How did the housing bubble turn into the current credit meltdown? Well, the system was able to handle the ‘normal’ default rates until recently. A normal default, to me, is one occurring in a real estate market where values are increasing each year (amount doesn’t matter, it’s positive) and when a buyer defaults, the bank is able to recoup say 80-90% of the money owed. A 10% loss on 5% of loans offers manageable numbers. Now, in more recent times, we had a cycle where short rates dropped to 1%, and a standard ARM, was offered at under 4% (this is not the teaser, this was the real rate). Now, with the 1 year t-bill at 5% or so, the rate has adjusted to near 8%. A $250K mortgage payment would jump from $1200 to $1800 over this 2 year period.
Next, add the fact that the homes were over valued and these weren’t $250K loans but two to three times that. Then to top it off, the initial payment in my example wasn’t really $1200, but an interest only teaser rate of 3% offering a payment of $625. (So for a $500K loan the payment rose from $1250 to $3600!)
This all created a cycle where nothing was normal. A large number of mortgages were offered as ARMs that were time bombs, financially, all of which would create a potential problem of some sort. This wasn’t just new homes, there was refinancing as well. Stories of people moving from a 30 year fixed at 5% to an ARM which was destined to go to 8%, to pull cash out to do God knows what, just broke my heart.
The sheer magnitude of the amount of paper involved is the answer to this question. If this were isolated regionally, or to a small number of lenders, it would have less impact. As Nouriel Roubini’s article (what a gem, I didn’t realize he maintained a blog) states, half the mortgages originated in 2005-2006 were of the nature I described.
Then next thing to note is that these loans are not just held by the banks that lent out the money. For some time there has been a market in CMOs (wiki(collateralized mortgage obligations)) which has created the potential for defaults to have an impact which is far reaching. Businesses have invested their hoards of cash in CMOs as have pension funds and 401(k)s. We are now in the midst of a meltdown on a scale not seen since the wiki(Savings and Loan Crisis) in the 80s. Maybe it takes this long to forget the events that precipitate such a meltdown, as if ‘this time things are different’. Once again, those who forget the past…..