If only it were limited to a handful of lenders making aggressive loans to some irresponsible borrowers. . .
To understand how deep this goes, take a moment to look at what happens when a subprime loan is issued: The lender packages it with other similar loans and sells the bundle to Wall Street, where they're structured into funds -- very loosely similar to mutual funds -- called Collateralized Debt Obligations ("CDO's".)
The Wall Street Journal reports that there are nearly $500 billion in CDO's out there. Bear Stearns made headlines in the past week by bailing out investors in one of its funds, when the fund started experiencing losses as a result of defaults in the underlying loans of the fund.
Leaving aside the classist observation that nobody bailed out the "little people" who lost their homes to foreclosure, yet Bear Stearns reached into their own pockets to the tune of billions of dollars so that investors in their fund wouldn't lose any money. . . why did Bear Stearns cover the losses?
The answer is one that will look and feel a whole lot like the Enron scandal.
Bear Stearns and other firms packaging CDO's have their own financial models that determine the value of the loans -- and with the subprime market experiencing such tremendous defaults, those values are way off: They're much too optimistic.
They call this "mark to model" valuation, instead of "mark to market" -- let's let the model determine the real value of the underlying assets, not the market. Kind of like dreaming up a spreadsheet about the house you want to buy and telling the lender not to insist on an appraisal: Let's just use the value from my financial model.
If Bear Stearns hadn't bailed out its investors, they would have forced the firm to sell the underlying assets to give the investors their money back -- and the market would have determined the true value of the underlying assets. Investors would have lost billions of dollars.
Sounds like the subprime borrowers' experience, doesn't it? Suddenly they cannot afford the payments on their own homes when the rates reset to higher levels, but with their homes actually worth less on the market than they were at purchase, they would lose money by selling. Only at this level, there's nobody reaching into their institutional pockets to cover the losses, and most subprime borrowers cannot afford to bring money to the closing table and get out from under their crushing monthly payments -- so they walk away, lose their house and add another unit to the homes for sale inventory, driving down values for everyone.
If you're still with me this far in the article, you may be wondering how this is likely to affect you. The answer lies in one word: illiquidity.
"Liquidity" is a financial term that refers to the availability of capital. After 9/11, the government provided tremendous liquidity by dropping the Fed Rate to near-all-time lows. Everyone had money to lend; everyone could borrow.
Now, the global economy is growing like crazy and banks all around the world are raising rates (tightening the money supply) -- creating illiquidity.
Now, CDO's are crashing (click here to read more technical analysis of how similar this debacle is to the Enron scandal) and the huge institutional investors who have been buying them are turning off the faucet -- more illiquidity. Less capital available to invest in CDO's; less money available to borrowers.
Fewer borrowers can qualify for homes, inventories are rising and we're not halfway out of the foreclosure wave associated with the subprime loan crash.
Look for real estate values to stay soft with exceptions in desireable markets. Look for long listing periods and frustrated sellers, wondering what their realtor is doing wrong or not doing at all.
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