"Toxic Assets" Explained

There are primarily two types of "toxic assets" (i) mortgages and (ii) derivatives.

Basically, the first type are bad loans. Many people who use such terms are referring to "sub-prime" loans, but not always.


(In what follows ignore federal funds rates-for simplicity)
As you're aware, banks use deposits (savings and checking accounts-which are bank liabilities) to fund long term loans (mortgages-which are bank assets). Deposits are short term in nature and mortgages long term. Generally, short term interest rates are less than long term interest rates so to compensate the amount of time one goes without the use of money. As a result banks earn more interest on their assets than they have to pay on their liabilities. Banks have problems when short term rates are higher than long term rates since they earn less on assets than they must pay on liabilities. In such cases the value of assets would decline and the value of liabilities increase. Simply put, Banks are required to maintain a certain ratio of assets to liabilities. If this ratio falls below the governments requirement they become insolvent, at which point the government assumes control and liquidates the banks assets to other solvent banks. One potential option is to sell (if they can) some of their mortgages before they become insolvent.

Fannie Mae and Freddie Mac, were created to purchase mortgages. Over time traditional banking changed. Banks no longer had to make loans with the intention of holding them, rather they could earn profits by underwriting a loan and then quickly selling it to Fannie and Freddie, who were for the most part obligated to purchase it. Some also made money by "servicing" these loans-that is they were responsible for getting the borrowers mortgage payments to the appropriate party.

Fannie and Freddie basically took these mortgages and turned them into bonds. For example, they might take 1000 mortgages and sell them as debt. The average income on these mortgages might be expected to earn Fannie and Freddie, say, 8%, which they would combine (called securitization) and sell as a 7% bond. These bonds are officially termed Collateralized Debt Obligations (CDO's). Until recently, the rating agencies (Moody's Fitch, & Standard and Poor's) often rated these as AAA, the highest debt rating possible. Insurance companies were big purchasers of these CDO's because they are often required to back their insurance policies with debt investments of the highest quality. AAA rated corporate debt might only yield 5% while these CDO's yielded 7%-hence the incentive to purchase.

The problem began in the 70's and 80's when borrowers increasingly assumed variable and adjustable rate loans. This made it easier to give people loans. The problem was and is that as the probability of default increases, so too does the interest rate on the loan, but the higher interest rate must be paid by individuals that are increasingly less likely to have the means to repay. Banks however no longer made loans with the intention to hold each of them, choosing to earn a little money by originating and servicing the mortgages by quickly selling them to Fannie and Freddie. Mortgage brokers increased in number without any intention of ever owning these mortgages which helped increase overall securitization.

Housing prices should increase with either inflation or by the amount wages increase from year to year-no more no less. But for 30-50+ years housing prices increased annually by 6-7% while inflation increased annually by 3-4%, until 2005. Thats when things got really crazy. Housing prices increased (I'm going by memory though should be close) in 2005 by about 15-20%, similarly in 2006 and part of 2007. That's more than a 40% increase in 2 years-an impossible amount, people's income simply can't support such increases. However many people began to speculate buying one or more investment properties. Others found imaginary money via "home equity" that banks would give them to purchase "better, bigger, or nicer" homes. Loans became increasingly less dependent upon the buyers income and down payment-obvious and big problems. Recently things got really crazy even fraudulent. Buyers were not required to show proof of income though would get 100% financing. All is fine when prices are forever rising, but anything that can't continue forever must end. The rest is (becoming) history.

The mortgages discussed above were "packaged" (or combined i.e. securitized) and sold as quasi "bonds" (CDO's). Since the owners of the mortgages did not service the loans the borrowers and lenders had issues renegotiating the terms of problematic loans. Basically the buyers of CDO's didn't properly understand what they were buying. Another case of incompetence, which will certainly go overlooked. The above hypothetical CDO consisted of 1000 loans. Accompanying each of the 1000 loans might very well be a 100 page description of each loan. To properly understand this single CDO the buyer would need to read 100,000 pages. My example doesn't do a real CDO justice. Understanding most CDO's requires reading about 1 million pages. This obviously didn't happen. As defaults on home mortgages have increased the value of these CDO's declined. Investors, having no idea how many loans within the CDO might default, scrambled to "catch up on their reading". Meaning investors were and are uncertain how many loans will default (or worse foreclose,) which means the interest or coupon payments are also unknown. When a Corporation defaults on a loan, debtors take the single entity to bankruptcy court. This is obviously much more difficult when there are thousands of entities. To further complicate the craziness, the declining value of homes means that the principal value of these assets are unknown. That is, unlike the buyers of corporate debt, who might derive a reasonable estimate of the asset value of a businesses assets, holders of CDO's have had a hell of a time figuring out how much the underlying assets are really worth.

Ultimately no one has any interest in buying these CDO's right now-meaning there is no market for these securities. (I must deviate for a moment.) Certain accounting standards require certain assets/liabilities be recorded based upon their "Fair Value" which is basically the quoted market price at the end date of a company's reporting period. (back to the discussion) Since there is currently no market for CDO's, accounting forces companies to report these securities as basically worthless. It should be clear: they are not worthless however, but accounting reports them as worthless. Such are "Toxic assets" Some companies must maintain asset to liability ratios. If large amounts of assets become worthless overnight (or liabilities increase enormously) this is bad. Removing these "Toxic" assets from their balance sheet means they are sold-in many instances at very large discounts to the real economic value separate from accounting "fair" value. If they can be sold, the company will have cash which accounting treats much more favorably. Their "Reported" financial position is then better and people might relax.

There are similar (though worse) problems regarding derivatives that involve AIG, CitiGroup, and many others, but I'll leave that discussion for another time.