Mortgage Crisis Question

Brad DeLong gives his stamp of approval to Steven Pearlstein's explanation of the mortgage collapse now in progress. It is, indeed, a very clear explanation of what went wrong:

Stick with me now, because this is where it gets interesting. For it is at this point that the banks got the bright idea of buying up a bunch of mezzanine tranches from various pools. Then, using fancy computer models, they convinced themselves and the rating agencies that by repeating the same "tranching" process, they could use these mezzanine-rated assets to create a new set of securities -- some of them junk, some mezzanine, but the bulk of them with the AAA ratings more investors desired. It was a marvelous piece of financial alchemy, one that made Wall Street banks and the ratings agencies billions of dollars in fees. And because so much borrowed money was used -- in buying the original mortgages, buying the tranches for the CDOs and then in buying the tranches of the CDOs -- the whole thing was so highly leveraged that the returns, at least on paper, were very attractive. No wonder they were snatched up by British hedge funds, German savings banks, oil-rich Norwegian villages and Florida pension funds.

What we know now, of course, is that the investment banks and ratings agencies underestimated the risk that mortgage defaults would rise so dramatically that even AAA investments could lose their value. One analysis, by Eidesis Capital, a fund specializing in CDOs, estimates that, of the CDOs issued during the peak years of 2006 and 2007, investors in all but the AAA tranches will lose all their money, and even those will suffer losses of 6 to 31 percent. And looking across the sector, J.P. Morgan's CDO analysts estimate that there will be at least $300 billion in eventual credit losses, the bulk of which is still hidden from public view. That includes at least $30 billion in additional write-downs at major banks and investment houses, and much more at hedge funds that, for the most part, remain in a state of denial.

This ought to give pause to anybody with plans for reform of, well, anything, that relies on the financial wizardry of Wall Street to magically make things wonderful. But that's not my reason for posting.

The question that I never quite see answered in these articles is:

What about those of use who have mortgages, but aren't idiots?

Kate and I bought a house about five years ago, after all, and took out a rather substantial loan to do so. We did not, however, do anything extravagant-- the price we paid for this house was within our means at the time, and is well within our current means. We've never missed a payment, and barring a total catastrophe, aren't in any serious danger of doing so.

The question is, does this crisis-- "the worst since 1929"-- pose a threat to people like us? Frankly, I could care less if some financial "geniuses" on Wall Street lose their shirts because they repackaged junk investments as solid (though I doubt they will-- that's not how the system works), and my retirment is so far off anyway that I'm not terribly concerned about that money, either.

I think that we're safe, unless this gets to the point where whole banks start disappearing, but I have to admit, I don't understand the system that well. If it turns out that I'm at risk because some jackasses decided they could make a mint by loaning money to people with no assets and meager income... Well, I won't join the torchbearing mob, but I'll give them directions.

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I don't see how. Possible problems are - the bank with which you have your mortgage collapses, your mortgage increases beyond your ability to pay, or your ability to pay falls below your mortgage.
Bank collapse is unlikely, and even if it did go, who would have a better claim on your house than you? I assume your mortgage is either fixed or has a fixed relationship to the federal interest rate - the bank can't just decide to double your repayments. And you have tenure.

As long as you're current on your payments, you should be fine. If you have a conventional fixed-rate loan with a reasonable rate, you're golden. If you have any sort of "exotic" loan, you should try to get out of it if you can. Even in the event of a banking-system meltdown, there'll be someone with an interest in having you continue paying.

There are only really two groups of people who suffer in this situation:

1. People who over extended themselves with their mortgage, but this group is highly sensitive to any change in the financial markets, especially interest rates.

2. Peope who are investors in the bank (including savers with that bank).

People who have a mortgage and aren't stuggling to pay are actually in the best situation, if there is a complete catastrophe and the bank dissapears, and no one is prepared to buy your debt, you no longer have to pay a mortgage (never, ever going to happen so dont get your hopes up). Or if the debt is purchased by someone else, or kept under current ownership but interest rates etc. are increased you can just move your mortgage to another provider at relatively small cost (maximum usually around 2% of the house value, rarely more than 1% unless you have a terrible deal).

I am posting from the UK so the rules and standard charges are probably slightly different, but i wouldnt worry at all if i were you.

Did I mention, be wary of financial advice from anonymous internet posters?

You should be fine, but you have one risk and one inconvenience: if your current loan-to-value is high, like 70+% and if prices decline by more than 25%, then you could be "upside down" or "underwater", if I have the jargon right. This could put you, temporarily, in a position having negative equity, which would mean you would take an actual loss IF you had to sell in a hurry, like due to changing life circumstances, and it would mean you had no equity to secure a loan on good terms, should you need one.

More generally, if you have to sell, you would find the price probably lower, so your gains would be less than expected, you would find it harder to find a buyer, and harder to get a loan for another purchase.
Other than that, you'd at most have an unrealised paper loss, which could go away eventually as the housing market reinflates.

For people with fixed rate mortgages and actual net equity, the main issue is that if something happens they have a smaller cushion and less flexibility to respond, since equity is lower on average and loans harder to get.

Shouldn't take financial advice from named internet posters either though.

Bear in mind that Wall Street recruited physicists to model and price the CDO's and various derivative contracts writtn on them :). They even had the gall to call themselves "financial engineers", as though that term has any meaning (after all what bridge ever failed due to too many people adopting the same contruction tactic?)

"Frankly, I could care less..."
I suspect you are actually more cold-hearted than this, and that your level of caring is so low, that you could, in fact, *not* care less :)

You should be fine, but you have one risk and one inconvenience: if your current loan-to-value is high, like 70+% and if prices decline by more than 25%, then you could be "upside down" or "underwater", if I have the jargon right. This could put you, temporarily, in a position having negative equity, which would mean you would take an actual loss IF you had to sell in a hurry, like due to changing life circumstances, and it would mean you had no equity to secure a loan on good terms, should you need one.

I'm not sure exactly what the situation is with house prices in the area, so I couldn't really say. One of the many nice things about tenure, though, is that it reduces the chances of needing to sell in a hurry...

Shouldn't take financial advice from named internet posters either though.

This mostly just confirms what I already thought, and it's not like I'm going to do anything on the basis of this advice, so I think the risk is pretty low...

I suspect you are actually more cold-hearted than this, and that your level of caring is so low, that you could, in fact, *not* care less :)

You're right.
I couldn't care less. Also, I can't type or proofread worth a damn.

I wonder how much of the financiers' miscalculations about these compound instruments can be traced to the assumption that borrowers are statistically independent.

By Johan Larson (not verified) on 07 Dec 2007 #permalink

The only way you can get into serious trouble, Dr. Tenured, is by missing mortgage payments or needing to move and therefore needing to sell at precisely the wrong time. I understand Kate isn't tenured, but you are, and that alone puts you in a stabler situation than about five sigmas of the rest of the world. (At least, those that don't own their homes outright.)

Also, Pearlstein's article is interesting chiefly for its lack of comparative numbers. Skimming it, I find a few numbers here and there (and they're big! and scary!) but they're not put into context well with the size of the housing market as a whole, the amount of monies lost in the S&L crisis, the amount of monies lost in the dot.com boom/bust, or the sizes of the economies at any of those times.

By John Novak (not verified) on 07 Dec 2007 #permalink

While you should be in good shape WRT your own mortgage (except for depressed housing prices, if you decide to sell), you may have exposure to mortgage-backed securities and not realize it. Many of these securities were rated as investment grade, so "conservative" investors like pension funds and "enhanced money market" funds invested in them. It turns out that these ratings were highly optimistic, and the securities are really worth a lot less now. If the securities are downgraded below investment grade, some of these funds are obligated to sell them quickly, and as "desperate sellers" may get an even worse price. A Florida municipal pension fund, and a GE Capital "enhanced money market" fund have had such problems, and it's not Wall Street tycoons who are affected.

Others here have pointed out that your individual investment will probably be sound. However, the broader market will feel the pressures of so many loans going south, so many prospective home buyers not able to get a loan, so many defaults on existing loans. This will drag on the economy as a whole, and some speculate that it may tip us over into recession at some point.

You may have tenure, but I'm sure even you will see some ill effects of the broader implications of the subprime meltdown.

PS: I am not an economist, but...

if the problems are as severe and widespread as some report, then there are precisely two ways out: the US can go through a moderately severe multi-year inflation period, in which house values are flat and wages, hopefully, eventually catch up

or, the US can go into a decade+ deflation with nominal house prices falling sharply and wages flat or declining. The nearest comparison would be the great depression.

Or, a miracle could happen.

If you own the house on a fixed rate mortgage, runaway inflation is a boon assuming your income more or less keeps pace. The 70's were a godsend to homeowners. My parents bought a 30K house on a 6% or so fixed rate mortgage in the late 60's. The inflation whittled the value of the mortgage down to nothing and the house was worth over 100K when they sold it in the early 80's. Sure everyone else gets hosed, but inflation is a blessing for those in debt with hard assets.

As others have pointed out, you're unlikely to be directly affected provided that you and Kate stay married and neither of you (or any children you might have in the near future) incurs large amounts of uncovered medical expenses. But you will see indirect effects, and some of these effects may be painful to you.

My first suggestion would be to open an account at a second bank or credit union. While your deposits are (at least theoretically) insured up to $100k, if the bank fails there may be a period of several months during which you will not have access to this money. Having an account elsewhere that you can use for paying the bills in the interim will let you keep the cash flowing.

As others have pointed out, there is also the question of whether some of your allegedly conservative investments (money market accounts, defined benefit pension plans, etc.) are exposed to this toxic waste. Read the prospectuses and reports carefully, and if you don't like what you see, bail.

At this point I wouldn't worry too much about either inflation or deflation. While we are at significant risk of having at least one of them in spades (and possibly stagflation, which combines the worst of both worlds), there are too many variables to tell whether we will go the route of Japan or Zimbabwe, or some anti-optimal combination thereof.

By Eric Lund (not verified) on 07 Dec 2007 #permalink

"or, the US can go into a decade+ deflation with nominal house prices falling sharply and wages flat or declining. The nearest comparison would be the great depression."

Actually, the nearest comparison is Japan, 1990-2007. Japan had an enormous real estate bubble leading up to 1990, and has just barely re-entered the world of positive interest rates.

One technical detail would be, as Steinn said, if you end up owing more than your house is worth. Some mortgage contracts require mortgage insurance for loans where the equity is less than some threshold of the amount owed. I know some people who are personally affected by this and it is something that you may have to look into.

By Brad Holden (not verified) on 07 Dec 2007 #permalink

one possible bad scenario I can imagine is that your current lender gets into difficulties, re-sells your loan and your new lender is a more screwy bank with disorganised insurance department that will keep messing with your escrow, not pay your homeowners insurance and taxes on time and so on. One does not want to have to hire a lawyer to fight a abusive or incompetent company.

calculatedrisk blog seems pretty good, I just found it.

Look back at their 'due diligence' post from last summer about how many warnings had to be ignored for this.

The worry is that lots of people aren't going to be paid back the money they put into lots of things.

Look for an update on this, if you can find one:
http://www.writingshop.ws/assets/images/debt.gif

Where's the money going to come from, if so much of the debt is based on vapor? I know, innovation ....

Checked the holdings in your 401k if you have one? I had a long talk with the Schwab people on the phone about mine because I couldn't find any money market or bond choice (supposedly most conservative) that didn't show a lot of 'mortgage' holdings. They tried to convince me that all of those were protected by something called 'wrap' companies -- insured.

A few days later I start reading about the 'wrap' insurer companies they named as possibly not having enough money to cover the bonds if their value collapses, and if the insurers can't cover them, then the value of the bonds gets degraded from AAA or whatever to lower -- and right now nobody seems to be interested in buying any of them.

There is a book that's been out a while, 'What if the Baby Boomers Can't Retire' -- it asked, when this crowd gets to retirement and wants to sell their stocks, who will want to buy them and at what price?

Same question arrived a bit earlier for the housing-based bonds, it seems.

You know the short answer -- shear the sheep when you know the weather's going to get cold. Let the sheep shiver. Always that way.

By Hank Roberts (not verified) on 07 Dec 2007 #permalink

The NYT wrote about people very much like you who are getting badly screwed by the subprime crisis. They were careful and prudent, but their neighborhood has deterioriated badly from all vacancies caused by foreclosures.

http://www.nytimes.com/2007/09/02/business/yourmoney/02village.html

So the question is not just: "How prudent are you?" but also "How prudent are you neighbors?"

Then, too, there is the question of where your college has invested its endowment.

One more point.

You wrote: "Frankly, I could care less if some financial "geniuses" on Wall Street lose their shirts because they repackaged junk investments as solid (though I doubt they will-- that's not how the system works)"

They may not be losing their shirts, but the NYS Comptroller has projected that Wall Street bonuses will be significantly down this year, which translates into lower state tax revenues, which could mean tighter state budgets, which could pretty directly impact you next year. NYS state might do some budget-tightening that could increase income tax rates across the board and/or lower state aid to local governments and school districts, which could result in higher local property taxes.

http://www.osc.state.ny.us/press/releases/oct07/103007.htm

"You're right.
I couldn't care less. Also, I can't type or proofread worth a damn."

He's wrong. Either "could care less" or "couldn't care less" are common English usage, and both mean the same thing.

The hangover from the party will be greatest where the party was the loudest: California, Arizona, Florida. That is where you find people with 700k$ in debt on a house identical to one that just sold for 400k$. And what happens to the value of the 400k$ house if the other one goes vacant, burns down, becomes a dope farm or, worst of all, filled with college students?

How many houses are for sale in your neighborhood? For how long? That is your first indicator.

The side effects are the bigger concern. It might be that there are no problem loans in your neighborhood, yet the person who wants to buy a house there cannot get a loan. (That is what is killing the market in many areas.) What if your bank or investment fund is holding worthless paper? Only some things are FDIC insured, as cities and schools in Florida found out when there was a run on a state-managed money-market fund. The result was that some school and city (read police and fire) paychecks were at risk. Read your prospectus carefully. Very carefully.

By CCPhysicist (not verified) on 10 Dec 2007 #permalink