For Sale: Toxic Assets

By Laurie Hartzell on August 7, 2009 7:47 AM

From economists and politicians to next-door neighbors, everyone seems to have a theory about what has driven the nation’s economy into the ground. Solutions to the problem, however, seem harder to find than a loan on a three-bedroom condo.

Simon Wilkie, professor and chair of economics at USC College, has a threefold explanation for how we got ourselves into this quandary — but most importantly, he offers a way to help the country out of its mess.

“One contributing factor is that we had a long period with very little economic growth in the ’70s and ’80s,” he said. “So what started to happen in the ’90s was that, all of a sudden, the gains from investment in information technology appeared and this growth came along.” According to Wilkie, who joined the College’s Department of Economics in 2008, people mistakenly thought this growth was sustainable and would continue unaided.

The second factor he believes led to the downturn is what popular media has dubbed the “moral hazard problem,” which resulted when the financial sector in the United States went through a period of reform and created new financial instruments such as mortgage-backed securities.

“Essentially, the bundling of loans into tradable assets meant that interest rates fell as loans became more liquid. But as a result, those writing the loans could pass the default risk on to someone else,” Wilkie said. “So we had an increase in the demand for housing because more people could afford it, but a decline in underwriting standards.”

And the third factor, Wilkie asserted, was the rapid growth of China. “In order to fuel its growth, China kept the country’s currency low, and by doing this, it accumulated more than 1 trillion U.S. dollars,” he said. This money was then reinvested in U.S. Treasury bills. The massive supply of funds kept American interest rates low but, in the long term, it was an unsustainable source of income.

“This is the general consensus,” he noted, regarding his version of events. “The disagreement is what to do about it.”

For his part, Wilkie has chosen to focus on toxic assets as one way to begin repairing the U.S. economy.

Given this nasty name for a reason, toxic assets are a collection of loans and securities for which borrowers have stopped making payments, and whose value has fallen to unknown amounts. Because their value is unclear, there is no market for these assets.

Until such a market is created, toxic assets will remain with the banks and continue to tie up funds and prevent other loans from being made. Although these assets are only one cause of the recession, their sale would allow banks to start lending again.

So how do you create value in an item such as a loan?

Pulling from his expertise in game theory as it applies to business strategy, Wilkie has formulated a toxic asset auction proposal that he will submit to Washington, D.C.’s economics experts. Game theory, an interdisciplinary type of applied mathematics, focuses on how the interaction of individuals influences the choices each person makes.

Auction design is just one example of game theory and the most relevant to Wilkie’s plan. In an auction, the ultimate price paid for an item is a result of ascending bids, each of which is determined by previous bids. Bidders, therefore, create their own market and value for an item based on what other bidders are willing to pay. Wilkie’s plan utilizes applied game theory to create a market for toxic assets and to auction them off successfully.

Wilkie’s experience as chief economist at the Federal Communications Commission proved to be essential in devising this proposal. In 1994, the FCC consulted game theorists such as Wilkie to design an auction for electromagnetic spectrum licenses — permits for the use of radio airwaves.

In this type of auction, the bidding is conducted online and all available licenses are auctioned off in rounds to anonymous bidders. After each round is completed, the results are opened so that all bidders can see the prices and therefore have a better idea of the value that other bidders place on the licenses. The bidders then can use this information to determine their future auction decisions and purchases.

“That was before eBay,” Wilkie said. “It was the first electronic, ascending-bids simultaneous auction, where lots of things were auctioned off at once. The idea of auction theory is that if each of us has a little piece of information, together we actually know quite a lot. So if we did all of the auctions at once, and they were open, then there would be a good deal of information about the prices in every market.”

Governments have since used this revolutionary auction design to sell more than $100 billion in spectrum licenses worldwide.

In the case of toxic assets, their value is unknown because the initial trades were not observed by the public or a third party. “Part of the reason that the market for these assets has fallen apart is that it was all done with bilateral trades. It was not an open market,” Wilkie said.

Even if the government adopts various economic solutions such as Wilkie’s toxic asset relief proposal, he concurs with many economists’ views on a timeline for recovery. “It’s probably going to be two to three years,” he said.

An improved housing market will be one benefit of resolving the toxic asset predicament. Once housing prices stabilize, Wilkie noted, it will be a good sign that the nation is digging its way out.

When he’s finished with his toxic asset relief proposal, Wilkie will present it to the Treasury Department and the National Economic Council with the hope that his ideas will help balance the economy.

Economists Caroline Betts and Robert Dekle share their insights into the nuances of the economy at http://college.usc.edu/our-experts-weigh-in/

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