The difficulties of a toxic asset ETF.
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By Bradley Kay | 04-22-09 | 06:00 AM | Email Article

Within the medieval pseudoscience of alchemy there was a centuries-long search for a tool, the philosopher's stone, that could turn worthless lead into ever-desirable gold. There has been a similar quest in the ETF world for the past few months: Could an ETF of toxic bank assets help the current financial crisis by converting impossible-to-sell securities into a transparent, market-priced portfolio? After all, ETFs have already brought exceptional liquidity for individual investors to previously obscure areas of the bond, commodity, and global equity markets. If liquidity really presents the main difficulty in valuing the toxic assets weighing down on bank balance sheets, could the millions of investors on major equity exchanges help? Here at Morningstar, we do not believe so for a multitude of reasons, involving both the nitty-gritty of how to build an ETF of toxic assets and the very nature of the complex securities that caused all this trouble in the first place.

Bradley Kay is Director of the European ETF Research team.

Unfortunately, we have to defer the latter points to another article that delves into the rise and fall of structured finance, and how it led to such a large amount of precarious assets that now endanger the banks who created them. For now, we will just take as given that banks hold these complex assets, which are essentially deeds entitling the banks to a share of the payments on a variety of mortgage, business, and consumer loans. However, those shares of the payments have been sliced and diced multiple times, pass through several intermediaries, and have such a confused paper trail that no one in the banking world quite knows how much they're worth anymore. If the prospects for these assets already sound pretty hopeless, you're getting a pretty good idea of why we are so skeptical.

How to Even Begin?
When a sponsor creates an ETF in the first place, they need to set aside a pool of money that begins to buy up a portfolio. Here is the first problem with a toxic asset ETF. If there are no prices for these securities, how will a portfolio manager begin to buy them? The entire point of the fund would be to create some transparency and market prices for these financial products. The first portfolio manager would have little more clue how to price them than the banks who are so uncertain about their value in the first place.

Thankfully, there is a way around this issue. Initial prices matter only if a portfolio manager buys assets from multiple banks, if the assets change ownership. If an ETF bundles assets from only one bank, then the bank simply goes from holding the assets to holding all the shares in a portfolio of the assets, and we no longer need to worry about setting an initial price. Those shares may then be sold on the open market for whatever investors are willing to pay, providing a source of cash to replace its risky assets.

Unfortunately, this does not get rid of the fundamental risk with building such a portfolio: Investors might find the ETF holdings worthless. This solution would merely pass the risk on to the bank holding the assets, rather than a portfolio manager who pays cash for the initial stakes before going to market. How many banks are solvent enough to take the risk that part of their assets suddenly obtain a clear market price of $0? Given the cash hoarding and aggressive deleveraging of major U.S. banks, it seems unlikely that any would take a flyer on offering the market assets which they still believe are worth something.

Arbitrage? What Arbitrage?
This lack of prices for toxic assets undermines the very arbitrage mechanism that provides the main selling point for ETFs. When the market price of an ETF moves too far below the value of its holdings, major trading firms buy up the shares of the ETF, exchange them for the holdings, and then sell the holdings on the market until balance is restored. However, this mechanism falls apart when there is no way to sell the underlying holdings. The only price available for holdings of a toxic asset ETF would be the market price of the ETF, so there would be no meaningful net asset value to arbitrage against. It would make no difference if a fund of toxic assets came out as an ETF or a closed-end fund, because no one could add or remove portfolio holdings at any price other than the fund's market price.

The Market's Smart. Not Psychic.
The entire point of the toxic asset ETF would be to establish market prices for these difficult-to-price securities clogging up bank balance sheets, but how likely are exchange investors to succeed where so many finance experts failed? The true difficulty of pricing these assets comes from the severe obfuscation caused by poor legal documentation and several layers of sliced cash flows sitting between the toxic asset on one end and the loan or mortgage payments flowing in the other. If investors or banks could find out where the money supposedly flowing to their assets originates, they would at least have a fighting chance at valuing the securities.

If the major banks can not track down all the contracts and data affecting their assets' values, what hope does the ETF provider who buys the assets have? Accurate market prices do not come from some ethereal property of public exchanges, they come from thousands or millions of investors using all the information at their disposal to try and estimate how much a particular asset is worth. If the toxic asset ETF can not disclose all the paperwork relating to the complex cash flows and ultimate origins of its holdings, investors will not be able to assess the portfolio value with any confidence, and market prices for the fund will be extremely conservative if they exist at all.

So What Opportunity Is There?
All the problems discussed in this article only show that the ETF structure is not a Philosopher's Stone. It cannot take illiquid, opaque, potentially worthless assets and turn them into transparent investments with sensible prices. However, it remains a great way to take obscure, but still understandable, corners of the capital markets and open them up to the wide pool of investors beyond major banks and hedge funds. ETFs could still help banks with raising capital based on their assets, just not from the most toxic assets. Instead, we believe there is some real promise in portfolios of the very distressed securities directly backed by subprime mortgages.

These subprime mortgage-backed securities, or SMBSs, though also sometimes considered toxic, lack most of the drawbacks that could sink an ETF of the worst slag weighing down bank balance sheets today. First, they have something like a market price to begin with. A company named Markit launched a series of indexes tracking subprime mortgage pools in the beginning of 2006. Since then, it has launched several of these indexes tracking different vintages of mortgages and different risk slices of those pools. Banks currently use these indexes to help mark their assets to market, and a portfolio manager could use them as a good guide for building an initial ETF portfolio without overpaying.

Second, SMBSs have a much greater degree of transparency. The original sliced securities have detailed contracts spelling out which pool of mortgages pays out to which slice, and when and how payments will accrue to each shareholder. Even better, since these securities are only one step removed from the original pool of mortgages, investors can track the default rates, delinquency rates, and other crucial characteristics of that pool. In other words, investors actually have a chance to figure out for themselves how much they think these shares are worth.

Finally, these securities are probably still worth something. The Markit ABX.HE index prices currently suggest that formerly AAA rated SMBSs should trade for about 25 cents on the dollar. Although that is an extreme discount, it is still a far sight more than 0 cents. Furthermore, there are still actual houses with real land that lie behind these securities. Even if every single subprime mortgage goes into foreclosure, there will still be some value recovered by reselling the house, and that would probably even put more than 25 cents into the pocket of investors holding the least risky subprime mortgage-backed assets.

As for banks, if they currently hold risky mortgage-backed assets worth 25 cents on their balance sheets, they may be happy to exchange them for the 25 cents in risk-free cash even if they believe the assets to be worth more. The ability to show a low-risk balance sheet and begin to lend more would be sufficient compensation. In the current turmoil, cash is king, and an ETF of SMBSs could help recapitalize banks by matching their distressed but still comprehensible assets with the investors out there who still have some cash and the willingness to take on risk for sizable potential returns.

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