Q&A / TOXIC ASSETS: Bad investments turn into a paper time bomb

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 $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 catch-phrase that’s cropped up in popular culture 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 had an innovative design that made them appear safe. Other toxic assets include exotic financial instruments such as collateralized debt obligations and credit default swaps, a kind of insurance on bond or loans that evolved into a speculative investment in their own right.

Q: Why did they turn bad?

A: Blame it on the subprime mortgage. Mortgage-backed securities were backed in part by subprime mortgages, which began to suffer widespread defaults beginning in the second half of 2006. Values for the securities plunged, forcing companies that held them to take huge losses —- in some cases into the billions of dollars.

Meanwhile, firms such as insurance giant AIG that issued credit-default swaps as insurance against these losses suddenly were left facing huge payments.

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

A: In short, they’re trying to heal the big financial firms. The theory is that taking the toxic assets off of the companies’ balance sheets will free them up to make new loans. It’s not clear how quickly the banks will respond, but they will be in a better position to restore the battered credit markets, said Don Sabbarese: director of the Econometric Center at Kennesaw State University.