You’ve been hearing about toxic assets a lot lately, but they don’t come from nuclear waste dumps, so what exactly are they?
When you get a mortgage, your lender will often sell it right away to an investment bank that will package your loan with a pool of hundreds, maybe thousands of other loans. Then, investors can buy into a piece of that pool of loans and trade it, and so forth.
Here’s the problem: Let’s say a particular pool of loans consists of subprime mortgages and for this example, most of those loans are now in default because the homeowners couldn’t afford to pay them anymore. Let’s also say that at the peak of the market, that pool of subprime loans was worth $10 billion... (read more)
So the bank borrowed against the $10 billion value of the loan, but now that most of those loans have defaulted and no one wants or can buy the homes associated with it, what is that asset worth? On the open market, if no one wants to buy something, essentially, it’s worth nothing.
That’s what we mean when we talk about a toxic asset, it’s a scenario where the value decreases so much that it’s a drag on the institution’s entire portfolio. And, remember in this hypothetical scenario, the bank borrowed against the $10 billion that loan was once worth.
Now the pool of loans is in default and no one wants to buy it, plus the bank is responsible for the cost of maintaining the properties associated with the loans. So instead of making money, this essentially worthless asset is costing the bank.
And because the bank borrowed against the loan’s original value, this pool of toxic loans taints everything else by essentially throwing the bank’s whole balance sheet out of whack.
When you get a mortgage, your lender will often sell it right away to an investment bank that will package your loan with a pool of hundreds, maybe thousands of other loans. Then, investors can buy into a piece of that pool of loans and trade it, and so forth.
Here’s the problem: Let’s say a particular pool of loans consists of subprime mortgages and for this example, most of those loans are now in default because the homeowners couldn’t afford to pay them anymore. Let’s also say that at the peak of the market, that pool of subprime loans was worth $10 billion... (read more)
So the bank borrowed against the $10 billion value of the loan, but now that most of those loans have defaulted and no one wants or can buy the homes associated with it, what is that asset worth? On the open market, if no one wants to buy something, essentially, it’s worth nothing.
That’s what we mean when we talk about a toxic asset, it’s a scenario where the value decreases so much that it’s a drag on the institution’s entire portfolio. And, remember in this hypothetical scenario, the bank borrowed against the $10 billion that loan was once worth.
Now the pool of loans is in default and no one wants to buy it, plus the bank is responsible for the cost of maintaining the properties associated with the loans. So instead of making money, this essentially worthless asset is costing the bank.
And because the bank borrowed against the loan’s original value, this pool of toxic loans taints everything else by essentially throwing the bank’s whole balance sheet out of whack.
