Toxic Assets: What it Means, How it Works (2024)

What Are Toxic Assets?

Toxic assets are investments that aredifficult or impossible to sell at any price because the demand for them has collapsed. There are no willing buyers for toxic assets because they are widely perceived as a guaranteed wayto lose money.

The term toxic asset was coined during the financial crisis of 2008to describe the collapse of themarket formortgage-backed securities, collateralized debt obligations (CDOs) and credit default swaps (CDS). Vast amounts of these assets sat on the books of various financial institutions. When they became impossible to sell, toxic assets became a real threat to the solvency of the banks and institutions that owned them.

Understanding Toxic Assets

Toxic assets were originallycalled troubled assets. It took the financial crisis of 2008 to produce a more vivid term. That was when it became clear that some of the biggest U.S. financial institutions were sitting on a vast quantity of worthless assets. In fact, they were losing value at a pace that many had not thought was possible.

This underestimation of the downside risk might have been in part a lack of imagination, but it was exacerbated by a lack of rigor by the ratings firms.

How an Asset Goes Toxic

A toxic asset can best be described through an example. John buys a house and takes out a $400,000 mortgage loan with a 5% interest rate through Bank A. Through the process known as securitization, Bank A turns the loan into a mortgage-backed security and sells it to Bank B. Bank B now owns an income-producing asset: the 5% mortgage interest paid by John. John continues to pay his mortgage because home prices are rising and his mortgage is shrinking. He's building up equity that he can tap into at some future date. Everybody wins.

Then home prices start falling. It turns out John borrowed more than he could afford, and the house is worth less than he owes on it. John defaults on his mortgage. Bank B no longer receives the payments to which it is entitled. The house can be sold at a loss if at all. Bank B's mortgage-backed security has become a toxic asset.

Scale this up by a factor of millions, and you have the story of the mortgage meltdown.

Dealing with Toxic Assets

There isn't a definitive playbook on how to deal with toxic assets but there is one example of a strategy that worked.

In the wake of the 2008 financial crisis, the Troubled Asset Relief Program (TARP) was the U.S. government's solution. It created a legally-mandated and government-sponsored buyer of last resort that took these assets off the books of financial institutions and allowed them to stem the bleeding.

This, along with actions taken by the Federal Reserve to pump money into the system, likely saved the global economy from plunging into a full-out depression rather than a severe recession.

In December 2013, the Treasury wrapped up TARP and the government concluded that its program had earned more than $11 billion for taxpayers. TARP recovered funds totaling $441.7 billion compared to $426.4 billion invested.

The government also claimed credit for preventing the American auto industry from failing and saving more than a million jobs, helping to stabilize banks and restoring credit availability for individuals and businesses.

Who Wants Toxic Assets?

Some professional investors specialize in accumulating toxic assets. They are convinced that the value of these assets is depressed far below the levels that their fundamentals justify.

These so-called vulture investors hope to profit when the fear has subsided and the market for such assets returns.