Toxic Mortgages: Where are they Coming From?

Since 2007, we have constantly been hearing about something called toxic mortgages.

Are they some sort of new sophisticated rocket-science financial product created by the MIT trained gurus from Wall Street?

In fact, the answer is yes, but let us start from the beginning (or rather the end).

Toxic mortgage is just an expression used by some journalist in 2007, and then this good (or rather bad) sounding expression has caught on fire. It is now meant to represent an asset that is significantly under water (say 50%), mostly mortgages but the adjective toxic could also designate other toxic assets such as structured products or derivatives products.

As it is understood nowadays, toxic assets are largely investments backed by risky subprime mortgages.

A toxic asset is an asset that lost a lot of value, but most people do not really understands how it works. This is what makes it toxic, it could ruin your health as you would lose money without understanding why.

Now let us move the clock back to 2007. What happened in the summer 2007 is that the financial crisis and the ensuing recession started when two hedge funds from Bear Stearns imploded. Or in other word lost their entire value in a matter of weeks. So what happened and how could it have happened?

If we go back in time a little more around one decade give it or take it, the early 1990’s where the years when mortgage backed securities became very popular. These are arguably the most complicated type of financial derivatives, because the number of significant factors necessary to price them is greater than most other sophisticated derivatives assets.

In particular, the prepayment rate is a key factor which does not exist in other assets, but introduces a new dimension into the pricing problem. Without going into too much technical details, mortgage backed securities have become the favorite playground of the most highly technical math gurus on Wall Street, who have been able to create all sorts of products with all sorts of risk/reward profiles.

Including products that can almost lose their entire value overnight!

So this is how it all started. Millions of people, from the low-income home owners to the CEO of Bear Stearns used the complexity of mortgage backed securities to hide the fact that tremendous risks were taken, without letting the rest of the public know.

Or maybe few people really understood what was going on and most people were simply complacent. This is what happens during most bubbles. People close their eyes when they make easy money. Even the risk management team at Bear Stearns, which was supposed to be among the sharpest and most perspicacious group of risk analysts around, had no idea of the true risks hidden in their portfolios.

Once these two hedge funds started to melt down, the rest was just the snowballed effect of lifting the curtain on the rest of the financial industry, with all its ugly greed and abuse.

Now we are told that banks’ balance sheets are so full of toxic assets that we cannot loan to businesses and individuals. Indeed the Banks balance sheets devastation caused by the mortgage market implosion has been so profound that it has impeded their ability to conduct their normal business.

Like all crisis and bubbles, it will be cleaned up and end up in the history books. President Barack Obama is working hard to make sure that the financial industry is reformed in depth, and cleaned up of its sick greed. And with is a new expression was born, the toxic mortgage.