What's Really Inside a 'Toxic Asset'

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In the good old days, homebuyers signed a mortgage, banks loaned them money, and that was that.

But these days, most mortgage loans are bought and sold in a secondary market.

When housing went from boom to bust, mortgages (especially subprime and Alt-A loans) were at the center of the economic crisis. And the term 'toxic asset' was born.

'Toxic asset' generally refers to pools of mortgages packaged by Wall Street firms, which sell them to investors as bonds called residential mortgage-backed securities (MBS).

Bundled inside these securities are bad mortgages (risky loans in danger of default or foreclosure) along with good ones (mortgages made to borrowers with strong credit, with little chance of default).

The bonds are rated by the usual agencies, including Moody's , Fitch, or Standard & Poor's. Investors who prefer safer bets choose A-rated bonds; investors with a greater appetite for risk go for the B-rated bonds.

As long as the mortgages in the pool stay current (meaning borrowers are making their monthly payments on-time), every investor who owns a chunk of that pool gets a check in the mail.

But, when homeowners stop paying their mortgages, investors (starting with the 'B' tranche) stop getting paid. When their investments become worthless, payments to the holders of the 'A' tranche dry up, too.

And that's why these investments are so potentially 'toxic." (You can read much more about toxic assets, mortgage-backed securities and related investments here).

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  • Diana Olick serves as CNBC's real estate correspondent as well as the editor of the Realty Check section on CNBC.com.

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