Concept of toxic asset
«Toxic asset» is an expression that popularized certain financial products following the financial crisis started with the subprime in the USA. This expression encompasses financial products, of which paladins are the CDS – Credit Default Swaps and CDO – Collateralized Debt Obligation.
Structure of a toxic asset
At the origin of the subprime mortgage crisis – there were loans that were unimpeded by the commercial banks. Investment banks sold a supposedly risk-free financial product (within the investment banks themselves there are financial reports to comment on the poor quality of CDOs), investors all over the world were buying CDOs without noticing the risk involved leading to the contagion of this ‘Toxic waste’ for other financial systems, the rating agencies earned by rating the CDO with maximum mark and the insurance company AIG relied on its own financial system selling insurance policies on the subprime portfolios thinking to be a financial product with quality and safety.
CDOs are agreements that by exposure to a loan portfolio. The losses incurred by the credit portfolio are taken in reverse order of seniority, so, on the one hand, the junior tranches receive higher coupons (interest rates) and on the other suffer the first portfolio losses.
CDS, however, are agreements that serve for the institutes/individuals if they act against the risk of default: the contract buyer agrees to pay a premium periodically, while the seller agrees that in case a credit event happens to a particular contract, the buyer will be compensated. Yet this financial debt has become highly speculative because it would have all the more value, the greater the bankruptcy propensity of its underlying asset.
The crucial and unexpected problem was in the face of non-compliance with these credits, the real value of the securities, as measured by valuation, dropped to zero, which led, for example, to the bankruptcy on September 15, 2008 of one of the largest US banks, the “Leman Brothers “And significant stock-outs of financial institutions around the world, such as American International Group Inc. (AIG), the largest US insurer, that the day after bankruptcy news from Leman Brothers, had a 61% drop.
Other examples of banks that suffered the negative effects of the US financial crisis were investment bank Bear Sterns, real estate credit bank “Fannie Mae” and “Freddie Mac” in the US and “Nothern Rock” in the United Kingdom, but these have had the support of their governments to avoid their insolvency. These are some examples of the consequences that the securitization of mortgage credits and their non-compliance have caused to the global financial market, which is why these securities have been designated as toxic assets.
Expansion to the real economy
These toxic assets created a high degree of mistrust in the international financial market, due to the lack of knowledge of its magnitude, leading to a drastic reduction in lending among banks in the international money market due to the uncertainty of compliance with the obligations of the borrowing banks. Faced with this reality, liquidity in the financial system was not high and as a consequence, banks significantly reduced financing for the economy, reducing investment and consumption, fostering a recessive and capital deficient economic cycle.
The detection of toxic assets in the financial system and the decline in US consumption were two events that profoundly disrupted the US economy, because a significant part of the North American population applied its surplus resources in real estate and the stock market, which were the most affected, further contributing to a decrease in purchasing power and a consequent decrease in demand.
