And The Slide Continues

Merril Lynch:

Merrill Lynch on Thursday reported a $9.8 billion loss for the fourth quarter, the largest quarterly loss in its 93-year-history, as troubles in the subprime mortgage market took another big bite out of its balance sheet.

Merrill, one of the Wall Street firms that has been hardest hit by the subprime hurricane, said Thursday that it recorded more than $14 billion in write-downs and “credit valuation adjustments” in the fourth quarter related to subprime mortgages and collateralized debt obligations, which are complex debt securities often linked to subprime mortgages. That is on top of $7.9 billion in write-downs at Merrill in the third quarter.

The rise in defaults and delinquencies among United States homeowners has sharply reduced the value of subprime-related securities, many of which are held by Merrill and other financial firms. The latest write-downs pushed Merrill to its second consecutive quarterly loss as well as a $7.8 billion loss for the entire year. Merrill hasn’t lost money for a full year since 1989, Bloomberg News reported.

Just out of curiosity, does anyone remember when the subprime mess first started to be talked about? I remember Kevin Drum talking about the housing market bubble as early as 2003-2004, but where was the first mention of possible problems with subprimes? When?

*** Update ***

More news:

The prolonged slump in housing pushed construction of new homes in 2007 down by the largest amount in 27 years with the expectation that the downturn has further to go.

The Commerce Department reported Thursday that construction was started on 1.353 million new homes and apartments last year, down 24.8 percent from 2006. It was the second biggest annual decline on record, exceeded only by a 26 percent plunge in 1980, a period when the Federal Reserve was pushing interest rates to post-World War II records in an effort to combat an entrenched inflation problem.

Many economists believe that the current slump in housing will rival the dive in the late 1970s and early 1980s when housing construction fell for four straight years before beginning to recover after the severe 1981-82 recession. For December, construction fell by a bigger-than-expected 14.2 percent.






125 replies
  1. 1
    Zifnab says:

    That’s a damn good question.

  2. 2
    Horselover Fat says:

    Don’t know how old they are, but I know I have been following blogs like “The Housing Bubble” and “Bubble Markets Inventory Tracking” for at least 2 and a half years. Subprime and lending practices have been part of the discussion the whole time.

  3. 3
    Elvis Elvisberg says:

    It’s not just subprimes, incidentally.

  4. 4
    Wilfred says:

    Kevin Drum? 2003-2004? How about Karl Marx 1867-1879? The whole sub-prime project is a textbook example of the fetishization of capital.

  5. 5
    taodon says:

    Until recently, I was employed as a loan coordinator for a large bank. In 2003, it was decided that our office would stop accepting sub-prime non FHA loans, even for ‘look-sees’. The underwriters also, at that time, began looking at interest only loans as if the cap had been reached – and if they could not qualify on that, it was rejected. That was considered to be a radical move in the industry.

    At the time, some of our brokers left us claiming we were draconian in our practices, and that no one else was being this way. Now, I think my company saw the writing on the wall. That tells me a lot of these people knew, and the majority did nothing because of greed. Now we all have to suffer.

  6. 6
    Dennis - SGMM says:

    According to this Krugman column, a Federal Reserve official, Edward M. Gramlich (Recently deceased), tried to get Greenspan to increase oversight of subprime lending as early as 2000. Of course, nothing was done.

  7. 7
    Punchy says:

    I feel like I’m going to learn some new stuff today. So many peeps here edumucated on this stuff.

    How long will it take for this stuff to shake out? Is my plan to buy in August smart, or should I wait longer?

  8. 8
    myiq2xu says:

    I’m just glad I wasted all my money on booze and cheap women. I’d be pissed if I had saved it for nothing.

  9. 9
    Jim M says:

    The bubble was starting late 2003 in the CA, FL and IL markets. For the people paying attention to the Real Estate market, Subprime lending sky rocketed in 2005 and 2006.

    The thing is, the credit/financial mess is due more to the deriviatives based on these mortgages not the mortgages themselves. If it was just the homeowners defaulting we would have been looking at a $10B to $25B hit not the $300 to $500B hit that were seeing.

  10. 10
    Randolph Fritz says:

    How long will it take for this stuff to shake out? Is my plan to buy in August smart, or should I wait longer?

    At least two years, I’d think. Not much help to someone planning on buying soon, I’m sorry to say.

  11. 11
    D-Chance. says:

    Not that it isn’t troubling, but it isn’t exactly new. Ponzi rears its ugly head regularly. Remember those wonderful 90s, when the NASDAQ was approaching 5000? “The end of the business cycle as we know it”? Remember TheGlobe.com, that online company with almost zero assets and an IPO of $9 per share that shot up to $97 its very first day on the market? That was my red flag to reallocate and get out. Watching stupid shows on the cable networks where some dumbasses buy a house for a half-mil, invest another $100K and their own fly-by-night labor and contractors, then try to flip it for six-figure profits (ta-daaa! It’s that simple folks, go out and try it yourselves!)… that was another red flag to abandon another investment vehicle.

    You have to hand it to the buzz-generators, though. The talk gets hot and heavy. The early birds get in and clean up. Then, the “greater fool” theory kicks in. People knowingly and willingly overbuy knowing there’s a greater fool around the corner to bail them out. The sheep keep flocking in, and once the pen is crowded to the point of oversaturation, the gates slam shut and the shearing begins.

  12. 12
    zzyzx says:

    I read housing bubble blogs and I think they make some good points, but they also overstate the problem. It’s more fun to talk about The Greater Depression that will make the 1930s look like the dot com boom than it is to say that houses are slightly overpriced and will revalue themselves.

    Also there’s a religious aspect at play too, where people think of themselves as practicing the one true way and anyone who strays from their path of righteousness deserves to be punished. Seriously, read the comments and you’ll see lots of rants about those who didn’t save the right way should suffer. Sure lots of innocent people would be destroyed too, but it’s worth it for the true believers. It’s like reading rapture sites sometimes.

  13. 13
    Punchy says:

    The thing is, the credit/financial mess is due more to the deriviatives based on these mortgages not the mortgages themselves.

    Can you explain this in layman’s terms?

  14. 14
    Horselover Fat says:

    It was largely people getting commissions for writing loans, quality be damned. The commissions were bigger the worse the terms of the loans, like interest rates and prepayment penalties. Lots of people were sold subprime loans who had credit good enough to get better loans.

    Plus of course origination fees etc.

  15. 15
    zzyzx says:

    “How long will it take for this stuff to shake out? Is my plan to buy in August smart, or should I wait longer?”

    Buy if you can afford it. Then again I’m a fan of thinking of my home as a place to live instead of an investment. In theory I could probably sell today and walk away with $200k or so. However, I like my house and I’d rather live there than have the money.

  16. 16
    libarbarian says:

    OFF TOPIC BUT AWESOME

    Just saw this on Yglesias

    J. Goldberg gets panned by … super Neocon Michael Ledeen

    Jonah, instead, says (pg. 80) “Fascism, at its core, is the view that every nook and cranny of society should work together in spiritual union toward the same goals overseen by the state.” That is not fascism […] Just a few lines later, he claims that “Woodrow Wilson was the twentieth century’s first fascist dictator,” and that’s just silly.

  17. 17
    empty says:

    when the subprime mess first started to be talked about?

    Duncan Black has been talking about this with almost the obsession that Sullivan has for the Clintons and it seems for almost as long. (The “almost” is an exaggeration because to be as obsessed as Sullivan usually requires therapy).

  18. 18

    The thing is, the credit/financial mess is due more to the deriviatives based on these mortgages not the mortgages themselves.

    Can you explain this in layman’s terms?

    The easiest way to describe this is that, when you buy a bond (or other security, such as the stuff backed by mortgages), you can buy insurance on it. If the bond defaults, the insurance covers your losses. One of the main terms you’ll hear used to describe this insurance is “credit default swap.”

    What happened was is that far more insurance was sold than there were asset backed securities to insure. Mortgages are really only a part of the problem. People were insuring something they didn’t own. So, if the securities tank, the losses to the people who sold the insurance vastly exceeds the amount of money lost on the mortgages themselves. So much so, that it looks like a lot of the people who sold the insurance aren’t going to be able to pay up on the swaps they sold.

  19. 19
    srv says:

    Stop saying sub-prime. It’s a lie.

  20. 20
    F. Frederson says:

    where was the first mention of possible problems with subprimes? When?

    Subprime lending itself didn’t take off until 2003-4, with the really crazy stuff being issued during 2005-6. There were probably people laughing at these loans as they were being made on various broker boards, but the idea that the whole lending sector had gone nuts probably didn’t emerge until late-2006. (At least that’s my recollection – it’s hard to search for web pages by post date.) The latter half of the bubble depended on these crazy products as by that time most buyers couldn’t afford homes in bubbly areas with a traditional 10-20% down FRM.

  21. 21
    Xenos says:

    I started closely following the real estate/credit bubble back in 2004. I could not figure out how prices were still going up when by any semi-rational analyis 90% of the population could not afford it (I was in the Boston area).

    My sense of it is that the subprime component of the bubble was just then kicking in. Prices continued to rise beyond all reason because brokers were making so much money selling the riskier loans, and since housing was the only growth area of the economy no-one wanted to kill the last golden goose. Well, second to last golden goose, as medicine has somewhat higher barriers to entry than the real estate industry has.

    Still, I remember reading Drum in the early days and saying “Wow – someone else out there realizes there is a problem here!”

  22. 22
    Caidence (fmr. Chris) says:

    Merrill Lynch has other things to clean up first

    (h/t goes to Cunning Realist)

  23. 23
    Caidence (fmr. Chris) says:

    Is my plan to buy in August smart, or should I wait longer

    MUCH longer. The market’s legs are giving out. After it’s legs give out, the extra value from the bubble still has to drain completely…

    Maybe once the market starts functioning minimally again, you can buy a house to stabilize your investments… but I’ m not an authority, you should check with a fin. adviser.

    Only exceptions to this are in the super-schazzy areas, Beverly Hills, Manhattan UES UWS SOHO, etc.

  24. 24
    Zifnab says:

    Only exceptions to this are in the super-schazzy areas, Beverly Hills, Manhattan UES UWS SOHO, etc.

    I heard the real estate in those areas was getting snatched up by foreign investors, which propped the prices up. Something about a weak dollar and a collapsing market making the properties a steal for people with incomes abroad.

  25. 25
    Jim M says:

    Punchy

    In a nutshell, Hedge funds & the Banks packaged and repackaged these loans several times over and have overleveraged themselves(15 to 25 dollars per 1 dollar base value).

  26. 26
    The Other Steve says:

    The problems first started showing up on balance sheets in Q3 of 2006. That seems to be about when MortgageImplode.com came out.

    But I guess I knew there were problems back in 2004, when I sold my old house and moved to a new one. That was when the market began to soften.

    Although I knew that the market was unsustainable going back to 2000… But I learned from the stock market bubble of the 1990s it’s better to try to take advantage of unsustainable markets, then it is to sit out.

  27. 27
    The Other Steve says:

    Merrill Lynch has other things to clean up first

    (h/t goes to Cunning Realist)

    LOL!

  28. 28
    Xenos says:

    If you want to get a house at a decent price, you may well be able to get something in August. But be picky. If you can keep renting, you can keep saving, meaning that you may be one of the very few people able to buy a house in couple years.

    Don’t try to catch a falling knife – pick it up after it has fallen to the ground and has sat there for a year or more. And don’t get sold like this poor guy.

  29. 29
    Nylund says:

    The derivative in really simple laymen’s terms:

    They made bets. Think of the kentucky derby. Its not just a horse that loses, but everyone who bet on that horse as well. In many cases, for ever $1 billion in loans, there was another $10 billion in bets.

    Another way of thinking about it is as if they were Pokemon cards. At one point in time everyone wanted them and they were worth a lot, then one day, people woke up and realized they weren’t and some people’s highly valued collection became piles of stupid paper overnight. Problem is, these were used as collateral for other bets. So at one point, people were like, “don’t worry, if I lose the bet, I’ll give you my pikachu card, its worth tons! But when people woke up and realized a pikachoo card really wasn’t worth that much, so they had to declare that lost value and try to come up with another way to get the money they promised to pay.

    Maybe thats too silly of a metaphor, but close enough to get a sense of the truth.

  30. 30
    Dreggas says:

    Punchy Says:

    I feel like I’m going to learn some new stuff today. So many peeps here edumucated on this stuff.

    How long will it take for this stuff to shake out? Is my plan to buy in August smart, or should I wait longer?

    I would wait until at LEAST 2009. That’s assuming things will shake themselves out, odds are they won’t. As to when this started, the 03-04 timeframe is about right. That’s when Alt-A companies started playing around with subprime (or at least when the one I worked for did). Remember when rates started being cut after 01 there was a refi-boom. I worked from 00-06 in the industry and here’s the timing as I saw it.

    2001 – 2003 – Refi boom as rates were cute

    2003 – 2005 – Alt-A and Subprime lending pick up also reinforced by supply/demand housing prices rose artificially

    2004 – 2005 – HELOC (Home equity lines of credit) becom all the rage as people who do own homes start borrowing against them.

    2005 – 2006 – Option-Arms are the new Arm’s. As “normal” subprime and Alt-A lending started to slow down this was “the next big thing” to keep the market going. Housing became so expensive in many areas that even the normal subprime/Alt-A lending wasn’t sufficient so people took a gamble on the teaser rate figuring they’d be able to refi down the road.

    Some of the dates overlap but this is how I recall it.

  31. 31
    The Other Steve says:

    How long will it take for this stuff to shake out? Is my plan to buy in August smart, or should I wait longer?

    I think we’ll know by August if we’re in for deep shit, or it’s bottomed out.

    So I would stick on that plan, and wait and see.

    By then you’ll find houses that have been on the market for over a year, which will put you in a good negotiating point.

  32. 32
    over_educated says:

    Uh… Where the heck was Sarbane’s-Oxley during alll of this. Weren’t the post Enron reforms designed to prevent crazy stuff like this from happening?

    I think of more signifigance is Moody’s pondering of whether to lower Ambac’s rating. Ambac and MBIA insured all of these exotic derivative AAA rated bonds. If they don’t have the cash to cover… Things could get very interesting.

  33. 33
    The Other Steve says:

    Dreggas has the timeline about right.

    2001-2003 was the second refi boom. The first occured in 1998. That was when rates dropped down to 7%. 2001 was when they went down to 6%, and then continued down to 5%.

  34. 34
    The Other Steve says:

    Uh… Where the heck was Sarbane’s-Oxley during alll of this. Weren’t the post Enron reforms designed to prevent crazy stuff like this from happening?

    SOX basically prevents a company from hiding losses.

    It isn’t designed to prevent anything other than hiding shit under the rug. SOX is about transparency, like all SEC regs.

  35. 35
    Punchy says:

    In a nutshell, Hedge funds & the Banks packaged and repackaged these loans several times over and have overleveraged themselves(15 to 25 dollars per 1 dollar base value).

    Unfortunately, I’m a smart person, but not in this stuff at all. I don’t even know what this means. Is it anything like margain in a daytrading account? Borrowing to buy stocks, only to have them crash and then actually owe more than your initial capital? Or something?

    If a bank loans money to me to buy a house, I owe the bank. Seems simple. what does repacking a loan mean?

  36. 36
    Zifnab says:

    So at one point, people were like, “don’t worry, if I lose the bet, I’ll give you my pikachu card, its worth tons! But when people woke up and realized a pikachoo card really wasn’t worth that much, so they had to declare that lost value and try to come up with another way to get the money they promised to pay.

    Maybe thats too silly of a metaphor, but close enough to get a sense of the truth.

    Any analogy that involves Pokemon when compared to fiscal responsibility is a win.

  37. 37
    Zifnab says:

    Uh… Where the heck was Sarbane’s-Oxley during alll of this. Weren’t the post Enron reforms designed to prevent crazy stuff like this from happening?

    SOX basically prevents a company from hiding losses.

    And the subprime implosion wasn’t about loses so much as it was about risk. If I sell you on a $250k mortgage, then roll it into 250 $1k bonds with a 5% yield, the bonds are all worth $1k, for all you know, right up until you decide you can’t pay the note anymore. If I’m sitting on a $1k bond that has suddenly become worthless, I’m obligated to let my investors know. But that doesn’t really save you.

    Without Sarbane’s-Oxley, Citigroup execs could have ridden the bubble for a while longer and just lied about how much all their assets were worth. So take comfort in that. This could have been worse.

  38. 38
    Punchy says:

    Nylund–thanks. That makes it really clear. I understand now. Collateral becomes worthless, so repayment becomes iffy. Too many people dont repay, and banks cannot/wont collect worthless/nonexistant collateral. Banks take hit.

    So what, in real life terms, was the collateral that suddenly became worthless? Or did banks just loan out without gathering sufficient collateral? And now banks, who own the house, have lost $$ b/c the value of the house has decreased so much? Does this sound right?

  39. 39
    Caidence (fmr. Chris) says:

    Unfortunately, I’m a smart person, but not in this stuff at all. I don’t even know what this means. Is it anything like margain in a daytrading account? Borrowing to buy stocks, only to have them crash and then actually owe more than your initial capital? Or something?

    If a bank loans money to me to buy a house, I owe the bank. Seems simple. what does repacking a loan mean?

    Assuming you’re a normal guy, you remember how much you had to learn just to get your first internet porn cake? The instruments of finance are exactly like that: a lot of small paper cuts.

    If you’re a computer geek, just imagine reading the Bat Book (O’Reilly Sendmail book) front to back, back to front. And 20 more books.

    The moral of this story: finance is actually a huge geek territory. With more hair grease.

  40. 40
    The Other Steve says:

    Many economists believe that the current slump in housing will rival the dive in the late 1970s and early 1980s when housing construction fell for four straight years before beginning to recover after the severe 1981-82 recession. For December, construction fell by a bigger-than-expected 14.2 percent.

    I would agree. If you consider that there have been like 2 million foreclosures in the last year, do we really need to build new houses?

  41. 41
    fester says:

    Going back to John’s question of when were people starting to talk about these types of things. I started to hear the phrase “potential secondary bubble” in 2001/2002 when interest rates dropping hard, the 30 year T-bill was discontinued and nothing really interesting going on in the cutting edge of the innovation economy. As Dreggas noted, at this time, almost all of the action was legit refinancing and the price increases were primarily interest rate driven (if rates drops, prices increase as the monthly payment for a loan of value X gets a whole lot cheaper).

    By about 2003 we were starting to see some stupidity, and blogs such as the Blogging of the President (now most of their econ writers at the Agonist, and Angry Bear started to say that something very screwy was going on in the housing market. By mid-2004 early opinion leaders knew that something very screwy was going on, but that there was still plenty of time to get in and make a lot of money as there were plenty of greater fools available. This is when we really started to see the dumb loans being pushed hard. 2005 and 2006 were ridiculous years as ‘housing is really different’ and its a ‘new paradigm’ language was employed. And then January 2007, subprime publicly imploded.

  42. 42
    Xenos says:

    Punchy-

    The other dynamic in this is that the banks underwriting the mortgages found that there was a tremendous market for even non-compliant (ie risky) loans. All those dollars sent overseas when we buy crappy consumer goods has to go somewhere, and an american mortgage at 9% and a 10% chance of default is better investment than a Chinese mortgage at 12% and a 40% chance of default.

    Huge sums of cash were sloshing around and looking for a home. So long as all the dubious paper secured by vastly overpriced homes were being sold, the party continued. When you take this classic bubble and hop it up with exotic new Wall Street leveraging systems you get the super-bubble.

    Now, as a nation, we have a choice between deflation and inflation. Based on Bernanke’s testimony (stimulus needed!) it appears we have chosen inflation. Everyone who has gone into gold over the last two years will be making out well, provided they get out before the inflationary spiral slows down.

  43. 43
  44. 44
    Horselover Fat says:

    We had a period of at least 4 years when there were at least 500,000 more new housing units constructed per year than underlying population growth could justify. Figure room additions etc to existing housing would easily offset any demolitions.

    There is mucho excess housing inventory out there to be worked off, which would seem to require a long period of less homebuilding than population growth would warrant.

  45. 45
    Chubbs says:

    Would it be appropriate to say the Invisible Hand just bitch slapped America, or not? I don’t know enough about the situation but love that saying. lol

  46. 46
    Dennis - SGMM says:

    I would agree. If you consider that there have been like 2 million foreclosures in the last year, do we really need to build new houses?

    AP says that housing starts are off by 25% with the downturn likely to continue.

    I live in Glendora, a small town thirty miles east of LA. The homebuilders went crazy. A few hundred homes have been built since 2005. A number of older homes on large lots were bought, the existing home bulldozed and replaced with several McHouses built cheek-by-jowl. A couple of the larger developments are not yet completed which will likely result in losses or decreased profits for builders and investors.

  47. 47
    p.lukasiak says:

    Is my plan to buy in August smart, or should I wait longer

    actually, you should start looking now. There are a lot of “distressed sellers” out there, because everyone is saying “don’t buy a house now, prices will go down”. So, if you enter the housing market as a buyer — you ARE the market.

    a couple of suggestions

    1) decide what you can afford, and pre-qualify for a mortgage for that amount with a locked in rate. By pre-qualifying, you not only create a psychological disincentive for yourself to spend more than you want, but the words “pre-qualified” are super-sweet music to the ears of sellers and their agents.

    2) Shop for a real estate agent — and tell them that if they want your business, they have to be willing to reduce their commission if a seller’s counter offer is close to your final offer. And, tell the seller’s agent the same thing — right now, agents are even more desperate than sellers, and rather than risk losing a sale, they’ll drop their commissions.

    3) It doesn’t matter how much a house is listed for, if you find a house you like, offer 90% of your pre-approved mortgage amount. While you’ll get ‘laughed at’ the vast majority of the time, eventually someone is going to make a counter-offer that comes close to what you can afford.

    4) Make your decision solely on the issue of “does this house fit my needs” and forget about whether, if you waited longer, you could get it cheaper. You are buying a home, not stocks, and the value of a house as an investment is secondary to the value of a house as a HOME for you and your family.

  48. 48
    AkaDad says:

    If we want to stop this from happening again, we need to provide less oversight through deregulation.

  49. 49
    Brachiator says:

    The prolonged slump in housing pushed construction of new homes in 2007 down by the largest amount in 27 years with the expectation that the downturn has further to go.

    Here is what drives me crazy about this stuff. There is more than a housing slump or a bursting housing “bubble” at work here. Even lazy ass business reporters write nonsense about the housing “bubble” and expectations that home prices would continue to increase.

    But wages have been stagnant and declining, the current tax system excessively rewards capital gains over ordinary income (wages, interest, etc) and increases in energy and food costs has reduced real income. So folks with sub prime (or even mighty prime)mortgages could not rationally count on increases in the value of their homes to help them if they could not get a raise, get a new job, or otherwise increase their incomes. Most of the news stories that I have read concerning the mortgage mess simply ignore the stagnation of real incomes, or only consider the decline of the middle class as an afterthought to stories about the home loan mess.

    The other thing that is interesting is how a lot of folk, especially folks in the government, ignored or under-estimated the extent of the problem. The BBC news site has a useful timeline of stories related to the mortgage mess going back to February of 2007, with links to full reports. Notice how often, people were warned about an impending crisis, and how lenders just kept on churning out increasingly worthless loan products (e.g. “20 September 2007 — Deutsche Bank boss Josef Ackermann warns of losses from sub-prime exposure”).

  50. 50
    Jake says:

    SOX basically prevents a company from hiding losses.

    It isn’t designed to prevent anything other than hiding shit under the rug. SOX is about transparency, like all SEC regs.

    I suspect the rugs have big smelly piles under them, but we’ll hear about them later. An air tight regulation means squat without enforcement.

  51. 51
    Caidence (fmr. Chris) says:

    4) Make your decision solely on the issue of “does this house fit my needs” and forget about whether, if you waited longer, you could get it cheaper. You are buying a home, not stocks, and the value of a house as an investment is secondary to the value of a house as a HOME for you and your family.

    Now, see, that’s just silly. You’re being a pragmatist, and worrying about things like “children” and “spouse”.

    This is a finance thread about the market breakdown. Greed got us here, and greed motivates us (or at least me). Save your silly “family” stuff for cambodia, you commie!

    (j/k, in case you can’t tell)

  52. 52
    Dennis - SGMM says:

    If we want to stop this from happening again, we need to provide less oversight through deregulation.

    And make the Bush tax cuts permanent, can’t forget that one.

  53. 53
    Punchy says:

    3) It doesn’t matter how much a house is listed for, if you find a house you like, offer 90% of your pre-approved mortgage amount. While you’ll get ‘laughed at’ the vast majority of the time, eventually someone is going to make a counter-offer that comes close to what you can afford.

    I was tipped-off to go after a foreclosed house, at dirt-cheap prices. As long as it wasn’t a trashed house, the discount is unbeatable. Since I loathe to buy anything super new/clean/fancy, I figged that this may be the best way to go. Have close friends who are wicked boss at fixing up stuff that may need it (flooring, etc)

  54. 54
    Brachiator says:

    Hmm. Let’s try that link to the BBC one more time.

    BBC News Timeline: Sub-prime losses

    The BBC News site also has an interesting story on the particularly nasty impact of the sub prime mess on Cleveland, and how Deutsche Bank Trust ended up holding the bag on a lot of the mortgages through its use of investment pools.

    Foreclosure wave sweeps America

    Even if you don’t believe in heavy government regulation, it is inexcusable that there was apparently no public interest in cautioning consumers about the possible pitfalls of these loans coming from either the government or the media. Free markets here seems to mean free to be predatory.

  55. 55
    AkaDad says:

    And make the Bush tax cuts permanent, can’t forget that one.

    Exactly. That way we have less money to provide the oversight. It’s really just common sense.

  56. 56
    Dennis - SGMM says:

    Oversight of the financial markets is just a holdover from the days of that Depression-prolonging FDR. It’s obvious from recent events that the titans of finance are so clever that they require not oversight but freedom from all government fetters.

  57. 57
    Robert Johnston says:

    The thing is, the credit/financial mess is due more to the deriviatives based on these mortgages not the mortgages themselves.

    Can you explain this in layman’s terms?

    I own a large pool of risky mortgage loans that pay 12% interest, with a 5% chance of default on each of the loans. I sell bonds that pay 5% interest, backed by the income from all the mortgages. Even if 5% of the underlying loans default, I’ll be able to pay off all the bonds with room to spare. I’ve sliced and diced the risky mortgages into safe bonds, with some extra money left over for me to pocket.

    The problem comes when that 5% risk of default isn’t independent, as in the case of a real estate bubble. There may, for example, be a 20% chance that 20% of the mortgages default and an 80% chance that 1.25% of the mortgages default. The expected percentage of mortgages to default is still 5%, but the bonds I’ve issued are now highly risky. 20% of the time I’ll default on the bonds, and 80% of the time I’ll make myself fabulously wealthy.

    The derivative bonds, which are a safe investment if the risks on the underlying mortgages are independent, are very risky if those risks on underlying mortgages are linked. A lot of people sold very risky bonds that got rated as safe investments because of the failure to believe in a housing bubble. A lot of people sold bonds backed by bonds backed by mortgages, further obscuring even higher risk investments.

    So there’s a mess because a lot of bonds that were sold and rated as safe were, in fact, very risky, and that risk has come home. But the problem is bigger than that. The terms under which these bonds were issued tend to make refinancing of the underlying mortgages at less than full principle impossible. When mortgages start heading into negative equity all over the place because housing prices drop 15% and people bought their houses putting only 5-10% down, the lender and the home owner would generally have their best interests served by negotiating a 10-20% reduction in principle on the mortgage to get it out of negative equity rather than having a default and foreclosure, because a lot more value than that is lost in a typical foreclosure.

    However, because of all those risky mortgage backed bonds out there, these negotiated reductions in principle don’t happen. Ownership interest in the mortgage is diversified among bondholders, and terms of the bonds won’t allow the issuer to negotiate reductions in mortgage principle that might make him unable to meet his bond payments without bondholder approval. Because negotiations with the homeowner are effectively impossible, the bond issuers end up foreclosing.

    Foreclosure, however, is tremendously expensive. So, because of these bonds, homes in slight negative equity go into foreclosure, resulting typically in a 40-50% loss to the lender rather than a negotiated 10-20% loss. You end up in a panic cycle, where erosion of housing prices causes negative equity, negative equity causes mortgage defaults, mortgage defaults cause bond defaults and foreclosures, and foreclosures further drive down housing prices. Because of these derivative bonds, the housing bubble is force to burst, taking out credit and financial markets with it, rather than to slowly lose steam over time.

    Hence, “the credit/financial mess is due more to the derivatives based on these mortgages not the mortgages themselves.”

  58. 58
    Dug Jay says:

    One of the few upsides to all this gloomy news is that many of you will find that working for the Chinese in the near future will improve your efficiency, and over a very short timeframe, eliminate slovenly work habits. On the other hand, they aren’t the most understanding of landlords or of so-called “free thinking,” especially while undertaken on the job.

  59. 59
    Krista says:

    How long will it take for this stuff to shake out? Is my plan to buy in August smart, or should I wait longer?

    I think we’ll know by August if we’re in for deep shit, or it’s bottomed out.

    So I would stick on that plan, and wait and see.

    What about building? I know that our bubble-bursting won’t likely be as drastic as yours, but there will still be ripples. And the husband and I start construction in April. I’m a tad worried about rates.

  60. 60
    grumpy realist says:

    (Popped back for a looksee…)

    1. Don’t try to catch a falling knife. Also depends where you are looking at buying–has the local area really, really bottomed out yet? I was in Japan for most of the collapse of the Bubble–Japanese real estate prices slid for 15 years, with a 40% collapse from the original top. So don’t think that we can’t have similar price collapses here in the US.

    2. CDOs: You take a basket of dodgy debts, combine the expected income streams, then start slicing up what you have again. You expect that you’ll get at least $X /month with 99.9999% probability, so that gets sold off as “AAA” risk. Getting a further $Y /month is a little iffier, so that gets sold off as lower rated risk. And so forth. The problem is, the probabilities of default that got fed into the calculations were only beta risk and the calculations totally left out systemic (alpha) risk….meaning there was no qualification for “what happens when our entire financial system freezes up.”

    3. THEN what happened is the bright boys in the bank took baskets of CDOs and did the same thing again….

    4. AND given that we’ve got actual property rights mixed up with all of this and the slicing and dicing (not to mention a heck of a lot of sloppiness in property transfer recordances), and you can see why in a lot of cases, we don’t even know WHO in fact holds the mortgage? One reason why so few mortgages are being refinanced (1%).

  61. 61
    Rex says:

    There are a couple of aspects not mentioned here.

    The mortgages were repackaged as derivatives like CDOs and RMBS and sold on the market. The subprime segment of these derivatives promised higher yields than the typical CDOs and were bought up by hedge funds seeking the Alpha returns. Bear Sterns’ hedge funds that imploded had purchased these products and leveraged them to the level of 80:1 as I recall.

    The value of these derivatives was based on financial alchemy that divided the returns into tranches that were supposed to represent the risk associated with the paper. The top 20% were the best and the bottom 20% were the worst and each has credit ratings that correlated to this degree of risk. Then the bottom 20% were repackaged based on the same tranches and voila, the top 20% became high grade investments again. Ratings agencies like S&P and Moody’s gave these high grade ratings because they believed in the alchemy because that was how it worked in the textbooks.

    The valuation of the derivatives was based on having a market to sell these derivatives. Without a market for them, the value of this paper went into freefall. Many of the funds had simply assigned a value to them that seemed appropriate. When it came time to give them a ‘market value’ there was no market and required massive write-downs. This is not restricted to the subprime market though–many other higher grade derivatives have been similarly punished and some investors with money to spare are grabbing them up at discounts. I read recently that the Kuwaiti sovereign funds are buying them up.

    Regarding buying a house in August, it would be helpful to know the location you are talking about. Although this is a national phenomenon, not all places will be punished equally. Also consider your financing options. Inflation is on the march and the Fed needs to decide how to combat it–either leave rates low and risk further battering to our dollar and the chance of a huge inflation bubble or raise rates to hem it in and risk further freezing out potential buyers. Tinker with a mortgage calculator and different loan amounts and likely rates. You might find that paying 10% more for a house at 5% is a superior strategy than paying a lower price at 7%.

    Alan Greenspan, despite all of the blame than can be directed at him in this mess, made a very prescient comment when he said in August 2004: “Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher asset prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums.”

    And here we are.

  62. 62
    p.lukasiak says:

    What about building?

    if you are acting as your own contractor, there is nothing wrong with building. With the slump in new housing construction, you should be able to negotiate prices on raw materials (and don’t forget that, as fewer new homes are built, that is felt in the market for home appliances, etc….. especially on the high end. Don’t be afraid to go into a store, look at something, and say ‘wow, I really like that, but its outside my budget” and try and negotiate a better price even if it isn’t outside your budget) — and maybe even labor.

  63. 63
    grumpy realist says:

    Oh, and the other problem we have out there with CDO-backed bonds is that although a lot of companies out here bought insurance against the possibility of the CDO-backed bonds defaulting, the companies issuing such insurance virtuously invested their payments in (get this)….investment pools backed by the very same CDOs. Oops.

    THIS is the major problem: the stuff out there has been so sliced and so diced that nobody knows exactly where the financial bomblets are hidden, so there’s been a collapse across the board of trust in financial instruments and “debt”. (And no one now believes the ratings agencies: “AAA” has been shown to mean very, very little.)

  64. 64
    Jim M says:

    Thanks Robert for giving a longer explanation that I didn’t have time to give(at work).

  65. 65
    crw says:

    How long will it take for this stuff to shake out? Is my plan to buy in August smart, or should I wait longer?

    No one really knows how long this stuff will take to shake out. But keep in mind, real estate markets are still local. Not all areas of the country experienced bubbles so, conversely, not all areas will see real estate meltdowns.

    IF you’re buying for shelter and IF your market is not overvalued and IF you can get into a standard FHA fixed rate mortgage with 10-20% down and IF you plan to keep your house for a decade or more, there’s no reason not to buy. Where people are getting hurt is they bought overvalued homes with low or no down payments on bad loans. Now that the market is going south and rates are resetting, they can’t make their payments AND they’ve gone upsidedown on their loans (meaning the value of the loan is now greater than the selling price of the house) so they can’t get out or refi. Oh yeah, add in scummy things like prepayment penalties that also lock them in.

    Just use some common sense. Don’t try to time the market. If you can afford a house on a ‘safe’ loan and plan to keep it, buy. If the market is too expensive for you or you’d have to resort to risky loans to get the house, or you think you could move again in the short term, don’t.

  66. 66
    Rex says:

    Oh, and one last thing. I am a commercial appraiser and do not consider myself to be a full-fledged expert, even less so when the bubble was starting to inflate, but we knew in 2004 that something was not right and that easy money, or as we called it ‘funny money’, was starting to skew values. It is not possible that so many seasoned veterans of the industry and other debacles like the S&L scandal did not know what was going on. They knew it and they liked it.

  67. 67
    Krista says:

    p.lukasiak Says:

    What about building?

    if you are acting as your own contractor, there is nothing wrong with building. With the slump in new housing construction, you should be able to negotiate prices on raw materials (and don’t forget that, as fewer new homes are built, that is felt in the market for home appliances, etc….. especially on the high end. Don’t be afraid to go into a store, look at something, and say ‘wow, I really like that, but its outside my budget” and try and negotiate a better price even if it isn’t outside your budget) —and maybe even labor.

    Awesome! Thanks! And yes, we are acting as our own contractors and will be doing most of the finish work ourselves, which should also save us a bundle (my father-in-law is making all our cupboards, and we only have to pay for materials.) But yeah, I’ll definitely do some haggling on stuff.

  68. 68
    grumpy realist says:

    Rex, are CDOs generally considered derivatives? I was studying them when Moody’s was interviewing me for a quant position. I always thought of them as “sliced debt”. (Not to say that you can’t add derivatives which just makes the thing worse.)

  69. 69
    Dreggas says:

    over_educated Says:

    Uh… Where the heck was Sarbane’s-Oxley during alll of this. Weren’t the post Enron reforms designed to prevent crazy stuff like this from happening?

    SOX was a freaking nightmare for us Programmers to implement into Loan Origination Systems. The bottom line is SOX would not have done a damn thing to stop this because the fact is, once the company made the loan, they made the loan. The problem was when everyone started playing hot-potato with the “bulks”.

    Basically let’s say a mortgage company makes 100 loans of $500,000 each (incidentally these would be all ALT-A since, to be prime, they have to be below 450,000). That’s $50000000, now they package up those loans into one big bundle called a bulk. That “package” is then sold on the secondary market, aka Wall St. to investors. Now the company has made a little off of this with regard to bids etc, but the people on wall st. buying it plan to make money off the interest on those loans.

    So they buy it but then dice it up and repackage it with some of their loans and spread it out even more. Eventually those 100 loans are all over hells half-acre. Suddenly people can’t pay, not a big deal if it’s 100 loans, but we’re talking a lot more than 100, we’re talking large percentages of loan originations. Suddenly the value of that paper goes down, people are foreclosed on, and the ones holding the potato start to tank. The lenders themselves (those only doing loans and mortgages) go down first, followed by those who bought their paper. Dominoe effect.

  70. 70
    Rex says:

    grumpy,

    Honestly, my nomenclature is a not as sharp as I would like for it to be. I have always called it a derivative and I know that I didn’t just pull it out of thin air but I could be wrong.

    Wikipedia, which admittedly is not the be-all-end-all of information offers this definition:

    Collateralized debt obligations (CDO)

    Main article: collateralized debt obligation

    Collateralized debt obligations or CDOs are a form of credit derivative offering exposure to a large number of companies in a single instrument. This exposure is sold in slices of varying risk or subordination – each slice is known as a tranche.

    In a cashflow CDO, the underlying credit risks are bonds or loans held by the issuer. Alternatively in a synthetic CDO, the exposure to each underlying company is a credit default swap. A synthetic CDO is also referred to as CSO.

    Other more complicated CDOs have been developed where each underlying credit risk is itself a CDO tranche. These CDOs are commonly known as CDOs-squared.

    Definition here.

  71. 71
    Rex says:

    I think it is also a testament to how complex the repackaging of the loans became that even people who work in the industry don’t know precisely what or how these investment vehicles work or what they specifically ought to be called.

  72. 72
    Punchy says:

    Thanks RJ, Rex. I’ve never seen so many people know so much shit about so much shit. Much appreciated!

  73. 73
    Dreggas says:

    Rex Says:

    I think it is also a testament to how complex the repackaging of the loans became that even people who work in the industry don’t know precisely what or how these investment vehicles work or what they specifically ought to be called.

    The guy who ran secondary where I worked was a genius, in the sense that he knew how to do all the rates and calculations and splits in his head. Not saying it was genius in a good way, just saying he knew his stuff.

  74. 74
    Brachiator says:

    Just out of curiosity, does anyone remember when the subprime mess first started to be talked about?

    More on how this mess started. Back in July 2005, a BBC news story noted the following:

    “People who have a poor credit history or are self employed are finding it easier to borrow money to buy a home, market analyst Datamonitor has said. Banks are increasingly willing to relax their rules because the mainstream market is saturated, Datamonitor said. In 2004, lending to people with low credit scores grew twice as fast as mainstream mortgage lending. ”

    But even here was a caution that was ignored: “Problems have been emerging, however, and in recent months several High Street banks have warned that levels of bad debt are on the increase.”

    The thing is, the credit/financial mess is due more to the deriviatives based on these mortgages not the mortgages themselves.

    There is a great deal of truth to this. In the old days, a mortgage loan was linked to a bank’s actual deposits. Then somebody decided to get fancy and repackage loans and sell them to other lenders and investors. A very concise story with a great graphical explanation of old and new mortgage practices can be found here:

    The US sub-prime crisis in graphics

  75. 75
    Punchy says:

    Thanks RJ, Rex EVERYONE. I’ve never seen so many people know so much shit about so much shit. Much appreciated!

    Fixed for completeness.

    Then I read this:

    The bottom line is SOX would not have done a damn thing to stop this because the fact is, once the company made the loan, they made the loan. The problem was when everyone started playing hot-potato with the “bulks”.

    and I have to continuously remind myself that this is, indeed, written in English. All of this shit seriously feels like another language. And I promise to return the favor if and when John ever posts about Ksp values for aluminum chloride and how the common ion effect can be reduced by increasing the average kinetic energy of the system or through selective pH adjustments.

  76. 76
    jh says:

    If a bank loans money to me to buy a house, I owe the bank. Seems simple. what does repacking a loan mean?

    Punchy

    Here’s what was going on with the subprime RE market in a nutshell.

    Banks used to originate loans and hold them on their books. This meant you would walk into a bank, sit down with a loan officer and determine what you could afford to pay for a home; with reasonable downpayment of course (10-20%). The bank in turn would look at your credit, take your downpayment and do the loan.

    The loan would then be listed on the bank’s ‘financial records as an “obligation” in the amount you borrowed.

    The dollar value of this obligation was important because sometime after the last Great Depression, those ‘budinsky’ Federal regulators imposed what are called “Reserve Requirement” rules on banks. These rules stipulated that for every $1 a bank loaned out, it had to keep a certain amount in ‘reserve'(usually 10cents on the dollar). That way if some of its borrowers defaulted on loans, the banks could remain solvent – keeping all of its depositors and by extension the people ultimately holding the bag – Federal Deposit Insurers and by extension the taxpayer, happy.

    As you can imagine, even the largest banks eventually hit the cap on the number of loans they could make.

    Fortunately, Wall Street’s braintrust had a solution. If a bank no longer kept a loan on it’s books, it wouldn’t count against Capital Reserve restriction. So, they devised a way to get loans off the books: Securitization.

    “Securitaztion” simply means that a bunch of loans (hundreds or even thousands) were bundled up and sold as securities just like stocks and bonds.

    The loans had not only the intrinsic value of the backing collateral (real property in this case) but also could offer cash dividends (mortgage payments). Furthermore, the bundling of these loans were supposed to reduce default risk for everyone involved…..after all how many people could possibly default on their loans? (as it turns out, quite a few)

    ‘This is great!’ thought bankers and wall street. There’s no downside!

    In turn, Banks revised their business models. They were no longer in the business of orginating and holding loans, deriving profit from the interest paid by borrowers.

    Now, banks and the the associated industries (mortgage brokers aka salesmen, appraisers, and investment bankers) all made money from a commision model.

    Banks made their dough from loan origination fees, brokers made theirs by steering borrowers to the banks for the loans, appraisers made their money on the volume of appraisals ordered by banks, investment banks made their money from the fees to bundle and resell the mortgage securities, securities ratings agencies made fees to rate the securities “investment grade” and so it went.

    In world where everybody is dependent on a high volume of loans being written to make their profit and in which risk is supposedly mitigaged to the point of being (supposedly) negligible, previous standards for due diligence in loan underwrting went out the window and there was every incentive to do loans, ANY loans to keep the gravy train rolling.

    This meant credit was extended to every corner of the market, with every kind of loan product imaginable, from stated income “liar loans” to “Interest only” (a product previously reserved for commerical properties) to Option arms. If you had a pulse, you had a loan.

    To make matters worse, broker fee structures created the incentive to steer borrowers to loan products with higher fees, penalties and interest rates, putting even solid borrowers at greater peril of default.

    It was a perfect storm and it is the product of the greedy shortsightedness of the banking, realty and securities industries let run amok.

    Our current situation, by definition is a prime example of a “Moral Hazard”.

    BTW,

    That’s twice in my admittedly short lifetime that unregulated free markets have flumoxed up the economy and left the taxpayers holding the bag.

    “Bring on the government regulators” I say.

  77. 77
    Dreggas says:

    Punchy Says:

    and I have to continuously remind myself that this is, indeed, written in English. All of this shit seriously feels like another language. And I promise to return the favor if and when John ever posts about Ksp values for aluminum chloride and how the common ion effect can be reduced by increasing the average kinetic energy of the system or through selective pH adjustments.

    I tried to spell it all out in the rest of the post :).

  78. 78
    crw says:

    The bottom line is SOX would not have done a damn thing to stop this because the fact is, once the company made the loan, they made the loan. The problem was when everyone started playing hot-potato with the “bulks”.

    Moreover, this wasn’t a lack of laws problem. This was the Fed not using the powers they already had problem. As evidenced by the fact that they’re stepping up to the plate and proposing stricter oversight (now that the horse is out of the barn), no new laws needed. Go team Bush go!

  79. 79
    Kirk Spencer says:

    On whether to buy-build the house – repackaging good advice above: The answer depends on whether you’re buying it as a short-term residence, an investment, or a home into which you intend to settle. For the last only, now is as good a time as any provided you don’t use resetting payment plans of some sort. For the previous two, however, waiting is good. As to timing…

    It is possible everyone involved takes a lesson from what’s happening now and properly prepares for the secondary peak later this year (the “big peak” for subprime was this past December) and more significantly for the Alt-As scheduled to reset in 2010/2011. I’m betting they don’t, however. Not least, nobody wants to admit THAT much pain in the future. Failing to take it all at once means there is a lot more financial pain and foreclosures to come.

    On the foreclosure front, it’s worth pointing out that the NEW home inventory is just under 11 months now — that is, if no new homes were built and the current rate of sales were to continue it would take almost a year to clear the backlog. Add in the (real and anticipated) foreclosures plus the ‘normal’ selling of owner-occupied housing, and you can see that once the glut is recognized and pushing house prices down that it’ll be a while before shortages are perceived. FWIW, we don’t need to go to zero. 6 months is enough. Also FWIW, as it gets harder to get loans (due to standards tightening among other things) the sales rate will decline which further increases the months of inventory.

    For all the above reasons, unless buying a long-term home I’d plan on waiting quite a while – always keeping my eye open for good opportunities. Timing wise, I think we’ll see some opportunities in the upcoming “false bottom” around spring of 2008. There’s a 5-6 month window when most of the sub-prime reset surge is ended but the alt-a resets haven’t hit their stride – relatively speaking.

    As others have noted there are a lot of contributing issues. But a root to it all has been the bubble in housing-based finances – which has been growing since the 1990s, but exploded when the money leaving the dotcom bubble needed a place to go. While that’s unstable anything based on it can’t be stable. So yes, I expect some financial disruption for another four or five years, with much angst and anger at having to pay the piper.

  80. 80
    Dreggas says:

    What JH said.

    There was no regulation of this mess. Basically it was a free for all and just like Bush saying “go shopping” we had greenspan telling us to “buy a house”.

    Oh and just as there was loan speculation there was property speculation via “flip this house” type stuff.

  81. 81
    Dreggas says:

    For all the above reasons, unless buying a long-term home I’d plan on waiting quite a while – always keeping my eye open for good opportunities. Timing wise, I think we’ll see some opportunities in the upcoming “false bottom” around spring of 2008. There’s a 5-6 month window when most of the sub-prime reset surge is ended but the alt-a resets haven’t hit their stride – relatively speaking.

    Yeah The real killer is going to be Option-ARM’s which were a lot of the Alt-A loans. Yes they could be Liar loans but they were one of the few ways to get a loan on anything over 450k. Sure their were Jumbo’s and other lending vehicle’s but Alt-A was the quickest route.

  82. 82
    Dreggas says:

    Oh boy..

    As Atrios says, these are the Jenga pieces that will bring it down.

  83. 83
    Punchy says:

    I tried to spell it all out in the rest of the post

    You did. It made sense. Like I said uptop, I knew I’d learn a lot from you guys/(gals?) on this thread. And I understood ZERO of this before today.

    Seriously, I thought a bank just gave you a mortgage and held the deed for 30 years, period. The only derivative I’ve ever heard of (before today) was in calculus.

  84. 84
    The Other Steve says:

    SOX was a freaking nightmare for us Programmers to implement into Loan Origination Systems. The bottom line is SOX would not have done a damn thing to stop this because the fact is, once the company made the loan, they made the loan. The problem was when everyone started playing hot-potato with the “bulks”.

    The main problem with SOX is that nobody actually understands it, but you have tons of consultants running around saying “You need to do this to be SOX compliant”.

    There’s a lack of understanding today of how things work. A process or change is supposed to derive from a policy or rule. The SOX consultants demanding change without linking it to a policy.

    This is a general problem when you have IT people who have no college education, much less any understanding of business or government.

    I’ve been guilty of falling into the bad mindset myself. We had a myth going around once that we had to keep everything for 37 years. Source code, requirements docs, etc. Why 37? Because the life of a loan is 30 years, and there’s a 7 year window where they can sue. Finally legal stepped in and said “I don’t know where this came from, but it’s not true. The real policy is ‘It depends.'”.

  85. 85
    Dreggas says:

    Punchy Says:

    Seriously, I thought a bank just gave you a mortgage and held the deed for 30 years, period. The only derivative I’ve ever heard of (before today) was in calculus.

    That’s how it used to work, now…not so much.

  86. 86
    Dreggas says:

    TOS:

    Agreed. It was a nightmare LOL.

  87. 87
    Tsulagi says:

    Didn’t take a rocket scientist or even a George Deutsch at NASA to see problems coming. And I think it’s going to go beyond the subprime market.

    You could see problems coming in your own mail. It’s slowed a bit, but not very long ago I used to get, as Ron Paul would say, CRAZY offers. A lot. Home equity loans offered at 125% loan to value. Name companies offering 100% LTV refinancing in no-fee ARMs with initial teaser rates. Some of them even knew the amount of my existing mortgage enticing me to cash out my equity within a week. Could even do it online. Bizarre. How many did that?

    Even if you were ID home-schooled you could see the potential mess. If someone’s net worth was basically their home, if they took one of those products spending their equity then had a hiccup in their income, or the baby had a hiccup requiring on-going medical care, they’re toast. I think there’s more to come especially during a declining home market.

  88. 88

    SOX basically prevents a company from hiding losses.

    It isn’t designed to prevent anything other than hiding shit under the rug. SOX is about transparency, like all SEC regs.

    I suspect the rugs have big smelly piles under them, but we’ll hear about them later. An air tight regulation means squat without enforcement.

    Sarbanes-Oxley has nothing to do with this particular problem. SOX says that you have to sign off on your financial reports, in which, among other things, you have to honestly report the value of the investments that you have. The problem is that everyone completely misunderstood how much many of these assets were worth. They weren’t lying, for the most part; they were just wrong. It got worse when the markets dried up last spring, and a lot of this stuff stopped trading. If you own a security, and the assets it contains are experiencing a shifting market, but no securities like the one you own are trading, there’s no good way to put a value on it. How the hell do you list it on your balance sheet?

    So, a lot of companies just used a mathematical model to decide what the value was. Unfortunately, they left all of the optimistic assumptions in the model that they’d used to value it before house prices started dropping.

  89. 89
    Tsulagi says:

    But yeah, I’ll definitely do some haggling on stuff.

    You might also look to see if home-building-supply chains like Home Depot and Lowe’s down here have credit card offers. Three years ago I renovated a guest cottage on our property. HD and Lowe’s then (maybe still) were offering 10% off your first purchase if you took one of their cards.

    I did then between the two charged about $15k. Then paid the balance on the first statements as they have ridiculous interest rates around 18%. Of course, the wife quickly found a use for the $1500 savings.

  90. 90
    Shawn says:

    Looking at this graph it looks like ARM resets will peak in September, around $35bn dollars worth, about $25bn of that in subprime ARMs. IMO, we’ll be seeing a lot more foreclosures this year. The worst is still to come.

  91. 91
    Brachiator says:

    If a bank loans money to me to buy a house, I owe the bank. Seems simple.

    This gets really fun. It may be that the wise guys who came up with the idea of repackaging loans have actually outsmarted themselves. Loans can be repackaged so often that it is no longer clear who actually can hold title to the property.

    From a November NY Times story (“Foreclosures Hit a Snag for Lenders”):

    “Judge Christopher A. Boyko of Federal District Court in Cleveland dismissed 14 foreclosure cases brought on behalf of mortgage investors, ruling that they had failed to prove that they owned the properties they were trying to seize….

    The ruling was issued Oct. 31 by Judge Boyko, and relates to 14 foreclosure cases brought by Deutsche Bank National Trust Company. The bank is trustee for securitization pools, issued as recently as June 2006, claiming to hold mortgages underlying the foreclosed properties.

    On Oct. 10, Judge Boyko, 53, ordered the lenders’ representative to file copies of loan assignments showing that the lender was indeed the owner of the note and mortgage on each property when the foreclosure was filed.

    But lawyers for Deutsche Bank supplied documents showing only an intent to convey the rights in the mortgages rather than proof of ownership as of the foreclosure date.”

    The story is in the NY Times archives, but may still be accessible:

    Foreclosures Hit a Snag for Lenders

    All this subprime repackaging crap violates all kinds of basic accounting principles in failing to clearly link the loans to a tangible asset (the damn house).

    In addition, the lenders, and the business reporters who cover the mortgage market got so caught up in admiring the “sophistication” of these lending practices that they seemed not to notice that they were not founded on any substantial business practice. In a sad way, this somewhat resembles aspects of the Enron mess, where the razzle and dazzle concealed a complicated, but ultimately fraudulent, shell game.

  92. 92
    Krista says:

    You might also look to see if home-building-supply chains like Home Depot and Lowe’s down here have credit card offers. Three years ago I renovated a guest cottage on our property. HD and Lowe’s then (maybe still) were offering 10% off your first purchase if you took one of their cards.

    It’ll be a whole separate animal with us, I think. We have to finance all that stuff in-store because as builders, we will have a progressive-draw mortgage. The first draw will cover the bill for the foundation, and the second draw will cover all the labour and materials involved in making it weathertight. But they only give you that money when that step is actually completed. So we have to buy all our materials up front, and we most certainly don’t have enough cash in hand for that. But hey, if we’re going to be buying the majority of our materials there for a 1700 square-foot house, that’s a fairly sizeable chunk of business for them, and I fully intend to play hardball.

  93. 93

    Rex, are CDOs generally considered derivatives? I was studying them when Moody’s was interviewing me for a quant position. I always thought of them as “sliced debt”. (Not to say that you can’t add derivatives which just makes the thing worse.)

    CDOs are sometimes derivatives, sometimes they are not derivatives, and sometimes they include some assets that are derivatives and some that aren’t.

    A derivative is any financial instrument for which the price is derived from some sort of underlying asset, rather than containing that underlying asset itself. A simple Mortgage Backed Security, in which someone has pooled a bunch of mortgages, and then sold slices of that pool, is not a derivative. When you buy a piece of that security, you are buying a piece of the mortgages themselves.

    Options are derivatives, because they do not involve owning the underlying asset (such as a share of stock) itself. They give the right to buy or sell a share of stock, so the price of the option is derived from the price of that stock, but you don’t own the stock itself as long as you own the option.

    The form of derivative that is most coming into play in this mess is, in a variety of forms, Credit Default Swaps. Basically, a CDS is an insurance policy. To buy the swap, you pay someone an upfront fee, or continued premiums, and if the bond that is covered by the CDS defaults, then the person that sold you the swap has to make you good. There are a huge number of variations on this, but they all boil down to this rough idea. Some CDOs include not only parts (generally the really sucky parts) of asset backed securities, but also some CDSs as hedges.

    One thing to remember about the finance industry is that, just because you don’t own something, doesn’t mean that you can’t sell it. You can. It is also true that, just because you don’t own something, that doesn’t mean that you can’t buy insurance on it. The notional value of the insurance sold on asset backed securities is a couple orders of magnitude greater than the value of the mortgages themselves. So, when some of these critters go belly up, the losses extend far beyond whoever owned the securities and the people they bought insurance from. A lot of people are on the hook for paying out insurance to people that never owned the bonds in the first place.

    One interesting casualty of this phenomenon may be Goldman Sachs. Right now, they’re looking really good, because, about a year ago, they started to bet that all of this was going to go bad. Effectively, they bought a hell of a lot of that insurance, and now stand to make a lot of money. What is about to happen to them is that, having booked these profits, they now have to worry that the people they bought the insurance from don’t have the money to actually pay it.

  94. 94

    […] not self-regulation 17 Jan 2008 Posted by Watts in Uncategorized. Tags: finances, regulation trackback From the comments thread at Balloon Juice on the ongoing housing market collapse, caused by thesub-prime collapse, which was caused in no small part by banks giving loans to people they knew were risky investments and then turning around and selling options and derivatives on those risky loans—thus ensuring that a default on those loans would cause a cascading effect throughout the financial market: […]

  95. 95
    Shawn says:

    Tsulagi Says:
    You might also look to see if home-building-supply chains like Home Depot and Lowe’s down here have credit card offers. Three years ago I renovated a guest cottage on our property. HD and Lowe’s then (maybe still) were offering 10% off your first purchase if you took one of their cards.

    Also, if you go to Home Depot and Lowes websites or stores, you can usually sign up to receive a 10% off coupon in the mail. I think it’s a new homeowner discount.

  96. 96
    myiq2xu says:

    Shorter version of all the above explanations:

    The “experts” fucked up, so we are gonna get fucked.

  97. 97

    Looking at this graph it looks like ARM resets will peak in September, around $35bn dollars worth, about $25bn of that in subprime ARMs. IMO, we’ll be seeing a lot more foreclosures this year. The worst is still to come.

    The ARM resets are only the beginning of the problem, and not the worst of it. There are a couple of things that you need to avoid conflating. An ARM reset is when the rate on your adjustable rate mortgage changes to meet the new market rate, which is usually defined as LIBOR + a percent or two (or more, ffor some loans). This can be pretty bad.

    It gets worse. What we also have to worry about are the recasts. A lot of mortgages made over the last several years were interest only, or even negative amortization; these were collectively called hybrid loans, and most of them were ARMs. By the way, when you hear about these products, remember that they were never marketed to subprime borrowers; these are prime loans, though they get called Alt-A because they don’t conform to certain guidelines.

    On the hybrid loans, the minimum payment you are required to make for some initial period, often as long as 3-5 years, was less than the amount you would need to pay to amortize the mortgage. With interest only, the minimum payment would leave the outstanding balance of the loan unchanged. With negative amortization, the balance would actually increase.

    There comes a point, called recast, when the borrower has to start paying the fully amortizing amount. There are various triggers for when this is. The increase in monthly payment from a recast is usually much larger than it is from a simple reset. Recasts probably aren’t going to peak until 2009-2010, well after the ARM mortgages have gone through their first round of resets. That’s going to be a whole ‘nother round of carnage.

  98. 98
    Dreggas says:

    It gets worse. What we also have to worry about are the recasts. A lot of mortgages made over the last several years were interest only, or even negative amortization; these were collectively called hybrid loans, and most of them were ARMs. By the way, when you hear about these products, remember that they were never marketed to subprime borrowers; these are prime loans, though they get called Alt-A because they don’t conform to certain guidelines.

    This was the bitch right here. When you were paying IO (Interest Only) you were only paying for the Interest at that time and not paying a cent of principle. So 5 years later you still owe, let’s say, 600,000 AND the interest on it. Not to mention the fact that given this market that home is only now worth, say 450k (being modest) so you just lost 150000 and saw your payments go through the roof.

    Bent over barrel + No lube = you.

  99. 99
    Tsulagi says:

    But hey, if we’re going to be buying the majority of our materials there for a 1700 square-foot house

    Good luck in building your house. Seriously.

    But you might want to learn some deep-breathing techniques and have some anti-stress medications on hand in advance.

    A couple we know did the same building their house. It took much longer than expected. Mainly due to some unexpected soil problems requiring extensive site prep and foundation footings. It caused some stress in their relationship. A few times when I went over to pitch in some labor they weren’t talking to each other. And sometimes they didn’t appreciate my efforts to get them to laugh at the situation.

    But it got done, and now they’re both really happy they did it. Financially even with additional expenses they made out really well.

  100. 100
    Xenos says:

    Not to mention the fact that given this market that home is only now worth, say 450k (being modest) so you just lost 150000 and saw your payments go through the roof.

    No problemo. Put the keys in an envelope, send them to the bank (a/k/a ‘jingle mail’), take self and ruined credit to a new rented home. You can even take the kitchen appliances with you, the water heater, the copper pipes, etc. Hell, roll up the turf in the front yard and plant it around the new trailer you buy in your child’s name.

    Wait seven years. Repeat process from the start, this time making sure to get out at the top.

  101. 101
    Emma Anne says:

    So 5 years later you still owe, let’s say, 600,000 AND the interest on it. Not to mention the fact that given this market that home is only now worth, say 450k (being modest) so you just lost 150000 and saw your payments go through the roof.

    And then what happens is what Calculated Risk calls “jingle mail” – mail the keys to the lender and walk away. The ensuing foreclosure lowers the price of houses in that neighborhood some more, and now the neighbors owe more than their house is worth. Etc.

  102. 102
    Emma Anne says:

    Here’s how I understand the whole mortgage securitization thing:

    (1) A bunch of mortgages are bundled together. They won’t all go bad, so AAA bonds are sold which have first claim on the proceeds from the mortgage payments. Very safe. AA bonds have secong claim, Still very safe. Down around BBB, not quite as safe – aka junk bonds. So far so good. If this is where it had stopped there would be no problem. Most mortgages haven’t gone bad and won’t. Only the junk bond holders will lose their money, the way it should be. But wait! There’s a step two.

    (2) A bunch of those BBB bonds are gathered together into a CDO. All of the BBB bonds won’t go bad at the same time, so AAA bonds are sold which have first claim on the proceeds from the all those BBB bonds. But the problem is that too many of those BBB bonds did go bad at once – because they aren’t all that independent of each other. House prices started to go down in big swaths of the country. So the “AAA” bonds from the CDO might still be good, but the supposedly still very safe AA bonds go bad.

    (3) More of the same -> even some AAA bonds go bad. AAA bonds are owned by pension funds and local governments and so on. Blood in the streets.

    And I don’t buy that the banks and rating companies and investment bankers really didn’t understand the risk. *No one* thought, ever, about the possibility that house prices could drop around the country? Please. They just thought someone else would be left without a chair when the music stopped.

  103. 103
    Emma Anne says:

    Hey, Xenos posted while I was typing. Pwned.

  104. 104
    Zifnab says:

    This was the bitch right here. When you were paying IO (Interest Only) you were only paying for the Interest at that time and not paying a cent of principle. So 5 years later you still owe, let’s say, 600,000 AND the interest on it. Not to mention the fact that given this market that home is only now worth, say 450k (being modest) so you just lost 150000 and saw your payments go through the roof.

    Bent over barrel + No lube = you.

    Good news is that we’re seeing record levels of inflation. Even a 9% mortgage loan doesn’t look that bad when inflation is at 15%. Of course, since real wages haven’t been tracking with inflation much, we could also see a continuing wave of foreclosures straight into the recession we’ve been digging. I mean, the bottom line is that you can’t get blood from a stone. All these bad loans aren’t going to make any money from broke people. But we have seen a very effective gutting of the middle class.

    I seriously don’t see many good endgames for our economy at this rate. No middle class means sweeping poverty. Those cheap goods can’t flow in from China forever. And when people are too poor to shop at Walmart… Eventually, the bottom falls out on this thing for real. Fuck all this, I’m moving to Switzerland.

  105. 105
    Punchy says:

    But hey, if we’re going to be buying the majority of our materials there for a 1700 square-foot house, that’s a fairly sizeable chunk of business for them, and I fully intend to play hardball.

    Good luck with that. I’m not sure most national chains will be flexible on the price. I cannot speak for Home Depot, but Best Buy is extremely unlikely to adjust the cost of appliances, fridges, etc. They open themselves up to charges of favoritism, racism, etc. when they are percieved to have a floating price.

    If your store is just a local mom-and-pop, I’d bargain the crap out of them. But nationals are pretty firm, and they have to be.

  106. 106
    Xenos says:

    Best Buy for appliances? Ever check out a Sears Outlet? The prices are about 60% normal, and they hold amazing sales, too. May well be worth a drive to Halifax.

    Last time I renovated a kitchen I made out like a bandit on some really nice stuff with minor cosmetic issues. Man, I miss that convection oven to this day…

  107. 107
    Brachiator says:

    Here’s how I understand the whole mortgage securitization thing:

    (1) A bunch of mortgages are bundled together. They won’t all go bad, so AAA bonds are sold which have first claim on the proceeds from the mortgage payments. Very safe. AA bonds have secong claim, Still very safe. Down around BBB, not quite as safe – aka junk bonds. So far so good. If this is where it had stopped there would be no problem. Most mortgages haven’t gone bad and won’t. Only the junk bond holders will lose their money, the way it should be. But wait! There’s a step two.

    Ah, no. The problem was that an entire market was created to cater to home buyers who were high risk. Lenders disregarded their own credit rating systems. Some consumers were allowed to get loans based on “stated income,” that is, there income was whatever they said it was with no supporting documentation.

    Further, consumers were encouraged to refinance loans, creating more stuff to be “securitized,” based solely on the supposed increased value of their homes, again without regard to their fundamental ability to make mortgage payments, and with the further sting that “teaser” interest rates guaranteed that their mortgages payments would increase fairly steeply in the future.

    The bond ratings as AAA or BBB, etc., had absolutely no meaning because the lenders had already suspended every method by which loan risk could be reliably measured.

    What amazes me is that anyone thought that this nonsense could succeed for any length of time.

  108. 108
    Grumpy Code Monkey says:

    What amazes me is that anyone thought that this nonsense could succeed for any length of time.

    Who could have foreseen that the financial equivalent of the Second Law of Thermodynamics (booms eventually bust) would bite us in the ass yet again?

  109. 109
    grumpy realist says:

    The fact is, a lot of the financial engineering was handed over to the quants, who were told to come up with particular probabilities and risks. Which they did.

    Problem is, gas molecules never scream and all stampede into a corner of a box. Humans often do. Result: correlations –> 1, we’re screwed.

    EVERYONE thought that someone else was minding the store. The lack of supervision remained invisible due to the continually rising real estate prices. Then the real estate market has a hiccup and–as Warren Buffett said: “when the tide goes out, you see who’s been swimming naked.” Whoops.

    I knew the whole thing was a mess back in 2003 when I heard Greenspan touting ARMs. My business partner and I couldn’t believe our ears.

  110. 110
    Dreggas says:

    Zifnab, my situation as well as that of a lot of others right now is summed up in two words: “Salary Freeze”.

  111. 111
    grumpy realist says:

    JMN, thanks for the explanations on CDS–I studied a bit on swap pricing but didn’t get into the nitty gritty of the rest of the beastiary.

    And I should have remembered that derivatives were more than the call/put variety–one of the financial magazines did an article back on derivatives based on the weather for use by Japanese temples. (This makes more sense when you realize what’s going on–Japanese temples get a lot of their income for the year when people visit on particular holidays and make offerings. If the weather is bad, less people come, ergo less income.)

  112. 112

    JMN, thanks for the explanations on CDS—I studied a bit on swap pricing but didn’t get into the nitty gritty of the rest of the beastiary.

    Hey, no problem. Two years as an options trader should be good for more than just a nervous breakdown.

  113. 113
    conumbdrum says:

    Here’s where we need Darrell and scs to bloviate on how the American economy is the greatest in the world and all those losers who took out bogus house loans deserve to lose their homes for being greedy something-for-nothing deadbeats… and, lest we forget, the American economy is the greatest in the world.

  114. 114

    Here’s where we need Darrell and scs to bloviate on how the American economy is the greatest in the world and all those losers who took out bogus house loans deserve to lose their homes for being greedy something-for-nothing deadbeats… and, lest we forget, the American economy is the greatest in the world.

    Well, unless you really believe in decoupling, we aren’t going to lose as much ground relative to the rest of the world as it first appears. There are a bunch of countries that need to come up with an economic model of, “Let’s sell lots of things to Americans and loan them the money to do it at the same time>”

  115. 115
  116. 116
    Krista says:

    Best Buy for appliances? Ever check out a Sears Outlet? The prices are about 60% normal, and they hold amazing sales, too. May well be worth a drive to Halifax.

    That’s where I got my kitchen set. :) Yeah, the Sears Outlet is pretty sweet. We also found a great deal at kijiji.com. We got enough maple for our cupboards and our stair treads, for $1/board foot. I couldn’t get over how expensive stair treads are if you buy them pre-made!

    I’m still going to try to haggle a little bit. I managed to snag a contractor’s discount at one smaller place, and I’m hoping I can leverage that with some of the other places.

    And yeah, we’re fully aware that by the end of this building process, we’ll both have bruised necks from repeatedly trying to strangle each other. ;)

  117. 117
    Delia says:

    Who could have foreseen that the financial equivalent of the Second Law of Thermodynamics (booms eventually bust) would bite us in the ass yet again?

    Who indeed? I may be naive financially, but I knew there was something wrong back in 2004 when I was helping my mother house-hunt and the real estate agent started blathering on about “creative financing.” She (the agent) tried to make me feel like a dork because I was skeptical of these newfangled arrangements and thought they sounded like trouble.

    And I consider I did the good deed of at least twenty years when my mother decided to stay in her old house but took out an “interest-only” refi on it. I managed to persuade her to refinance back to a conventional loan back when it was still possible to get a good rate. It was the real estate agents who were on the front lines of persuading people to go for these insane loans.

  118. 118
    Tax Analyst says:

    BTW – The same type of things is about to start happening with Auto Loans. Seems that dealer’s have been offering Finance deals that allow the buyer to tack their OLD car loan balance onto the new one, and stretch the payments out over 7 or 8 years to keep the payments the same as they have now. So you taken in your old car…where you might still have a Principal Balance of, say, $15,000, buy a NEW car for $40,000, they give you peanuts for your old wheels…you don’t care, after all, your Monthly Payments are still going to be the same…and, hey…the guy said, “You can always re-finance if you want to”, and voila, $50,000+ balance – but you’ve only got $40,000 FMV – and that’s when you first put your ass in that driver’s seat…you drive off the lot and that drops.

    Anybody see a possibility of a “Loan Default” in that scenario?

    I read that last year (probably 2006, actually)20% of consumer spending was drawn from Home Equity. I’m guessing that would account for an awful lot of car payments, since it seems likely the same type of consumer would be attracted to that type of loan.

    And that, “You can always re-finance” thing? Fahgetaboutit – ain’t happening no more.

  119. 119
    Tax Analyst says:

    Dreggas Says:

    Punchy Says:

    I feel like I’m going to learn some new stuff today. So many peeps here edumucated on this stuff.

    How long will it take for this stuff to shake out? Is my plan to buy in August smart, or should I wait longer?

    I would wait until at LEAST 2009. That’s assuming things will shake themselves out, odds are they won’t. As to when this started, the 03-04 timeframe is about right. That’s when Alt-A companies started playing around with subprime (or at least when the one I worked for did). Remember when rates started being cut after 01 there was a refi-boom. I worked from 00-06 in the industry and here’s the timing as I saw it.

    2001 – 2003 – Refi boom as rates were cute

    2003 – 2005 – Alt-A and Subprime lending pick up also reinforced by supply/demand housing prices rose artificially

    2004 – 2005 – HELOC (Home equity lines of credit) becom all the rage as people who do own homes start borrowing against them.

    2005 – 2006 – Option-Arms are the new Arm’s. As “normal” subprime and Alt-A lending started to slow down this was “the next big thing” to keep the market going. Housing became so expensive in many areas that even the normal subprime/Alt-A lending wasn’t sufficient so people took a gamble on the teaser rate figuring they’d be able to refi down the road.

    Some of the dates overlap but this is how I recall it.

    Pretty good summary – seems accurate.

  120. 120
    Tax Analyst says:

    Brachiator Says:

    The prolonged slump in housing pushed construction of new homes in 2007 down by the largest amount in 27 years with the expectation that the downturn has further to go.

    Here is what drives me crazy about this stuff. There is more than a housing slump or a bursting housing “bubble” at work here. Even lazy ass business reporters write nonsense about the housing “bubble” and expectations that home prices would continue to increase.

    But wages have been stagnant and declining, the current tax system excessively rewards capital gains over ordinary income (wages, interest, etc) and increases in energy and food costs has reduced real income. So folks with sub prime (or even mighty prime)mortgages could not rationally count on increases in the value of their homes to help them if they could not get a raise, get a new job, or otherwise increase their incomes. Most of the news stories that I have read concerning the mortgage mess simply ignore the stagnation of real incomes, or only consider the decline of the middle class as an afterthought to stories about the home loan mess.

    The other thing that is interesting is how a lot of folk, especially folks in the government, ignored or under-estimated the extent of the problem. The BBC news site has a useful timeline of stories related to the mortgage mess going back to February of 2007, with links to full reports. Notice how often, people were warned about an impending crisis, and how lenders just kept on churning out increasingly worthless loan products (e.g. “20 September 2007 —Deutsche Bank boss Josef Ackermann warns of losses from sub-prime exposure”).

    “Yes” to everything in this post. Good stuff.

  121. 121
    Tax Analyst says:

    Robert Johnston Says:

    The thing is, the credit/financial mess is due more to the deriviatives based on these mortgages not the mortgages themselves.

    Can you explain this in layman’s terms?

    I own a large pool of risky mortgage loans that pay 12% interest, with a 5% chance of default on each of the loans. I sell bonds that pay 5% interest, backed by the income from all the mortgages. Even if 5% of the underlying loans default, I’ll be able to pay off all the bonds with room to spare. I’ve sliced and diced the risky mortgages into safe bonds, with some extra money left over for me to pocket.

    The problem comes when that 5% risk of default isn’t independent, as in the case of a real estate bubble. There may, for example, be a 20% chance that 20% of the mortgages default and an 80% chance that 1.25% of the mortgages default. The expected percentage of mortgages to default is still 5%, but the bonds I’ve issued are now highly risky. 20% of the time I’ll default on the bonds, and 80% of the time I’ll make myself fabulously wealthy.

    The derivative bonds, which are a safe investment if the risks on the underlying mortgages are independent, are very risky if those risks on underlying mortgages are linked. A lot of people sold very risky bonds that got rated as safe investments because of the failure to believe in a housing bubble. A lot of people sold bonds backed by bonds backed by mortgages, further obscuring even higher risk investments.

    So there’s a mess because a lot of bonds that were sold and rated as safe were, in fact, very risky, and that risk has come home. But the problem is bigger than that. The terms under which these bonds were issued tend to make refinancing of the underlying mortgages at less than full principle impossible. When mortgages start heading into negative equity all over the place because housing prices drop 15% and people bought their houses putting only 5-10% down, the lender and the home owner would generally have their best interests served by negotiating a 10-20% reduction in principle on the mortgage to get it out of negative equity rather than having a default and foreclosure, because a lot more value than that is lost in a typical foreclosure.

    However, because of all those risky mortgage backed bonds out there, these negotiated reductions in principle don’t happen. Ownership interest in the mortgage is diversified among bondholders, and terms of the bonds won’t allow the issuer to negotiate reductions in mortgage principle that might make him unable to meet his bond payments without bondholder approval. Because negotiations with the homeowner are effectively impossible, the bond issuers end up foreclosing.

    Foreclosure, however, is tremendously expensive. So, because of these bonds, homes in slight negative equity go into foreclosure, resulting typically in a 40-50% loss to the lender rather than a negotiated 10-20% loss. You end up in a panic cycle, where erosion of housing prices causes negative equity, negative equity causes mortgage defaults, mortgage defaults cause bond defaults and foreclosures, and foreclosures further drive down housing prices. Because of these derivative bonds, the housing bubble is force to burst, taking out credit and financial markets with it, rather than to slowly lose steam over time.

    Hence, “the credit/financial mess is due more to the derivatives based on these mortgages not the mortgages themselves.”

    That’s a superb post. Let me just add that in many of these bond situations there are different levels of Risk for the bondholders. My understanding is that folks who took a lower Interest rate received a preferential position in cases of default losses. That, of course, makes a negotiated reduction a virtual non-starter. If I’m in the Top Tier because I took a lower rate of return there is no way I’m going to agree to a reduction – My terms put me in position ahead of those who purchase the bonds at the higher return, higher risk features. I’m very likely to get all my money even if a foreclosure returns only 50% or 60% of the Principal Balance.

    I say, “I” hypothetically…no way I want to be involved in any way or either end of this type of bullshit.

  122. 122
    TenguPhule says:

    $300 billion more of big shitpile to go!

    For this year.

  123. 123
    Brachiator says:

    Let me just add that in many of these bond situations there are different levels of Risk for the bondholders. My understanding is that folks who took a lower Interest rate received a preferential position in cases of default losses. That, of course, makes a negotiated reduction a virtual non-starter. If I’m in the Top Tier because I took a lower rate of return there is no way I’m going to agree to a reduction – My terms put me in position ahead of those who purchase the bonds at the higher return, higher risk features. I’m very likely to get all my money even if a foreclosure returns only 50% or 60% of the Principal Balance.

    Interesting. So this makes the bonds somewhat like a pyramid scheme? The risk is not distributed equally based on the market or the quality of the loans packaged (say a collection of AAA and BBB corporate bonds). Instead, things are set up so that some investors are more likely to get paid while others who jump in later are more likely to be left holding the (empty) bag.

    The other weird thing. This is not a free market in which goods and services are distributed, but a false (Enron?) market. When the dust settles, many people lose their homes and may be saddled with debt on re-fi’s. Banks and other primary lenders are stuck with properties that they don’t want and cannot easily dispose of. In between, some folk have gotten fat on the fees generated as loan products unconnected to anything real get tossed around among investors.

    What a mess….

  124. 124
    bernarda says:

    Personally, I remember that more than two years ago a friend who had a real estate company told me that he was selling not only his company but his personal property as well because, figures to support him, the shit was going to hit the fan.

    He said that unpaids were rising with no end in sight.

  125. 125

    Interesting. So this makes the bonds somewhat like a pyramid scheme? The risk is not distributed equally based on the market or the quality of the loans packaged (say a collection of AAA and BBB corporate bonds). Instead, things are set up so that some investors are more likely to get paid while others who jump in later are more likely to be left holding the (empty) bag.

    It isn’t a pyramid scheme, and has nothing to do with timing. All of the different tranches of the security are marketed at the same time. The top tranches provide lower interest rates to reflect that they are less risky.

    The problem isn’t like a Ponzi scheme. It’s that the risk models behind the securities were badly flawed. It should be noted that they were badly flawed in exactly the way that financial models seem to screw up every 8-10 years, namely that they rely upon events that are usually independent remaining independent under stress.

Trackbacks & Pingbacks

  1. […] not self-regulation 17 Jan 2008 Posted by Watts in Uncategorized. Tags: finances, regulation trackback From the comments thread at Balloon Juice on the ongoing housing market collapse, caused by thesub-prime collapse, which was caused in no small part by banks giving loans to people they knew were risky investments and then turning around and selling options and derivatives on those risky loans—thus ensuring that a default on those loans would cause a cascading effect throughout the financial market: […]

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