What are ‘Toxic Assets’
Toxic assets are assets that becomes illiquid when its secondary market disappears. Toxic assets cannot be sold, as they are often guaranteed to lose money. The term “toxic asset” was coined in the financial crisis of 2008/09, in regards to mortgage-backed securities, collateralised debt obligations and credit default swaps, all of which could not be sold after they exposed their holders to massive losses.
BREAKING DOWN ‘Toxic Assets’
A toxic asset can be best described through an example:
If John Doe buys a house and takes out a $400,000 mortgage loan with a 5% interest rate through Bank A, the bank now holds an asset – a mortgage-backed security. Bank A is now entitled to sell the asset to another party (Bank B). Bank B, now the owner of an income-producing asset, is entitled to the 5% mortgage interest paid by John. As long as house prices go up and John continues to pay his mortgage, the asset is a good one.
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 become unsellable, as no other party would pay for an asset that is guaranteed to lose money.
In this example, the mortgage-backed security becomes a toxic asset.