TOXIC DEBT EXPLAINED

"Toxic" debt has become shorthand for the various asset classes hard hit by the financial crisis, such as sub-prime mortgages – the original "toxic" asset. The word "toxic" caught on because these assets have proved financially ruinous. They have seen their valuations cut and buyer demand dry up. The holders of the debt have in many cases fallen into a loss and been forced to raise emergency capital. The worst hit UK lender so far has been Royal Bank of Scotland, which has taken £5.9bn of writedowns and has had to raise £12bn from shareholders.

How much "toxic waste" is there?

Nobody really knows. Sandy Chen, banks analyst at Panmure Gordon, has estimated there are about $2,000bn (£1,127bn) of US sub-prime mortgages and another $1,000bn of "Alt-A or near-prime".
Those have been packaged into collateralised debt obligations (CDOs), pools of assets that are then spliced into several classes – from AAA secure through to BBB junk status.

More complex still are the "synthetic CDOs", which are not backed by assets but track asset performance. Panmure has estimated that there are $1,700bn of synthetic CDOs. Asset backed securities have also been packaged into CDOs and have suffered writedowns. US commercial mortgages and leveraged loans, the debt provided by banks to finance private equity takeovers, are similarly now worth less than headline prices.

Even insurance taken out to guarantee bonds sold by the banks has turned "toxic". As the so-called monoline insurers have had their ratings downgraded, the banks have been exposed to more potential losses. So, the potential exposure is hundreds of billions of dollars more than Panmure's estimate for the size of the sub-prime and near-prime market. As the economy weakens, the "toxic" portfolio is likely to widen to include credit card and car finance debt.

What's the cost?

How long is a piece of string? The International Monetary Fund in April estimated that the US sub-prime meltdown will cost banks and other institutions $945bn. For UK banks alone, it estimated the damage will be £20bn. Monoline exposures, commercial property and leveraged loans increase that estimate significantly.

News Courtesy of http://www.telegraph.co.uk/finance

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