"Toxic assets" refer to loans that have become "toxic" due to a decline in their value or a high risk of default, often securitized and sold to investors who suffer significant losses when the underlying loans fail. These loans are often collateralized by hard assets, such as real estate or equipment.
The growth of the subprime mortgage market in the early 2000s is basically the origin of toxic assets. Many banks and independent lenders packaged subprime mortgages or other hard asset loans into securities, known as mortgage-backed securities (MBS), and sold them to investors for a much higher yield than comparable fixed-income securities. However, the ratings of MBS were overly optimistic, and when the subprime market began to collapse in 2007 and 2008, the value of MBS plummeted. Many of the underlying mortgages were defaulting at higher rates than expected, causing significant losses for investors.
Toxic assets were not limited to the subprime market, with commercial real estate loans becoming toxic when many properties became vacant, causing property values and rents to decline. Collateralized debt obligations (CDOs) were also a problem. CDOs were created by pooling together various types of debt, such as mortgages, auto loans, and credit card debt, and dividing them into tranches based on their risk characteristics. CDOs were popular with investors because they offered higher yields than other types of fixed-income securities. However, as with MBS, the ratings of CDOs proved to be overly optimistic. When the underlying debt began to default, the value of the CDOs declined sharply, causing significant losses for investors.
The impact of toxic assets on the financial system was significant. Finance companies, banks, and other financial institutions that had invested heavily in these assets suffered massive losses, causing many to fail or require government bailouts. The decline in the value of these assets made it difficult for financial institutions to raise capital, leading to a credit crunch that made it challenging for businesses and individuals to borrow money.
The US government created several programs aimed at purchasing toxic assets from financial institutions, with the most prominent being the Troubled Asset Relief Program (TARP), which authorized the US Treasury to purchase up to $700 billion of toxic assets. However, the program was largely unsuccessful in achieving its goals, and most of the money was used to provide capital injections to banks.
As of July 2009, the economy remained mired in recession, with many businesses and individuals still struggling to obtain credit. Although the financial system had stabilized somewhat, there were still concerns about the health of the banking sector and the potential for further losses from toxic assets.
For a detailed explanation of "troubled assets" and where this issue stands, an excellent analysis: The Fall of the Toxic-Assets Plan in The Wall Street Journal.
Toxic assets played a significant role in the 2008 financial crisis. The securitization of subprime mortgages and the creation of complex financial instruments led to risky investments that proved costly when underlying loans began to default. The resulting losses caused a downward spiral in prices and a credit crunch, making it difficult for businesses and individuals to borrow money. Government programs aimed at purchasing toxic assets were largely unsuccessful, and the impact of toxic assets continued to be felt as the economy struggled to recover.
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