Imagine buying a sick race horse for cheap hoping that over time she might squeeze in a few more paydays before heading to the glue factory – enough paydays to pay the purchase price and turn a tidy purse. In the horse race of mortgage finance, that filly is named “Toxic Asset” and she’s a mudder through and through.
When you look into the manure pile of residential mortgages sold, resold and sold again over the last few years, it‘s enough to make you gag and turn away in horror. Toxic Assets in the mortgage realm are packages of delinquent mortgages (bonds) – a sour amalgam of overvalued property loans whose loan-to-value ratio is so out of whack that there is no longer a functioning market for their sale. On their face, these mortgages might have turned a substantial payday, but that was back when unemployment was a colt and a fading pulse could field a mortgage Jockey. Now, with two-year old mansions out to pasture and money tighter than a Pelosi smile, those same mortgages have been scratched. No longer race worthy, they’ve become toxic, but that doesn’t mean they won’t run. A bunch of smart guys parlayed these broken down roans and packaged them into bonds, some of which are foaled into separate offerings and handicapped at different rates. Banks play the bookmakers and sell them to willing bidders who wager that their Toxic Asset will explode out of the chute and out run the purchase price before collapsing. While most end in a dead heat, a few hit the Trifecta.
Many of the loans that make up these assets are the subject of what is known as a strategic default or withering payment – a condition where the original borrower has decided that he is so far underwater (his debt exceeds the total asset value) that it would be stupid to continuing paying the debt service on that asset. He plans to default or to pay only a small portion of the monthly mortgage payment. Here’s where the connection to you and the real estate market begins. The more confidence a delinquent mortgage holder has that his mortgage is a mudder and may be salvageable, the more expensive that toxic asset will become – expensive because the likelihood that it will pay out is far greater. So, while expensive, those assets are also more likely to win, place or show. That’s the turn and the stakes are high. Once a toxic asset becomes toxic, it can’t go back to being a healthy asset again. Instead, the investor rides it out hoping for a long and potentially lucrative death.
So the Toxicity Derby is a true gauge of market health. When bookmaking banks holding toxic assets are unwilling to accept significant price reductions for their toxic assets, buyers baulk, demand decreases and no one runs. Hence, the turf is frozen. But when confidence returns, values rise and with them demand for the Dark Horses – Toxic Assets. In this way, they are the primordial stuff of recovery – the putrid goo from which true recovery evolves. So keep your eye on the Toxicity Derby. It may the true indicator of overall recovery.