After the 2008 financial crisis, the terms "toxic loan" and "toxic assets" entered the general lexicon, as such loans were a primary cause of the market meltdown that year. Although the term used to describe these assets makes it easy to infer that they're no good to have on a balance sheet, many casual investors and market watchers may not understand what it is about these assets that makes them poison to an investment portfolio.
Mortgages are loans that are backed by collateral, the house the mortgage is used to purchase. In normal circumstances, this provides lenders with protection. When borrowers default, they seize the home and sell it to recoup the initial investment used to buy the home. When real estate values plummet, that safeguard falls apart. If a bank forecloses on a home worth 60 percent of the amount lent originally to purchase it, when it sells the collateralized home, it's stuck with a staggering 40 percent loss. This is one type of lending that makes up toxic loans.
Loose Lending Practices
The other practice that leads to toxic loans is improper lending procedures. Before the 2008 financial crisis, many banks provided mortgages to homebuyers with credit that could be described as shaky at best. Banks sometimes packaged these to investors to hide the risks that came with handing out mortgages to risky lenders. Other times, mortgage underwriters didn't vet candidates sufficiently and were unaware of the credit risks mortgage customers posed. Either way, many borrowers received loans that were a much greater risk than they appeared on paper, making many mortgage-based bonds also as risky.
Fallout of Toxic Assets
There's always going to be a small amount of toxicity in the loan market, but in 2008 when the housing bubble burst, the number of toxic assets on banks' books skyrocketed. With banks foreclosing on homes at a remarkable rate and unable to recoup their assets by reselling them, many banks had large amounts of toxic assets on their books, which caused a massive loss for investors who backed mortgage instruments. This toxicity threatened to undermine entire banking institutions, with many losing large portions of their assets in toxic sinkholes. Further compounding the problem, because banks had no way to gauge how many toxic assets other banks had on their books, they couldn't gauge inter-institutional lending risks and stopped loaning other banks capital, helping to tighten already strained credit markets.
The Troubled Asset Relief Program provided federal funds to help relieve banks of some of their toxic assets, purchasing large numbers of underwater loans from lenders to clear the loss from the books. Other investors saw opportunities and, judging that the market was at rock bottom, bought toxic loans from banks at a value between the mortgage's balance and the home's value. Other toxic assets were merely written off as losses.
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