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Housing Lossage in a Nutshell
Sep. 22nd, 2008 01:49 pmSo, we are in the midst of the deflation of a massive housing bubble. That is to say, home prices, nationally, are up a whole lot higher than the people who live in those houses are willing / able to pay for. (For the purposes of this article, I want to ignore the distinction between 'willing' and 'able,' that's a different post, and I also want to ignore the question of exactly how did they get into that circumstance. That's going to be in a different post)
So, that's a problem if you're one of the few million people who bought a house (and a mortgage) in the last couple years who can't really afford the home that you bought, so you're now not making payments on it. It's also a problem if you're one of the few million other people who would like to sell or refinance your home, but are watching house prices fall because there are all of these desperate sellers suddenly on the market, and a whole bunch of foreclosed homes on the market as well, which means that prices are broadly falling. [Aside: They're falling more in places where people built a lot more housing than there's actually a need for, but they're falling mostly all over] Anyway, a lot of people thought of housing as something that always went up in value, so having prices fall is playing holy hell with their personal budgets.
That, in a nutshell, is how the housing market has gone broadly insane over the last year. Mortgages written in the prior two years, from 2005-2007, were particularly bad, and have been a lot more likely to go bad than ones written between 2002 and 2005, but pretty much every piece of residential property bought in the US since 2002 was probably bought at a higher price than it should have been.
But that's only the first part of the problem.
The second part of the problem is that the way that those mortgages were financed (since if you borrow money to buy a house, that money has to come from somewhere), was to get a group of mortgages into a bundle, and then sell a bond based on that entire group of mortgages. That's called a Mortgage-Backed-Security. Now, this is pretty cool - it means that more people can buy homes. However, it can go badly sideways if the people writing your mortgage can divorce themselves from the risk that you won't pay it back. Which is exactly what happened. Anyway, so, a Mortgage-Backed-Security pays an interest rate based on the interest rate that all of the borrowers in the pool of mortgages that make it up are paying, minus a percentage to cover how many of those payers don't actually pay their bills. Huh... What happens if more of those people don't pay than you expect? I hear you ask. Well, the financial institutions that put together MBSes thought of that. In particular, they bought insurance to cover that possibility. From companies like AIG. And up to a point, if the mortgage-holders aren't paying as much as you'd expect, the insurance company would make up the difference. Of course, if the insurance company badly underestimated how many of these MBS policies they would need to pay on, they were probably not collecting enough money for the insurance premiums, and they now have a problem. Oops. And, Yes, in case you were wondering, they were badly underestimating how much they should have been charging for those insurance premiums. Okay... So it's bad to be one of those insurance companies. What happens after that? Well, once you've run out of the insurance payment, those bonds just stop paying. So it's not good to be a bond-holder. Which, unfortunately, an awful lot of financial institutions, including banks, credit unions, etc, happened to be. So they're not getting all of the income from those bonds that they expect. Which means that they're also now having a bad day.
Continued in my next post...
So, that's a problem if you're one of the few million people who bought a house (and a mortgage) in the last couple years who can't really afford the home that you bought, so you're now not making payments on it. It's also a problem if you're one of the few million other people who would like to sell or refinance your home, but are watching house prices fall because there are all of these desperate sellers suddenly on the market, and a whole bunch of foreclosed homes on the market as well, which means that prices are broadly falling. [Aside: They're falling more in places where people built a lot more housing than there's actually a need for, but they're falling mostly all over] Anyway, a lot of people thought of housing as something that always went up in value, so having prices fall is playing holy hell with their personal budgets.
That, in a nutshell, is how the housing market has gone broadly insane over the last year. Mortgages written in the prior two years, from 2005-2007, were particularly bad, and have been a lot more likely to go bad than ones written between 2002 and 2005, but pretty much every piece of residential property bought in the US since 2002 was probably bought at a higher price than it should have been.
But that's only the first part of the problem.
The second part of the problem is that the way that those mortgages were financed (since if you borrow money to buy a house, that money has to come from somewhere), was to get a group of mortgages into a bundle, and then sell a bond based on that entire group of mortgages. That's called a Mortgage-Backed-Security. Now, this is pretty cool - it means that more people can buy homes. However, it can go badly sideways if the people writing your mortgage can divorce themselves from the risk that you won't pay it back. Which is exactly what happened. Anyway, so, a Mortgage-Backed-Security pays an interest rate based on the interest rate that all of the borrowers in the pool of mortgages that make it up are paying, minus a percentage to cover how many of those payers don't actually pay their bills. Huh... What happens if more of those people don't pay than you expect? I hear you ask. Well, the financial institutions that put together MBSes thought of that. In particular, they bought insurance to cover that possibility. From companies like AIG. And up to a point, if the mortgage-holders aren't paying as much as you'd expect, the insurance company would make up the difference. Of course, if the insurance company badly underestimated how many of these MBS policies they would need to pay on, they were probably not collecting enough money for the insurance premiums, and they now have a problem. Oops. And, Yes, in case you were wondering, they were badly underestimating how much they should have been charging for those insurance premiums. Okay... So it's bad to be one of those insurance companies. What happens after that? Well, once you've run out of the insurance payment, those bonds just stop paying. So it's not good to be a bond-holder. Which, unfortunately, an awful lot of financial institutions, including banks, credit unions, etc, happened to be. So they're not getting all of the income from those bonds that they expect. Which means that they're also now having a bad day.
Continued in my next post...
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