Bankruptcy

Why Has the Sub-Prime Mortgage Crisis Been so Toxic to the United States Economy

By Jonathan

In my last post, I attempted to offer a simple explanation about how the housing market in the United States got into trouble.   In this post I want to discuss some of the highlights (or lowlights) of what this crash means to you.

Let's start with some of the financial institutions that invested so heavily in those profitable subprime mortgages and securities that were created to allow investors to sell and resell parts of these mortgages.  When you hear the term "securitization" it means that an investment banker has created a security (think share of stock) from a package of loans.   Lenders and investment bankers got fat and greedy.

Remember the old line, solid mortgage lenders like Countrywide, Chase and Bank of America?  Remember the investment banking giants like Merrill Lynch and Lehman Brothers.  These institutions had made so much money lending, servicing and selling subprime loans and securities derived from those loans that they took outrageous risks. They borrowed billions of dollars to expand their subprime business.  When the subprime market collapsed, these institutions lost their cash flow and their credit ratings.  Lehman Brothers went out of business.  Merrill Lynch, formerly the most prestigious of all brokerage houses, had to sell itself to Bank of America at a fraction of its former value.

What does all this mean to you?   Many national, regional and local banks invested heavily in profitable mortgage backed securities.  Others made risky real estate loans, expecting to quickly sell these loans to investment bankers.  Now banks have to eat investment losses.  Real estate loans that were "performing" are not "non-performing."  Banks do not want to loan money to anyone but borrowers with perfect credit.  The market for loan backed securities is much smaller.  When credit tightens, businesses cannot get loans to expand because banks see these loans as speculative.  Homeowners with less than perfect credit cannot refinance.

This contraction in credit has had other effects.  Housing prices have collapsed in many markets because the market perceives that prior valuations were artificially inflated.  Easy money meant that less qualified buyers could afford bigger and more expensive houses.  Now there are fewer qualified buyers and the market is correcting its prior overvaluation.

Homeowners, especially those with adjustable rate mortgages, are facing increasing mortgage costs, while their home values have gone down and the likelihood of unemployment has increased.  Refinancing is more difficult because real estate may be worth less on the open market than current debt.   More and more homeowners have turned to bankruptcy in an effort to save their homes.  Many others have decided to just walk away from homes worth tens of thousands less than what is owed.  Abandoned homes in a neighborhood then drive values down further.

Next - the Obama plan - arguments pro and con

Full post as published by The BK Blawg on February 25, 2009 (boomark / email).