What is Toxic Debt and How Much is There?
From the Editors at Investment U
The market rallied on hopes that the federal government would step in to do what the original TARP plan was designed to do, purchase toxic debt. But there seems to be a great deal of confusion about what makes debt toxic, and how much of it is out there.
The easiest way to describe toxic debt is to see it as two separate issues. One, large amounts of loans were improperly given higher credit ratings (implying lower risk of default). The second is that the value of the homes securing these loans has dropped.
In a normal time period, when a homeowner defaulted on the loan, the home itself could be resold to recoup the loss. With millions of homes now worth less, there is no collateral to restore the debt holders. It’s what makes this debt “toxic.”
To give you an idea of the scope and size of the debt mess, take a look at the chart below. It lists the amount of outstanding toxic debt, its current value and the maturity value. The numbers are listed in billions, and they’re staggering.
Toxic Debt Totals
| Type |
Face Value |
Held by US banks |
Expected loss rate |
Hold-to-maturity value |
| Subprime residential mortgages |
900 |
400 |
32% |
200 |
| Option ARM residential mortgages |
600 |
300 |
27% |
200 |
| Credit card debt |
1,000 |
700 |
23% |
600 |
| Second lien/home equity loans |
1,100 |
1,100 |
13% |
1,000 |
| Consumer car loans |
1,100 |
600 |
12% |
600 |
| ‘Alt-A’ residential mortgages |
1,300 |
800 |
11% |
700 |
| Commercial real estate |
3,300 |
1,700 |
7% |
1,600 |
| Total |
9,300 |
5,700 |
|
4,900 |
| SOURCE: Goldman Sachs | ||||
The federal government could throw hundreds of billions more to fill the hole of defaulted debt, but it doesn’t begin to impact $2 trillion in losses. When the court of public opinion looks to see where all of that money went, they aren’t going to like what they see…
$350 billion only provided a bandage for banks. The money wasn’t spent on maintaining mortgages, it was spent maintaining the debt. It had to be. And without a way for banks to make themselves whole, we will see more bank collapses and more bailout money will be needed.
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