For most people in the United States, buying a home means getting a mortgage loan from a lender. When the lender issues this loan to homebuyers, they agree to pay it back in regular installments that total to the value of the home, plus a certain amount of interest. Having outstanding loans that borrowers are gradually paying off is usually good for a bank, but when mortgage loans become toxic, they can become a financial burden.
Loans in Default
Sometimes, borrowers encounter some event in their lives that causes them to become unable to make payments on their loans. When this happens, lenders have the legal right to foreclose on the home, which means that they can seize it and sell it in a public auction to recover the value of the mortgage investment that they put into it. The mortgage can be considered "toxic" as soon as the borrower stops making payments on it.
The Housing Market
Lenders do not like foreclosing on homes for several reasons. First, even if they can recover most of the value of the original loan, it is usually difficult to recover all of it. Second, large numbers of foreclosures can hurt markets, and poor markets mean a slump in business for lenders. For instance, if a bank suddenly forecloses on hundreds of homes in the same city, the city suddenly has far more homes for sale than what is normal, and this drives property values down. With property values going down, it becomes even more difficult for banks to get their money back by selling the foreclosed homes.
Causes of Toxic Mortgages
Toxic mortgages can be both the cause and the effect of general economic downturns. If a recession causes unemployment to suddenly shoot up, fewer people will be able to make their mortgage payments, and the total number of foreclosures will shoot up as well. When foreclosures increase, property values decrease, and this stalls growth in the construction industry, which in turn stalls growth in every other industry. Unable to sell these homes or pass these toxic mortgages to other banks for what they paid in loan money, banks might have to close their doors.
Governments can try to reverse the general economic trends associated with toxic mortgages by purchasing them from lenders. However, governments are hesitant to do this because they stand no chance of getting any direct payoff for doing so. When governments do take action, it is in the hope that countering the various effects associated with large numbers of toxic mortgages can help to turn the whole economy around.