Ok, another batch of questions have come in, all variants on

the same theme.

The question is, if mortgages are at the root of the current economic disaster, how can it possibly result in close to a *trillion* dollars worth of losses?

It definitely seems strange, on two different levels. On an absolute scale, it’s hard to see how mortgage losses could add up to a *trillion* dollars. And on a relative scale, it’s hard to see how the foreclosures could really overwhelm the lenders when even an extremely high foreclosure rate represents a fairly modest loss considered as a percentage.

Let’s look at the relative scale first. If we use extremely

pessimistic numbers, the loss looks bad, but not excessively so.

Take a pool of 100 mortgages for $100,000 each. We’re looking at

total loans of $10,000,000. If 20% fail, then ignoring any interest

earned on the others, we’re looking at a loss of $2,000,000. But

those houses aren’t worthless. Imagine that they’ve lost 40% of

their value – which would be very surprising. Then we’re able to

collect, in some form, about 60% of that $2,000,000 – or about

$1,200,000. So we’re looking at a loss of around 12%. And that 12%

loss is assuming absolutely astonishing rates of default, and

record-setting losses of home values, in excess of what we’ve

really seen. So how is it that losses that realistically can’t be

more than 10% can somehow blow up into this thing that’s

potentially taking down the entire economy?

And what about the absolute scale? The figures I can find

in a Google search suggest that the total value of all outstanding mortgages in the US is around ten trillion dollars. For mortgage failures to represent a ten trillion dollar loss, that would mean that one in ten mortgages is foreclosing – and that’s assuming

that a foreclosure represents a *total* loss of every penny of the loan. But the actual foreclosure rate – a *record high* – is barely more than 2%! That doesn’t make sense.

So how can mortgage failures be at the root of this disaster, where a $700 billion bailout might not be enough to prevent

financial ruin?

There’s a couple of answers.

First, it’s not just mortgages. It’s credit of all kinds. People were loaning money not just for mortgages, but for damned near anything you can imagine. Want to buy stock? The banks would loan you money. Want to build a bigger baseball stadium? The banks would loan you money. Want to buy a shitload of lottery tickets? The banks would loan you money. There’s a *lot* of loans

in this mess beyond just the mortgages.

That’s important, and it’s a big part of the mess, but it’s not the real key. What really created the disaster is a combination of leverage – that is, borrowing money to amplify an investment, and derivatives – fancy investments that are really nothing more than bets.

Leverage is easy to understand, and it’s easy to see how it leads to disaster. Suppose you’ve got $10,000 to invest, and there’s a really good investment that you think is going to make around 5%. But you want to make more than 5% on it. Now, suppose that you can borrow money at 2% interest. So you borrow $90,000, and invest $100,000. You’ll make $5,000 on the investment, and you’ll owe $1,800 in interest. So your profit on your $10,000

has been increased from $500 to $3,200. Now, think of what happens if your investment, instead of earning 5% ends up losing 2%. You wind up with $98,000; you owe $91,800. Your loss has been amplified from 5% to 18%!

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Investment firms were leveraging investments by a factor of close to 30 to 1.

Then we get to the derivatives and related “financial instruments”. A derivative is really a fancy term for a legal bet in the financial market. You think that some kind of asset is going to change value – so you bet that it will. It’s called a derivative because its value “derives” from the value of the asset that the bet is related to. But you don’t have to own *anything* to buy a derivative. It’s really a pure bet. The payoff of a derivative is really just the odds on the bet. So essentially,

investment firms were being high-class bookies.

So, if you thought that the dollar was going to go down, and

you wanted to make money off of it? Fine, no problem. No need to do something as complicated as pick a different currency,

whose value you think will increase. Just make a bet: buy a *derivative*. If it’s paying 2:1 – if the dollar goes down by 10%, you’ll make 20%!

Derivatives don’t represent anything real – they’re not built

on buying or selling things that have real value: they’re just

a fancy form of gambling. The *idea* behind them is that they’re like a kind of insurance. If you’re afraid of the dollar

going down, you buy some derivatives that will pay off if it does – so that you’ll be protected. Someone will take your money if it goes up, in exchange for paying you if it goes down.

The way that derivatives play into this isn’t particularly simple – there are tons of varieties of derivatives, corresponding to gambles on different assets. But the key features are:

- They’re completely artificial. There is no asset, no fundamental value underlying a derivative, beyond the contract, which is basically like the ticket you get at a racetrack.
- Since there is no valuable asset underlying a derivative, if a derivative goes wrong, you can lose everything.

Now, here’s where it gets interesting. Combine leverage and derivatives. You’ve got people buying derivatives, leveraged with huge loans – people borrowed money to *bet* on derivatives. And they used things like mortgage bonds as collateral on those loans.

The problems here should be obvious. You’ve got people betting borrowed money in ways where they can easily lose everything, including the entire amount they borrowed. And they “secured” those loans using bad mortgages.

So when a bunch of mortgages start to fail, suddenly you’ve lost the collateral on your bigger loan – and you’re expected to pay that back. And lots of those derivatives were the basis of the “insurance” backing the mortgage bonds; so you had loans built on loans.

Many of the big investment firms were letting people buy things like derivatives with as little as 3% down – leveraging

an investment by borrowing *30 times* the amount of the investment.

And there’s not just one level of this. There are loans to purchase derivatives based on assets that are based on loans to purchase other derivatives based on ….

Each level of leveraging represents a dramatic increase in the

amount of money at stake. So that original 10% loss on the mortgages can balloon by twenty to thirty times in one step of leveraging. Now consider that between all of the financial

constructs that the big firms were working with, you could easily have ten or twenty levels of leverage (which were justified by fake “insurance”, as I discussed in an earlier post), and you can start to see how losses that should have been no big deal can balloon

into something like what we’re seeing.