Here in the U.S. media we are constantly hearing about large investment banks’ balance sheets filled with toxic assets; hence, the reasons why they are incapable of loaning to businesses and individuals. However, many of us simply have no clue what these toxic assets are and why they have such a huge impact on the U.S. economy. This article will explain how the toxic assets affect, consumers, investors, businesses, and the overall U.S. economy.
Mortgage Loans, one form of a toxic asset, is basically a huge investment backed by a bunch of smaller risky sub-prime mortgages. Issuing these sub-prime mortgages to people who have little-t0-no chance of making the payments raises a serious ethical issue to the banks. In other words, when you see those forclosure signs littering the neighborhoods, you are probably looking at a toxic asset.
So one might ask next, how do these toxic assets get spread out to the public? Well, it all starts when banks lend money to a person buying a new home. The homeowner agrees to pay back the principal plus interest (usually in monthly payments) over a period of time. So there is nothing wrong with that right? Every individual is rational and will make all their payments on time without question…right? wrong!
This is wrong because these banks are fully aware of the financial status of the people to whom they are handing these sub-prime mortgages. Borrowers of sub-prime mortgages typically have weaker credit scores and reduced repayment capacity. Sub-prime loans have a higher risk of default than loans to prime borrowers. If a borrower is continuously missing mortgage payments to the loan issuer, the lender may take possession of the property, which we call a foreclosure. This action did not only destroy the U.S. housing market, it also destroyed the sick investors who were betting on people to default on their mortgages.
As the interest rates on these sub-prime mortgages began to increase, the homeowners were unable to afford their mortgage payments causing an increase in foreclosures. As foreclosures started to rise, the mortgage-backed securities lost their value and began to perform poorly for their investors. Poor investors I say!
Now that I covered the affects on consumers and investors, how does this affect the financial statements of a company? (the lender) As I mentioned before, these banks are the one’s who hold these toxic assets. When the housing market crisis started in 2007 and people stopped paying for their mortgages, the value of the sub-prime mortgages on the banks balance sheet was reduced significantly. As a result, banks lost all confidence in lending to each other and they had no more money to lend to the public because these toxic assets were taking up too much space on the balance sheet. So what happened next? The nation’s financial system became to overcrowded with all these toxic assets which led to the “credit crisis.”