Toxic Assets

Toxic assets are assets that become illiquid when the secondary market for buying and selling them disappears. Toxic assets cannot be sold because they are widely perceived as being a guaranteed way to lose money. The term toxic asset was coined in the financial crisis of 2008 to describe the drying up of the market for mortgage-backed securities, collateralized debt obligations and credit default swaps. These assets became difficult to move, resulting in large collections of these deeply troubled assets sitting on the books of various financial institutions. As the decline in value continued, these assets threatened the solvency of the banks and institutions that were unable to unload them.

Toxic assets were originally called troubled assets, as they weighed down the balance sheets of financial institutions. The troubled assets turned toxic when it was clear that financial institutions had no way to sell the vast swath of these troubled assets. The toxic assets destroyed the balance sheets of financial institutions by losing value at a pace that many did not think was possible. This underestimation of the downside risk was a combination of a lack of imagination encouraged by greed and questionable rigor applied against these assets by the ratings firms. 

A toxic asset can best be described through an example. If John buys a house and takes out a $400,000 mortgage loan with a 5% interest rate through Bank A, the bank now holds a loan contract that is transformed through securitization into a mortgage-backed security. Bank A is now entitled to sell the asset to another party, namely Bank B. Bank B, now the owner of an income-producing asset, is entitled to the 5% mortgage interest paid by John. As John continues to pay his mortgage, the asset is a good one. John continues to pay his mortgage because housing prices are rising and his mortgage is shrinking, resulting in equity building up in his house that he can tap into at some future date.

If, however, John defaults on his mortgage, the owner of the mortgage, whether Bank A or Bank B, will no longer receive the payments to which it is entitled. Normally, the house would then be sold, but if the house price has declined in value, only a portion of the money can be regained. As a result, the securities based on this mortgage will be difficult to sell, as no other party would pay for an asset that is guaranteed to lose money. In this simplified example, the mortgage-backed security becomes a toxic asset. Scale this up, and you have a rough retelling of the mortgage meltdown. 

There isn't a definitive playbook on how to deal with toxic assets. The Troubled Asset Relief Program (TARP) was the U.S. government's solution. It created a buyer of last resort that took these assets off the books of financial institutions, allowing them to stem the bleeding. This, along with other actions taken by the Federal Reserve, likely saved the global economy from a worldwide economic depression.