Toxic Asset - Market Freeze

Market Freeze

When the supply and demand of a good equal each other, so buyers and sellers are matched, one says that the "market clears".

Classical economics and neoclassical economics posit that market clearing happens by the price adjusting—upwards if demand exceeds supply and downwards if supply exceeds demand. Therefore, it reaches equilibrium at a price that both buyers and sellers will accept, and, in the absence of outside interference (in a free market), this will happen.

This has not happened for many types of financial assets during the financial crisis that began in 2007, hence one speaks of "the market breaking down".

One can explain this alternately as the price not adjusting down—the price is too high, with supply being too high, or alternatively demand being too low, or by the theory of an equilibrium price not holding—the price at which sellers will sell is higher than the price at which buyers will buy.

Prior to the crisis, banks and other financial institutions had invested significant amounts of money in complicated financial assets, such as collateralized debt obligations and credit default swaps. The value of these assets was very sensitive to economic factors, such as housing prices, default rates, and financial-market liquidity. Prior to the crisis, the value of these assets had been estimated, using the prevailing economic data.

When it became clear that such conditions would not continue, it was no longer clear how much revenue the assets were likely to generate and, hence, how much the assets were worth. Since the assets were typically very sensitive to economic conditions, even relatively small uncertainties in the economic conditions could lead to large uncertainties in the value of the assets, which made it difficult for buyers and sellers in the market to agree on prices.

Furthermore, banks and other large financial institutions were reluctant to accept lower prices for these assets, since lower prices would force them to recalculate the total value of their assets, and, if the loss was sufficiently large, force them to declare a negative total value. Several banks in the autumn of 2008 were forced to accept buy-outs or mergers because it was believed that they were in this situation. This re-evaluation of total assets based on prevailing market prices is known as mark-to-market pricing. The term zombie bank was introduced to describe banks, which would have become bankrupt if their assets had been revalued at realistic levels. Toxic assets, by increasing the variance of banks' assets, can turn otherwise healthy institutions into zombies. Potentially solvent banks will make too few good loans. This is the debt overhang problem. Alternatively, potentially insolvent banks with toxic assets will seek out very risky speculative loans to shift risk onto their depositors and other creditors.

Further, insolvent banks with toxic assets are unwilling to accept significant reductions in the price of the toxic assets, but potential buyers were unwilling to pay prices anywhere near the loans's face value. With potential sellers and buyers unable to agree on prices, the markets froze with no transactions occurring. In some cases, markets remained frozen for several months.