Toxic asset facts for kids

A toxic asset is a financial asset that has lost a lot of its value. It's also very hard to sell because there isn't a working market for it anymore. Imagine trying to sell a toy that no one wants to buy, even for a very low price. Because these assets are linked to a company's money and debts, their drop in value can be very risky for the company holding them. The term "toxic asset" became well-known during the financial crisis of 2007–2008, where they caused big problems.

When people can't buy or sell these toxic assets, the market for them is called "frozen." This happened to some toxic assets in 2007 and got much worse in 2008. Several things made these markets freeze. The value of these assets depended a lot on how the economy was doing. When the economy became uncertain, it was hard to guess what the assets were really worth. Banks and other big financial companies didn't want to sell these assets for much lower prices. If they did, it would make their financial records look bad, possibly making them seem like they didn't have enough money.

Sometimes, toxic assets are also called troubled assets.

Where the Term Came From

The term "toxic asset" was used a little bit before 2006. It might have been started or made popular by Angelo Mozilo. He was the founder of a company called Countrywide Financial. In emails from 2006, he used the word "toxic" to describe certain types of loans.

For example, he wrote in March 2006 that a certain type of loan was "the most dangerous product in existence and there can be nothing more toxic." In April 2006, he also said about other loans: "In all my years in the business I have never seen a more toxic product. It's not only subordinated to the first, but the first is subprime. In addition, the FICOs are below 600, below 500 and some below 400[.] With real estate values coming down ... the product will become increasingly worse."

Why Markets Freeze

When the amount of something available to buy (supply) matches the amount people want to buy (demand), we say the "market clears." This means buyers and sellers agree on a price.

Normally, in a free market, prices adjust. If many people want something, the price goes up. If no one wants something, the price goes down. This helps the market reach a balance where buyers and sellers are happy.

However, this didn't happen for many financial assets during the financial crisis that started in 2007. This is why people said "the market broke down."

One way to explain this is that prices didn't go down enough. Sellers wanted a higher price than buyers were willing to pay.

Before the crisis, banks and other financial companies had invested a lot of money in complex financial assets. These included things like collateralized debt obligations (CDOs) and credit default swaps (CDS). The value of these assets depended a lot on economic things, like housing prices or how many people paid back their loans. Before the crisis, experts estimated the value of these assets based on the economy at that time.

When it became clear that the economy was changing, it was no longer clear how much money these assets would bring in. This made it hard to know their true worth. Since these assets were very sensitive to economic changes, even small uncertainties could lead to big disagreements about their value. This made it hard for buyers and sellers to agree on prices.

Also, banks and other big financial companies didn't want to accept lower prices for these assets. If they did, they would have to show a big loss in their total assets. This could make them look like they were going bankrupt. Some banks in 2008 had to be bought out or merge with other companies because people thought they were in this situation. This process of re-evaluating assets based on current market prices is called mark-to-market pricing. Banks that would have gone bankrupt if their assets were valued realistically were sometimes called zombie banks.

Banks with toxic assets were unwilling to sell them for much less than their original value. But potential buyers were not willing to pay anywhere near that price. Because sellers and buyers couldn't agree, the markets froze. No one was buying or selling. In some cases, markets stayed frozen for many months.

Helping Banks with Toxic Assets

On March 23, 2009, the U.S. Treasury Secretary, Timothy Geithner, announced a plan called the Public-Private Investment Partnership (PPIP). This plan aimed to buy toxic assets from banks. After this announcement, the stock market went up by more than six percent, with bank stocks leading the way.

The PPIP had two main parts. One part, the Legacy Loans Program, aimed to buy home loans from banks. The Federal Deposit Insurance Corporation (FDIC) would help guarantee up to 85 percent of the price for these loans. Private companies and the U.S. Treasury would provide the rest of the money. The second part, the Legacy Securities Program, would buy certain types of mortgage-backed securities and other asset-backed securities. Money for this would come from the U.S. Treasury's Troubled Asset Relief Program (TARP), private investors, and loans from the Federal Reserve. The PPIP was planned to be about $500 billion.

Some experts, like Nobel Prize winner Paul Krugman, were critical of this plan. They argued that the loans involved gave a hidden benefit to asset managers, bank shareholders, and creditors. Banking analyst Meridith Whitney also argued that banks wouldn't sell bad assets at fair prices because they didn't want to show big losses.

Types of Toxic Assets

One example of a market that froze was the Canadian ABCP (asset-backed credit paper) market. The term "toxic asset" is often linked to financial tools like CDOs ("collateralized debt obligations"). These are assets created from selling parts of a bank's home loans. It's also linked to CDS ("credit default swaps") and the subprime mortgage market. However, the term "toxic asset" doesn't have one exact definition.

Related Terms

Toxic security is a name used after the subprime meltdown for financial tools that are hard to tell if they are an asset (something a company owns) or a liability (something a company owes). According to George Soros, "the toxic securities in question are not homogeneous," meaning they are not all the same.

One example is a credit default swap. This is like an insurance policy. The holder gets small, regular payments. But if a specific event happens (like a company not paying its debt), the holder has to make a very large payment.

The right to get a stream of payments is counted as an asset. The duty to make a payment is counted as a liability. With a credit default swap, the amount of money coming in and going out depends on a risk that is hard to predict.

The overall value of these expected money flows can be calculated using a model. But these calculations need a lot of trust in how likely the event is to happen, which might not always be true. Lawrence Levine, a director at RSM McGladrey, said, "There is no doubt there could be disagreement on what the fair value for these securities is."

See also

In Spanish: Activo tóxico para niños

• High-yield debt
• Subprime mortgage crisis
• Troubled assets relief program
• Home equity protection