What is Toxic Waste
Toxic waste is investment slang for extremely risky securities, often held in a tranche of collateralized assets.
BREAKING DOWN Toxic Waste
Toxic waste describes the financial equivalent of dangerous industrial byproducts. Securities in this category generally carry so much risk that investors have little or no interest in them, greatly reducing their liquidity. In many cases, toxic waste refers to a pool of troubled or toxic assets thrown together in an attempt to reduce risk in other parts of an asset portfolio. For example, financial institutions often structure collateralized debt obligations in tranches based upon their risk profile. The least-risky levels, known as senior tranches, typically include only debt issued to individuals or entities with high credit ratings. Riskier tiers contain lower credit ratings and generally demand higher coupon rates to compensate investors for the increased likelihood of default.
Depending on the underlying debts, the lowest tranches of collateralized debt obligations can become extremely risky. When the lowest tranches become so risky that investors refuse to purchase them at any price, they become illiquid. The financial community considers these assets toxic waste.
Toxic Waste as Contributor to the Financial Crisis of 2008
Collateralized debt obligations became a major repository of toxic waste during the financial crisis of 2008. Financial institutions sliced residential mortgage-backed securities (RMBS) into tranches and sold them to investors, pocketing fees. Many of those tranches got resold or remixed into other collateralized mortgage obligations (CMOs) or hybrid collateralized debt structures including different mixes of debt securities. Mixing such structures allowed financial institutions to mitigate some of the risk of lower-end mortgage tranches with less-risky debt obligations.
This environment made it difficult to determine the real risk of many structured debt obligations. The situation grew more complicated when mortgage defaults began to rise and investors found that the original RMBS vehicles contained poorly vetted mortgages practically doomed to default. The initial buyers of the lower tranches of RMBS debt had poor information about the actual risk involved. Many ended up purchasing and repackaging what in hindsight we know was toxic waste.
Once the investing community identified the presence of toxic waste, however, it became clear that it would be difficult to identify and contain those securities. The subsequent buying and selling of toxic assets meant they had become sprinkled throughout the derivatives markets dealing in collateralized debt. The resulting loss of confidence in credit agencies’ ability to identify the risk of a given derivative effectively paralyzed parts of the bank inter-lending markets while the mortgage industry melted down, leading to a credit crisis and, eventually, economic recession.