So were they foolish – yes, just like Vegas can give you the “fever”, plenty of people caught it in Southern California and wagered on the dream of continued real estate value.

I expect we’ll start seeing deals pop up in our neighborhood, you can’t believe the hype we all were subjected to here to pull our equity out, refi for a low variable rate, blah, blah, blah for YEARS. It was tempting to “drink the koolaid” and cash in. Thankfully we resisted, I just couldn’t believe that the house I paid $73,000 for in 1984 was really worth $480,000. Now the neighbors to this house are trying hard to sell theirs for $395,000 but for whatever reason it’s still sitting there….

I hope this passes but I don’t know if you saw Jerry Cramer on Fox? (I think) a few months (August) ago losing his cool, ranting, raving and predicting Armageddon. Scared ME….. I’m hanging on to my fixed rates and my cash!
http://www.youtube.com/watch?v=rOVXh4xM-Ww

Let’s start with what a bond is. A bond is a loan. When you buy a bond, you are loaning your money out to bank, corporation, or government, and they pay you a rate of interest. At some point in the future, the bond will mature, and you will get your principal back. Let’s call this principal value the “par” value of the bond.

If all things stay the same about external interest rates and the institution you loaned your money to, you can sell your bond on the open market at any time for your principal amount. Let’s call this value the emergency liquidation value of the bond or the “market value” of the bond.

Lots of things can affect the market value of the bond. One thing that can affect it is the ability of the borrower to repay the principal or interest on the bond. That ability is measured by the credit quality of a bond. The highest credit quality S&P rates bonds is AAA. If the ability to repay degrades, the credit quality will fall. If the credit quality falls, the market value of the bond will fall. For example, if I bought $10,000 of a 10 year bond paying 6% interest was initially rated at A rating, and suddenly we found out that the corporation would have a harder time paying back the interest and principal on their loan, my bond rating might decrease to BBB. If my bond credit rating decreases to BBB, I can no longer sell it for $10,000. In an emergency, I might only have to take $8000 for the bond now.

Now that the basics are out of the way, we might be able to understand the subprime stuff better.

Subprime mortgages were packaged up together and sold as bonds to financial institutions such as banks, hedge funds, insurance companies, etc. Let’s call this “securitizing” the mortgage. While everyone expected some of these mortgages to fall into foreclosure, because there were so many mortgages packaged in this bond, the interest people were supposed to receive on the rest of the mortgages would make up for the forecasting of the foreclosure rates. Let’s pretend that people thought that 25% of these mortgages would fall into foreclosure. If I had a slice of 1000 mortgages, and the 700 that didn’t fall into foreclosure paid a high enough interest rate, then I might think that this securitized mortgage bond was a safe bet in the aggregate. S&P thought so and gave these new bonds a fairly high credit rating.

Because these bonds had a high credit rating and paid a very good interest rate in a low interest rate environment, many financial institutions thought they would be safe and started buying these bonds in large amounts.

Suddenly, the foreclosure rate on these mortgages jumped much higher than expected. Let’s say they jumped to 50%. All of the sudden, these bonds looked much riskier. Furthermore, they interest they paid didn’t justify the risk. In other words, the credit quality of these bonds fell and fell hard. No one would buy them for the principal amount because they had a much greater chance of defaulting.

Because the credit quality fell dramatically, the market value of these bonds also fell dramatically. Banks, insurance companies, and hedge funds suddenly had a bunch of investments on their hands that were worth only half or less of what they thought they were worth.

Because banks, insurance companies, and hedge funds had much more risky investments in their portfolios, suddenly banks, insurance companies and hedge funds looked like bad credit risks too.

So other banks don’t want to loan to banks, insurance companies, etc., because they are afraid they won’t be able to pay them back. This starts the credit crisis.

Now it’s actually a lot more complicated than this. Plus there are other factors at play (such as construction job losses, risks in other securitization schemes, etc.) But this should get you started on it.

Hope this helps,
David

For example, we all have car insurance to cover a major accident. But if you get in a small fender-bender, do you always notify the insurance agent? No. You weigh the cost of fixing the car yourself versus the increased premiums you will pay in the future because you actually made a claim on the insurance. I suspect the same holds true with banks. If the bank made a bunch of loans that turned out bad, and then asked the insurer to cover them, what are the chances that the insurer would write future mortgage insurance policies for that bank?

Maybe insurance doesn’t work this way for mortgage insurance, but I’m pretty sure it does.

Here is one article on this:

http://www.latimes.com/news/printedition/opinion/la-oe-weiner3dec03,1,2752861.story

Until actual ownership of a house is established, the people in that house can’t be evicted for failure to pay the mortgage, nor can the house be sold.

Mainly in new-build neighborhoods where the financing was done by the builder.

I know someone in a 5 year old neighborhood with houses that originally sold for around 250k (here that’s middle of the road for a new house – nice, but nothing crazy) now about 1/3 are abandoned due to foreclosures or the like, and what has sold has done so for around 150k.

There’s some trickle effect, but areas that attract different types of buyers and have lower turnover don’t seem to be too effected.

-C

The cheap dollar is a good point–and also means that it will be more difficult for an American investor to take advantage of the market.

@Tom – That link was very helpful. It discusses the secondary mortgage market which sounds like it was an even riskier investment. It looks like there were people taking secondary mortgages which allowed them to forgo the mortgage insurance which would explain why many of the primary mortgages are having so many problems–they don’t actually have insurance.

http://money.cnn.com/2007/10/15/markets/junk_mortgages.fortune/index.htm

One of the side-effects of this is that investors who bought these securities don’t actually know which houses and which loans they “own”. There is a great deal of fear that many of the loans will go bad, and the uncertainty is causing investors to hold on to any money they have. For example, Citibank announced that it will take a $8 to $11 billion dollar write-off on these loans. That is a pretty large spread, and shows that Citibank itself has no real idea of how many loans may default.

As for the second question, at this moment the number of home loans that have actually defaulted isn’t too high (although the number is growing, certainly). As mentioned above, banks and others with homes to sell still hope to get top dollar, so the prices are still high. In a year or two, the owners will get desperate and prices will fall.

While being liquid is one thing, having a good-looking balance sheet is another. Houses are assets, even if not liquid, and banks simply lost a lot of money and thus feared having to report major losses in their bookkeeping.

Why is this a bad thing? Well, losses of this grandeur and rapidity make a bank look very unstable, and so their stock price will fall. If bank stock prices fall, investors will draw out their money, thus impacting liquidity even further.

Instability in banks will cause a stir across the entire industry, and this whole thing just spiraled on.

That’s just one facet of this whole mess.

Mortgage insurance only kicks in after foreclosure, when the lender has to sell the property “short” (for less than the loan amount). So you’re right, there should be a bunch of insurance companies getting into trouble at some point… and maybe it just hasn’t happened yet.

In the meantime, the banks have enough trouble even if they do make up partial losses through insurance.

The problem is not just the loans themselves, it’s that the banking industry became dependent on revenues from creating and selling little-understood financial instruments that change value based on the collective decisions made by homeowners on whether to pay, prepay or skip mortgage payments.

For the most part, the banks don’t hold mortgages themselves, but rather pass them on to the securities industry. Securities firms collect pools of thousands of mortgages with a notional value of billions of dollars. Then, they say to the most risk-averse investors, “the first $10 million that comes in belongs to you.” The next-most-risk averse get the next $10 million and so on. Since the overall pool is so big, this first slice is really, really safe (or so the story goes), as safe as a Aaa-rated government bond. Each successive slice (or “tranche”) is slightly more risky. As you start moving towards the riskiest tranches, it becomes more and more of a gamble as to whether the funds will come in.

Once the market woke up to the fact that lending standards were ignored, the risky tranches blew up, as expected. What was not expected is that the Aaa-rated stuff would also take a huge hit because of the scale of the problem. The mechanics of the cashflow are still sound – the holders of the (originally) Aaa-rated bonds are still likely to get that first $10 million out of the pool if held to maturity. But everyone’s moved closer to the risky zone. Thus, everything has to be revalued.

Since the extent of the problem has yet to be determined, the buyers of mortgage-backed securities don’t want to buy something they can’t value, and the sellers don’t want to sell at a loss. The inability to come to a clearing price is what’s causing the banks the huge problem – on their books they have to “mark to market” their securities, and if the market says those securities are marked down significantly, then all of a sudden they have less capital on their books, and a reduced ability to lend. Which cuts into bank profits, not to mention the functioning of the economy. Who knew?

I call it the “Caddyshack effect” – if someone throws a Baby Ruth into the pool, everyone gets out, even in the deep end where the “chocolate” is only 1 part per million.

Here’s an analogy: Suppose Major League Baseball decided to collect and resell every home-run ball hit into the stands during 2400+ games during a regular season. ESPN buys up the first thousand, FOX Sports gets the next thousand, NBC the third, CBS the fourth and so on.

Ever year from 1998-2006 there have been over 5,000 home runs (this year it dipped to 4,957).[1] Accordingly, MLB could sell no more than six of these contracts, the first being relatively safe, the fifth sold at a discount and the last one being highly speculative.

So what happens if, and this is of course a ridiculous and silly speculative conjecture, but suppose it comes out that a significant number of ballplayers have been juiced over the past 10 years? Why then, we might see a dip in home run production. Or maybe not, considering pitchers are juiced too. But it’s hard to say… but it’s not a sure thing that CBS will get a full set of home-run balls, and if NBC wanted to sell its contract to TV Asahi, well that’s where the analogy breaks down because the scarcity value of the remaining home run balls…oh well. The point is that the contracts would fluctuate in value independently of whether one team wins or loses, or whether the fans enjoy the game. Same in the mortgage market – it’s not the declining home prices and missed payments, it’s the fact that the missed payments are not following an expected pattern upon which billions was wagered. Hope that helped.

[1] http://www.baseball-almanac.com/hitting/hihr6.shtml

“Where are all the cheap houses?”

Look around you. It’s a cheap dollar.