In a very limited way. They help banks to shed their distressed assets and not get preoccupied managing them, at the same time get tax breaks for the losses. Their sale afterwards has not been a great experience in India. My personal experience has been that lenders push good loans into distress by their fear and knee jerk reactions on the slightest downturn. Poor appraisal and over lending are also cause of loans going bad & turning into distress assets.

Thanks Emmanuel. I take note of your points. Distressed asset markets allow risky assets to be easily reprised and sold; therefore lending institutions recover liquidity faster and the interest rate paid by debtors (households, small firms and states) should lower.  Suppose that in an average year 5% of the loans are defaulted. In 5 years lenders are losing 25% of their original loan outstanding. It seems to be a worthy reason to develop them.

No. Consider 2008.

Thanks Robert. 2008 was a particular and painfull event. Risky assets were packed, sold and ensured looking for abnormal profits. The temerity of the insurers increased the size of the business. Regulators did not take notice. Massive bailout applied to extended bankruptcy. The question is how to smoothly deal with day-to-day defaulted assets.  

Financial Institutions holding distressed assets are naturally willing to sell at the least price. This gives another institution who specialise in these types of assets to re price the assets and  buy them. Relieving these financial institutions of these toxic assets gives them opportunity to operate maximally. In this way the financial system is strengthened. On the other hand and  by this arrangement a new type of institution has been created thereby expanding the structure and depth of the financial system.  

Thanks Emeka. A financial asset is a contract between creditors and a given person, firm or state. The original clauses were broken, but the claims persist. At its original market asset value was $ 100 and now trades at $ 20. The new buyers see a yield and they know how to make it happen. The enforcement of contracts is a key factor behind these markets.  

Not sure I understand the question.  In my view, the day-to-day defaulted assets you refer to is an entirely normal market event, and it should be, otherwise markets would be risk-averse and stun innovative (but risky) endeavors.  Market responses are also entirely straight forward and classic, the asset market valuation drops until buyers appear.  How does this relate to healthy financial systems?  The health of these systems is only threatened when massive losses set in and the mass psychology of fear takes over.  But these massive and systemic instabilities (that is: bubbles) are in themselves indicators of *unhealthy* financial systems, nobody wants to miss the party while things go well, but everybody stays near the narrow emergency exit hoping they can get out before anybody else.  The *health* of financial systems would by definition relate to systemic issues, not they day-to-day defaulted assets you refer to. Just my 5-cent.

Thanks Frank. Your point is good and clever since, I agree, a trash market cannot solve systemic risks.  It seems to me this question applies more to developing than to mature financial markets. Idiosyncratic risk cannot be fully offset without a complete, stable and deep (healthy) financial intermediation.

Dear Mr. Victor,

I have another view point in the line of Mr.Frank's argument. Going by Indian experience, and the case of "populist and politically motivated loan waiver schemes"; institutional mechanisms to act as the lender of the last resort to willful defaulters can definitely not augur well for a financial system. True that lender of the last resort should exist in a ideal, deep, and broad financial system, but the behavioural impact on the borrowers once they understand that there is a institutional set up once they force an asset to distress, has to be examined. This is the direct lending and borrowing story.

Regarding the market based debt and market based equity markets, distress is somewhere priced and the expectations of returns are adjusted for the same. Only a tail event can throw things out of gear. Like Mr. Robert was referring to 2008, it was a classic case of a Capitalist nation protecting private exuberance with tax payer's money. Socialising Private losses. So a financial system is essentially circulating money of under privileged. If a private entrepreneur can be large hearted then distressed asset markets can be a boon for the lenders, but not ideal for a financial system.

Going by Frank again, "The existence of a strong fire extinguishing system and exit routes are very good risk mitigating mechanisms, but does it ensure sanity in the minds of users of inflammables".

In a highly segmented international financial system viability of distressed asset markets can be thought of, but in a highly integrated international financial system with both markets and asset classes interconnections, contagion effects might bring about systemic crisis. So the financial systems and the architecture itself might not be stable.

Thanks Mr. Kameshwar. Your point is well directed and enriches the analysis. A loan waiver scheme brings another perspective to massive bailout. From a social point of view a loan is an opportunity. The financial system assigns opportunities (to consume or to invest). As a default decision can be motivated by incapacity or unwillingness, those who, having money, do not honor their debts are in some way limiting opportunities to the ones who really needed them. A market or a policeman cannot prevent dishonest behavior. Cross border transactions worsen the problem…