Show Me The (Lost) Money!

Are American subprime mortgages the Black Swan that will lay low (for a while) our securities market and even the global economy?

Everyone can agree that if you buy a house and then sell it later for a higher price, you have made money in some sense. You might want to take out the transaction fees. You may want to take out real estate taxes and the cost of maintenance and upgrades. On income (as opposed to residential or purely speculative) property there is another whole set of calculations. But basically, you lose money if you sell for a lower price than you paid originally, and you make money if the sale price is higher.

In 2005 selling houses almost always resulted in making money. In 2007 selling houses is resulting in losses mainly for people who bought in 2006 or 2005, rarely for people who bought in 2004 or earlier.

Mental calculations of loss may be higher because people who are selling now are thinking about what they could have made if they had sold in late 2005 or early 2006.

So the reality is that not very much money, on a macroeconomic scale, is being lost in housing right now. Think about the scenario we read so much about: someone who took out a subprime mortgage, with no money down, in 2005 whose house has gone down in value and who has allowed the house to be repossessed.

How much did they lose? They invested no money down. They came out of the deal, two years later, with no money from the repossession of the house. They actually did not lose any money at all. In effect their mortgage payments were rents. We all tend to forget that while a house is mortgaged, we have a partner in the real estate, the holder of the mortgage.

In a slightly different scenario the house value may not even have gone down. Instead, after the ultra-low interest rate introductory period, the interest rate has jumped. Unable to make the new higher payments, the owners allow the houses to be repossessed. Again, the residents did not lose any money at all; they just had their hopes dashed. In this case the mortgage company has not even lost any money except to the extent that interest rates had been subsidized.

This whole scenario could change if we had a recession before the glut of houses for sale dries up. Home owners who sell could lose real money they put in as down payments and as principal payments on mortgages. In some specific geographies this has already happened: people and mortgage companies have lost real money. But there has always been a component of this in the housing and mortgage markets. It has been a long time since it has been a good idea to invest in residential housing in Detroit and other rust-belt cities.

So how did the Bear Stearns hedge funds lose so much money? They made a bet on mortgage default rates than seemed smart at the time. To the extent that there were potential real losses of money, they concentrated it in their funds. They bought collateralized debt obligations, CDO's, and other mortgage-releated securities.

How CDOs work has been covered by most major financial news organizations, so I won't go into that. I want to point out the contrary fact: On the whole, investors have not lost any money. Not yet. Not people who bought residential housing; not mortage companies; not holders of investments in mortgages.

What has been lost, in aggregate, is expected streams of income. Only those investors who bought mortgage-backed securities that concentrated the risks of subprime mortgages are suffering serious losses.

As a result, risks are being recalculated. Usually in situations like this, after risks have been under-assessed, they jump to being over-assessed. Which is safer for us all.