How 'Toxic Assets' Are Like Bad Apples

Apple analogy can help explain how "toxic assets" jeopardize the economy.

March 22, 2009 — -- The term "toxic assets" has now joined such historic terms of villainy as Watergate, junk bonds and Ponzi scheme.

They've brought the nation's banking system -- and the economy -- to the brink of collapse.

As the Treasury Department prepares to move forward with its plan to buy as much as $1 trillion in so-called "toxic assets" from the financial industry, it's important to understand just what toxic assets are.

Toxic Assets, Defined

Imagine the bank as a fruit stand. It sells oranges, pineapples, grapes and apples -- but there's a problem with the apples.

"They look beautiful and delicious on the outside but inside there are these horrible worms," Adam Davidson, a New York correspondent for National Public Radio, told ABC News. "They're rotten. They're disgusting. Suddenly you say whoa! I don't wanna eat apples!"

The apples represent mortgage-backed securities -- bundles of home loans bought up by the banks, now worth far less than the banks paid for them. Apple lovers can't tell which ones are healthy, so they stop buying apples. Fruit stands are now overloaded with rotting fruit.

"These are zombie fruit stands," Davidson said.

Stand owners can't repay the apple growers, so they don't get any other fruit, and the chain reaction continues: Stands and growers and fertilizer sellers topple one after another.

But just a handful of stands controls 90 percent of the fruit market -- so big that if they failed, the consequences would be disastrous.

"That's where the government comes in," Davidson said. "The government says it's in our interest. Everybody wants delicious apples. We wanna get this apple business going again."

Government Buys Bad Apples

So the government buys the bad apples. But first it has to find them. Treasury officials, in this anology, are like fruit inspectors, cutting in to test for worms. They even perform stress tests -- comparable to heating up sample fruit to see which will go bad as the weather heats up.

With banks, the government doesn't think all the mortgaged-backed securities are bad. In other words, the apples are not worthless. Uncle Sam hopes to recoup some of the money by selling some of the bad assets -- the financial equivalent of cider and apple sauce. To complicate matters further, some people don't think the apple stands deserve the help.

"People stand outside of the fruit stands. They've got you know pitchforks and torches," Davidson said, continuing the metaphor. "They're saying stop giving that fruit stand money. I hate that fruit stand. I just bought an apple there. It had a worm in it!"

Next Step: Buy the Fruit Stand

"When you have a disease that has the potential to affect all the apples but there's no way to know which apples are infected and which aren't, there's no easy solution," Davidson said.