A toxic asset can be best described through an example:
If John Doe buys a house and takes out a $400,000 mortgage loan with a 5% interest rate through Bank A, the bank now holds an asset - a mortgage-backed security. Bank A is now entitled to sell the asset to another party (Bank B). Bank B, now the owner of an income-producing asset, is entitled to the 5% mortgage interest paid by John. As long as house prices go up and John continues to pay his mortgage, the asset is a good one.
If, however, John defaults on his mortgage, the owner of the mortgage (whether Bank A or Bank B) will no longer receive the payments to which it is entitled. Normally, the house would then be sold, but if the house price has declined in value, only a portion of the money can be regained. As a result, the securities based on this mortgage become unsellable, as no other party would pay for an asset that is guaranteed to lose money.
In this example, the mortgage-backed security becomes a toxic asset.
Investment dictionary. Academic. 2012.