Toxic Debt

What Is Toxic Debt?

Toxic debt refers to loans and other types of debt that have a low chance of being repaid with interest. Toxic debt is toxic to the person or institution that lent the money and should be receiving the payments with interest. Toxic debt generally exhibits one of the following criteria:

• Default rates for the particular type of debt are in the double digits
• More debt is accumulated than what can comfortably be paid back by the debtor
• The interest rates of the obligation are subject to discretionary changes

Any debt could potentially be considered toxic if it imposes harm onto the financial position of the holder.

Breaking Down Toxic Debt

If a toxic debt has been securitized, then the risk of default is passed along with the asset that is being created with the principal or interest payments of the debt, resulting in a toxic asset. Debt itself is not a bad investment, especially if you are the lender and the borrower is making the payments. Debt investments like bonds are essentially the same thing as a bank loan. If the payments on these debts stop coming in or are expected to stop, the debt is on its way to becoming toxic debt.

The historical costs of toxic debt securities are higher than the current market price, so it ends up being an overall loss for the lender or investor. This can often result from unjustified high credit ratings, which implies that the risk of default on the security is much lower than the fundamental analysis of the debtor would suggest. Junk bonds are not classified as toxic debt upon purchase, because the buyer is aware of the underlying risk of these securities.

Toxic Debt Post-Financial Crisis

Toxic debt took on a different nuance as a result of the 2008 Global Financial Crisis and the role that mortgages and ratings agencies played in it. Banks were issuing loans to people who wanted a house and then repackaging those loans as securities to sell to investors. At some point, greed and lax oversight combined to the point where bad loans were being made—as with the NINJA loans—and packaged into securities that were given a higher rating than they deserved.

As these securitized toxic debts made their way through the financial system, underpinning further derivative products and acting as collateral for other activities, the foundations of the whole system were rotting even as it was seemingly still expanding. Toxic debt and the toxic assets created out of them were one of the main factors behind the Global Financial Crisis. 

Toxic Assets

Related to the concept of toxic debt is toxic assets. Toxic assets are investments that are difficult or impossible to sell at any price because the demand for them has collapsed. There are no willing buyers for toxic assets because they are widely perceived as a guaranteed way to lose money.

The term toxic asset was coined during the financial crisis of 2008 to describe the collapse of the market for mortgage-backed securities, collateralized debt obligations (CDOs) and credit default swaps (CDS). Vast amounts of these assets sat on the books of various financial institutions. When they became impossible to sell, toxic assets became a real threat to the solvency of the banks and institutions that owned them.