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What is Toxic Debt?

In the financial world over the last year, new buzzwords and phrases have been cropping up all over the place, and in this last year, one particular phrase has continued to catch the attention of many. Known as assets that were once quite valuable but now seem to be completely worthless, “Toxic Debt” has now become a common household word, describing everything from items that have suddenly become worthless or items that are simply too difficult to estimate any worth so that it is now worthless. This term, originally an American phrase, was originally used to reference loans backed by property that had been granted to people who actually didn’t have the means to repay. In order to deal with the desire of both national and regional banks to grow and expand, as well as helping to fuel the growth of housing, banks were lending out money to people who could not actually afford the mortgage payments. While this allowed people to acquire a home, the banks believed that with property prices increasing so much, there was no risk to the bank of the customer defaulting, as the property would always be worth more than the loan. For a few years, this particular business model worked quite well, up until the property market started to fall and people stopped spending and started losing their jobs.

  • In the US, regional banks did not often run actual portfolios for their balance sheets, but rather bundled up these loans into different packages that they would then sell to savings companies or even other banks. This became known as CDO, or Collateralised Debt Obligation, which would then be rated according to the different customers in the bundle. If the risk was high, the price was lower and the yield was higher. If the risk was lower, the price would initially be higher but then would lower the yield over time. At first, all of the loans for putting up property wound up creating a great deal of CDOs so that they could diversify portfolios, but the economy began to slow as more and more customers had to begin defaulting. That made property prices fall heavily, and the CDO actually wound up becoming worthless in many cases.

While originally from the US,
Toxic Debt is showing up in international markets, but notably in the UK. In the event that any derivative or asset that once had security watches the values diminish severely, it is now being classified as toxic debt, which is certainly problematic. The fact is that banks have to rely on the value of these assets in order to clear their obligations when someone has to default. If there is no value that the bank can fall back on, they then run the risk of losing their entire principal. These toxic assets only get worse as well, considering that there are customers who are still not paying, which makes it difficult to actually assess the damage done to the economy. Right now, banks are being forced to make concessions for the bad debt and the losses, so they have to take their capital and reserves in order to help deal with the bad debt. Their balance sheets are now weaker, so the regulatory authorities internationally need the banks to have minimum amounts of capital. Some banks had actually run out of capital in order to deal with debt.

There is good news, however, as groups have begun to use government funding to help bridge that gap between customer and bank so that there is revenue flowing back into the bank and then the Treasury. While it will take time, toxic debt is not going to be forgotten any time soon.
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