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December 21, 2007

Today's Housing Bubble Post - What's Going On?

-- by Dave Johnson

Here's what's going on in the financial markets:

Part 1: Mortgages

After the 2001 stock market crash the Federal Reserve dramatically lowered interest rates. This made the monthly payment on mortgages very low, so more people could afford to pay more for houses, or could refinance their house. This increased the demand for houses, making housing prices rise. Because housing prices were rising people started speculating, "flipping" and a number of other things that made prices rise into a bubble - with people buying houses solely because of the price increases.

So the price increases caused prices to increase, which cause an exponential price rise curve to develop.

Because of this, builders started flooding the market with housing developments and condos, greatly increasing the inventory of houses.

While all this was going on people with poor credit histories were able to get mortgages without any down payments, at a very low interest rate that would "reset" after 2 or 3 years, and without even having to show how much money they made.

Then came the day when prices stopped rising. Which caused all of those people who buy-because-prices-are-rising to stop buying. But many of them were "leveraged" -- they had huge loans that depended on rising prices for them to be able to sell to pay off the loans.

Then for some reason more and more of the poor-credit-history people who had no down payments and never proved how much they made started to not pay their monthly payments. Go figure.

And a lot of other things happened that caused people to stop being able to pay their mortgages. So more houses came on the market at the same times as fewer buyers wanted to buy and prices started to drop. As prices dropped people who had bought or refinanced their houses started finding that they owed more than the house is worth.

So lots of people will be foreclosed on and lose their houses, etc. and the lenders who loaned out those mortgages will eat the losses. Except,

Part 2: Credit markets

The lenders borrowed the money to make those loans. Or they "sold" the loans to "investors" looking for monthly payments at a higher interest rate than banks pay. And those investors borrowed the money to buy the loans. And because many people are defaulting on their mortgages, the people who made or bought them aren't getting paid, so they soon won't be able to make their payments.

So the companies that loaned the money to them won't be paid. And they borrowed the money to make those loans, and because they might not be paid back, they might not be able to pay the companies that loaned THEM the money.

To understand where this vicious cycle ends go to the beginning of the previous paragraph and read it again. Each time you finish, go back and start again. Keep doing that until you get the point. In other words, anyone who has made any loans is - or at least should be - wondering if they will be paid back.

(By the way, deposits in a bank, brokerage, etc. are part of that loop. Make sure that your money is moved to federally insured banks. If you have money in a money market fund you are somewhere in that loop and your money has been loaned out and you are not insured. That money has been loaned out to someone who doesn't know if they can pay it back. That's what a money market fund is. That's why it pays higher interest -- because risk = return.)

So that in a nutshell is what is going on. Until everyone "comes clean" and lets everyone else know how much "exposure" they have to bad loans, there is no reason to trust that they will be able to keep making their own payments on their own debt. And coming clean, or "unwinding" this might involve playing things out until everyone who is going to go bankrupt actually does so until we see who is still standing. Anyone who made loans or borrowed money is facing some level of risk right now. Anyone.

Posted by Dave Johnson at December 21, 2007 2:24 PM

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