Toxic assets
What are they?
Toxic assets are assets held by investment banks and other financial services entities that had value once upon a time, but which no one wants to buy any more because of uncertainty about their true value and fears that the loans underpinning them were made to people who will never, ever pay them back.
The most common kinds of toxic assets are those based on sub-prime and, increasingly, Alt A mortgages. These include things like mortgage backed securities (MBS) and CDOs.
Toxic assets usually coincide with level three (or tier three) assets. These are complex, hard-to-value and hard-to-sell securities (ie, all those named above). Tier three capital was invented by the Basel Committee for Banking Supervision in 1996 and is to be distinguished from tier one capital (ie, shareholders' equity and other core capital) and tier two capital (subordinated debt and other supplementary capital). For more information, click here.
What have they got to do with the financial crisis?
Toxic assets are at the heart of the credit crunch. Once dodgy loans had been made to sub-prime lenders and made into tradable securities, they were sold and permeated the entire financial system, thereby spreading the 'poison'.
How many of these toxic assets are there? Estimates of the value of Lehman Brothers' toxic assets varied from $40bn to $80bn. Merrill Lynch sold $30bn of its own toxic assets to LoneStar funds in July 2008 (but had to fund part of the purchase itself). However, this is only the tip of the iceberg. According to the US government, which in September 2008 was putting together a fund to buy them all up and unfreeze the banking system, they're worth a massive $700bn.
Toxic assets are a big deal because mark to market accounting regulations require banks to reduce their value in writedowns whenever their notional value falls (even if banks don't want to sell those assets). This leads banks to make big losses and means they have to raise more tier one capital to support their liabilities. In this situation, banks don't want to lend to each other or anyone else and credit is very tight.
Last updated on 26 September 2008.
