The phrase "toxic debt" has recently been added to the Oxford Dictionary of English, as the term has increased in popularity within the English language and the financial world. We aim to explain what it is and the impact of it, not just on the property markets at the public level, but right up to how the banks deal with debts and assets that have turned against them in the current poorly performing markets.
What is toxic debt?
Basically debt that has a high risk of default. It is toxic to the person or institution that is supposed to receive payments. It can be generated by individuals and institutions. The term originated in the US and was used to describe a class of assets, namely property, that have been financed and are not likely to be repaid.
Individual toxic debt:
A person takes out a mortgage for more than they can comfortably afford to repay monthly. They are unlikely to be able to keep up with repayments, particularly if interest rates increase substantially. Mortgages in the past have been easier to acquire in times of prosperity, with banks offering high loan to value (LTV) mortgages, and lending far beyond the means of the individual.
Institutional toxic debt:
A lending institution (bank) relies on leveraged funds in order to supply cash or loans to customers, they are in the same situation as the individual, and they are unlikely to be able to pay money out in times of crisis.
For example: In 2008 UK bank Northern Rock customers heard that the bank itself was in financial trouble and queued to withdraw their funds en masse. This resulted in the UK government having to intervene to the tune of 24 billion GBP and the bank becoming nationalised as a result. (The bail out was down to the toxic assets the bank had accumulated, rather than everyone withdrawing cash in a panic)
What impact has toxic debt had?
Banks now have a lack of liquidity caused by toxic debt; there is a feeling of wariness amongst the majority of banks and lending institutions around the world. This has meant tighter lending restrictions within the market (at an institutional level) and a lack of available loans for individuals (the public).
Three years ago, an individual could pop along to their bank and apply for a mortgage. If the client appeared to be a little bit on the high risk side for the bank, (a NINJA for example) the bank could just phone around and find someone that would lend. Now though, it is a very different story, hence it being so difficult for first time buyers and fledgling buy to let entrepreneurs to get a mortgage, and the buy to let mortgage market being less competitive on its rates and tighter with the lending criteria.
How toxic debt has been formed in relation to property?
Mortgage loans were given by banks to homeowners (sub-prime mortgages) with lower credit ratings and higher LTV (loan to value). This was a high risk strategy performed by banks and lending institutions. The increase in house prices meant that if homeowners defaulted on their loans the banks could repossess the property and recoup the money by selling it, however, as more and more individuals began to default, a huge supply of property came on the market lowering house prices, meaning both the banks and property owners made severe losses
So with the banks being bailed out, and toxic debt everywhere, how do banks miraculously now show profits?
As the title of this post would suggest, in layman terms it is pretty much just swept under the carpet, only to fester and later return again. What happens is the banks will neatly "re-package" toxic assets, and sell them on to other lenders at a reduced rate (whilst rather ironically laughing all the way back to their own bank, no-doubt). What this does is conveniently reduce the loss to the bank and theoretically regain some liquidity to the banks' balance sheet by basically "dumping" the debt elsewhere.
However, this is just the start of the process. The idea works well when the economy is doing OK, it's a bit like a supermarket ordering too many pallets of baked beans. As the sell-by date approaches and the retailer realises they have a baked bean time bomb on their hands, they have two choices: Keep selling the beans at the same price, and hope they get sold and run the risk of having to throw some away or, sell the last few pallets at a ridiculously low price, knowing that they will sell them, but their average profit per can will take a small hit.
The main problem arises though when ALL the supermarkets have ordered too many cans of baked beans and there just isn't enough toast to put them on. The banks at present are about to hit exactly this situation.
With all the toxic assets neatly packaged up and moved along, or at minimum reclassified as assets instead of mortgage defaults, the banking worlds' bank balances look miraculously rosy once again (Northern Rock for example, having been lent 24 billion GBP in September 2007, is now less than three years later showing a profit of just a shade under 350 million GBP ) Rocket scientist I am not, but I think we can all understand that something has been going on to create figures like that.
So what happens next for the banks?
Banks the world over will continue on this merry-go-round for as long as they can. Some will be bailed out using another new financial word in the dictionary "quantitative easing" which, simply put, is a licence issued by the government, to the government, to print money.
Quantitative easing, whilst seeming like a good idea at the time, can come at a price. A countrys' currency has to be based on something. Printing cash willy-nilly with nothing to support it except toxic debts/assets will only hold the financial status of the country for a short period of time. A prime example of the final fall for a country in modern day economics is Greece. How the Greek financial situation pans out over the next few years remains to be seen after its hefty bail out by the IMF……
- Tuesday 24 August 2010