Why is government buying more toxic assets?

Toxic assets are blamed for helping spark the biggest financial crisis since the Great Depression. And just last week, the Federal Reserve announced it would buy an additional $750 billion worth of toxic assets in the latest big-budget attempt to jump-start the economy.

Q: What, exactly, is a toxic asset?

A: A toxic asset isn’t a formal economic term but rather a catchphrase that’s cropped up during the recent crisis to describe assets whose value has fallen so much that their owners face enormous — and potentially fatal — losses.

The most common type of toxic asset, the mortgage-backed security, became wildly popular during the real estate boom earlier this decade. Easy credit led to a flood of mortgages, which were sold on the secondary market and bundled into securities. Big banks and other investors gobbled them up because they promised relatively good returns and were considered safe, with the risk widely distributed among hundreds of mortgages.

Other toxic assets include exotic financial instruments such as collateralized debt obligations and certain kinds of credit default swaps, which are essentially insurance against a bond or loan default.

Q: Why did they turn bad?

A: Blame it in on the subprime mortgage. Mortgage-backed securities were backed in part by subprime mortgages, which began to suffer widespread defaults about two years ago. Values for the securities plunged, forcing companies that held them to take huge losses — in some cases into the billions of dollars.

Meanwhile, firms that issued credit-default swaps as insurance against these losses suddenly were left facing huge payments. This is what got insurance giant AIG into so much trouble.

Q: Why is the Fed spending $750 billion more to buy mortgage-backed securities?

A: In short, it is trying to heal the big financial firms. The theory is that taking the toxic assets off the companies’ balance sheets will restore the flow of credit to individuals and businesses, said Don Sabbarese, director of the Econometric Center at Kennesaw State University. With last week’s announcement, the Fed now plans to buy $1.25 trillion of these securities.