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Toxic Assets | Here’s How They Crashed the Economy
What is a bank?
You may think of a bank as a place where you go and deposit your monthly wages, or somewhere where you open a savings/current account. However, the truth is that banks are far more complex than this today.
There are 2 main kinds of banks:
1. Commercial banks – they interact with individuals. An example is Lloyds Bank in the UK, or Bank of America in the USA. These are deposit banks; their purpose is to offer a place for individuals to store their money.
2. Investment banks – the original purpose of this type of bank was to help companies raise money from investors. Goldman Sachs or JP Morgan are examples. Since the 1980s, investment banks have played a huge role in creating all kinds of financial products. Some these products have been at the expense of society (remember Lehman Brothers?). One of these products is the ABS (Asset Backed Security).
What is an Asset Backed Security?
In a process called ‘securitisation’ (or securitization in the US), a number of loans such as mortgages and students loans, are pooled together to make one pot of assets. These assets are then chopped up and divided into small but saleable pieces, which investors can buy for a return.
The idea is:
1. Pooling loans together makes them more secure (an example of diversification)
2. Easier for banks to sell – easier for investors to understand and, therefore, buy
That was the idea; however, there was a problem.
Because there was a huge influx of demand for ABSs, many were actually overvalued which meant increasing amounts of relative risk.
The other issue was that the US housing market begun to go into a slump in 2007/2008, which meant many homeowners started to default on their mortgages. An ABS (often known as CDOs – collateralized debt obligations) would only be worth something if the stream of income from mortgages was consistent. However, because so many people were starting to default on their mortgages, ABSs started to become worthless.
Once people started to grasp the severity of the situation, investors were unwilling to buy any more of these securities, which meant the banks had a bunch of ‘toxic assets’ on their hands: assets that were becoming worthless as more and more people defaulted. This started a domino effect throughout the US economy, and eventually the rest of the world.
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