, so UK banks felt it too. This is all compelling evidence of a misapplied accounting rule.

Now, perhaps a skeptic would argue these are all one-off anecdotes, highlighting the talents of brilliant traders. However, there is a clear-cut example showing the accounting rule, not the assets, was toxic: Maiden Lane. Maiden Lane refers to three funds the Fed used to buy various "toxic" assets, and the first was established during the Bear Stearns saga. JPMorganChase would agree to participate only if the government took on Bear's troubled assets-which the Fed did via Maiden Lane I. This put supposedly toxic assets into a non-FAS 157 environment (since mark-to-market accounting didn't apply to the Fed), establishing a counterfactual.^[i] How did the assets fare without that accounting rule's onerous effects? Just fine, actually. The Fed's Maiden Lane fund actually produced profits because those "troubled" assets matured and paid back interest. How could an allegedly toxic asset possibly be profitable?^[ii]

We present this not to dwell on the past, but because it holds important investing lessons for the future. Given how prevalent 2008-related fears still are today, it is important not to rewrite what happened so it fits today's message that Asset X^[iii] is about to implode and take the world down with it. Though "toxic assets" comprise a large part of the narrative, abundant evidence refutes that claim: The assets themselves weren't problematic. Overlooked factors precipitated the Financial Crisis, and though it isn't the mainstream version, we're pretty sure it's also the truth. Understanding what actually happened in addition to what many people think happened is crucial when investing.