Price and Risk Factors of Toxic Assets - Essay Example

TOXIC ASSETS Please write First Time Please write time here Semester Fall Toxic Assets Toxicassets are those assets, which no one wants to acquire because no clear value is associated with them. Gordon (2010) asserts, “Toxic assets are, mostly, the investments backed by risky subprime mortgages that are held by the larger U.S. banks and that have lost value”. The price of toxic assets at which they are acquired do not reflect the real value of the assets, which results in increasing the risk factor associated with the toxic assets. Some of the major risks associated with the toxic assets include minimization of banks’ liquidity, unsatisfied customers, and profit’s privatization. Toxic assets are also known as dead assets because they have been utilized in the past and they are of no more value at present. “Toxic assets had a value at some point in time” (Smith, 2010). Toxic assets do not have any present value whereas many people, who have such assets, believe that their toxic assets are still of the same value as they had in the past. However, the reality of the value of those toxic assets is quite different. Minimization of the Liquidity Toxic assets often result in minimizing the liquidity of the organizations that possess such assets. It is because of the fact that toxic assets have no clear value and if the financial organizations such as banks acquire a large number of toxic assets assuming them to be of great value, minimal liquidity occurs because the value of the assets does not increase in reality, rather it just increases in the bankbooks. The banks find it very difficult to sell the assets in order to get the blocked money back in hands. Toxic assets are neither good for financial organizations nor for the economy of a country. They are worthless for the banking institutions as it becomes difficult for the banks to sell them to some other person at a reasonable price. Even if the financial sector of a country attempts to cope with toxic assets, the result is most likely to be the radical freefall of the country’s economy. Mortgage-Backed Securities Toxic asset is a form of Mortgage-Backed securities. Mortgage-Backed securities include loans that are given by a bank to a person to help the person build his own house. Banking institutions provide loan to the people, which is taken back from them along with interest on monthly basis. The repayment of loans to the banks is not an easy process for the people as the repayment is composed of high interest and the principal amount. When the people are not left with enough money to repay the loans to the banks due to increased sub-prime mortgage interest rates, the cycle stops and critical situation start to occur for the banks in the form of decreased level of available capital. Some of the most considerable negative outcomes of mortgage-backed securities include recession, decreased level of capital available to the banks, jammed sale and purchase of houses, inability of the banks to provide loans to the customers, and rise in the level of unemployment. Customer Dissatisfaction Inability of the banking institutions to serve their customers is another negative point related to the toxic assets which results in customer dissatisfaction. When a bank acquires a large number of toxic assets, it becomes unable to respond efficiently to the customers due to minimized liquidity and decreased financial strength. For example, of a bank acquires a large number of toxic assets, it is left with less money available for carrying out other banking services such as giving loans to the customers. Therefore, when the banks become unable to provide loans to the customers, it results in customers’ dissatisfaction from the banks. Toxic Assets, a Problem for the Banks What a bank needs to do in such a critical situation is to get rid of the acquired toxic assets in any case. It is because the toxic assets are of no use for the banks rather they just add to the administrative expenses of the banks. However, the problem for the banking institutions is that they hardly find any person interested in the toxic assets. Some people may take interest in buying the toxic assets from the banks at lower rates. Those people assume that, in the near future; the value of the toxic assets will rise again, but it happens very rarely. Banks often hesitate to get involved in selling the toxic assets at their face value because writing down the value of the assets is somewhat undesirable for the banks. Therefore, the problem persists for the banks as they avoid selling the assets at their face value to the investors. Role of the Governments in Handling Crises The real value of the toxic assets and the risks associated with them are not reflected by the prices at which they are acquired by a financial institution. The difference between the paid price and the actual price of a toxic asset is discovered in the situation of crises or in case of occurrence of the associated risks. When the difference between the paid price and actual value is discovered, the banking institutions try to sale out the assets but the banks do not find any person interested in the deal. In such cases, the government of the country plays its role in order to make the banking institutions come out of the crisis. The government buys all toxic assets by paying the money to the banks. However, it is not always in the favor of the government. For example, the government of United States of America fell into economic crisis as the result of acquiring a large number of toxic assets from the banking institutions in 2000s. Response of Banks to the Governments’ Deal It is commonly observed that the governments purchase the toxic assets from the banking institutions in order to help them come out of troubles. However, the problem here is that the banks do not want to sell their securities to the governments at distressed prices. Banking institutions want their assets to be sold at relatively higher prices. Therefore, the governments’ plans to buy the securities from the banks are rejected by the banks themselves. It is a common fact that the economy of the whole word is facing problems these days due to which no one can put any limit to the identification of the toxic assets. Some of the more bank assets such as commercial real estate are going to become toxic assets in the near future because of the economic instability. Where there is economic instability, rate of unemployment goes high which results in decreasing the buying power of the people. In addition, when the people will not have enough money to buy houses, the housing sector will be adversely affected. Therefore, if such situation occurs, houses will become a toxic asset, as the number of interested buyers will become very less. Toxic Assets and the Principal Amount Toxic assets lose their principal amount very rapidly, which makes them more and more undervalued with the passage of time. When an asset loses its principal amount, the percentage of interest on the asset also goes down. The likelihood of stabilizing in the financial environment also decreases with the decrease in the principal amount of the asset. An asset is valuable only when it is able to generate a considerable amount of income for its owner. However, in case of toxic assets, a constant decrease in their interest and the principal amount makes them worthless for their owners. For example, if principal amount of a toxic asset goes on to decrease constantly, the interest enjoyed by the bank, also become less. It is because amount of interest depends upon the principal amount of the asset. When the principal amount, which is the actual price of the asset, will be less, the interest on the asset will also become less. Toxic Assets Increase the Administrative Costs An important point to be mentioned is that the toxic assets have a high value at the time they are created. At that time, people take some interest in buying those assets. However, even at that time, buying the toxic assets is considered a high-risk investment. For this reason, banking institutions try to avoid investing in those assets but they cannot do so in most cases because toxic assets are generally provided to them in the form of a package, which contains some low-risk investment opportunities and other facilities for the banks. Therefore, the banks are compelled to obtain toxic assets in the form of highly attractive packages, which afterwards turns into a problem for the banks because they not only add to the administrative costs of the banks but also it becomes very difficult for the banks to sell them out. The toxic assets included in the package are sold to the banks at high prices but for the banks, they are of no significant value because they cannot add worth to the financial position of the banks. If a banking institution becomes overloaded with a large number of toxic assets, it may be unable to respond to the ongoing changes in the financial market (Smith, 2010). The problems occur for the banks in a sense that the acquired toxic assets, instead of adding value to the banks, add cost to the banks because the assets need storage space that the banks have to arrange in order to place and protect the toxic assets. Therefore, it can be said that toxic assets are worthless and they add nothing but the administrative costs to the company, which holds those assets. References Gordon, M. (2010). What Are Toxic Assets & How Did They Get to be Poisonous?. Retrieved from http://www.myfoxchicago.com/dpp/news/Toxic_Assets_Poisonous Smith, S. (2010). What Are Toxic Assets?. Retrieved from http://www.wisegeek.com/what-are-toxic-assets.htm Read More