Why is there not a large market for toxic assets?

One of the continuing problems in the banking sector is that the toxic assets on their balance sheets have not moved. Sub-prime and CBO securities continue to sit on the balance sheets of financial institutions. Of course, there has been trading, but there has not been a clearing of these assets out of the banking sector and into the hands of those who want to hold these risky assets. If these problems cannot be solved, there will be little success in having a public private partnership to purchase these assets. There are a number of reasons for this lack of trading.We will discuss three reasons. Two of them may be well known and the third is suggested by recent behavioral research.

Primarily, there is an asymmetric information problem between buyer and seller. For mortgage pools, the value is determined by the composition of the pool. The initial buyers usually have better information than those purchasers in the secondary market. Without good information on the defaults, delinquencies and composition of the mortgages, there is difficulty in valuing the securities. Ratings do not provide any benchmark information. Providing good information has always been a problem in this sector. Without clear data, trade is not possible.

The change in FASB rules which allow for book value accounting for banks will reduce the desire for banks to sell assets and realize the loss. The assets may be kept on their balance sheet at a higher value which may reflect the value to maturity. Why sell an asset today at current market expectations when there is the chance they may actually improve over time?

The third reason has to do with a potential uncertainty effect which has first been discussed by Uri Gneezy, John List and George Wu in their Quarterly Journal of Economics paper "The Uncertainty Effect: When a risky prospect is valued less than its worst possible outcome." The authors find that there are certain situations when the the value of project may not exist between the highest and lowest potential outcome. Investors may actually value something worse than the lowest possible realization because of high uncertainty.

Think about the implications of this type of outcome. The potential buyers of a sub-prime mortgage pool will view the asset as worse than the worst possible outcome given they cannot properly price the alternatives. How can this happen? Without going through all of the possible scenarios, think of the uncertainty that can occur if there are no clear ideas what the environment may look like in the coming years. The high uncertainty creates unusual response to potential outcomes which place a value that is outside of the norm.

What would be the type of uncertainty which could create these types of outcomes? What id the regulatory environment is not known? What if the tax environment not known? what if the bail-out plan for home owners is unknown? All will create an large uncertainty effect. The idea that the government may control the level of uncertainty that is faced by investors is very important. There is an important responsibility for regulators to minimize uncertainty.