Oh dear, what a mess we have now. Here is a pretty ugly cycle to think about.
- The housing bubble peaks and home prices stop increasing.
- People who assumed they would be able to sell or refi before their adjustable rate mortgages adjusted… couldn’t.
- Many of those people, especially the least likely to be able to pay among them who had gotten “subprime” mortgage loans, defaulted on their mortgages and got foreclosed.
- The foreclosures hurt the value of bonds that had been sold to finance the loans.
- As the value of the bonds decreased, the risk exposure of bond insurers (sellers or financial instruments called credit default swaps) increased.
- As the risk exposure of these insurers increased, the likelihood of some of them defaulting on their insurance policies increased.
- Because the credit default swap market is completely unregulated (thanks to Phil Gramm and his Republican friends) it is impossible to know what the likelihood is that any of these insurers would default on their policies.
- Which has lowered the value of the credit default swaps that people have bought (the insurance policies).
- Credit default swaps are carried on banks’ balance sheets as assets.
- The amount of lending banks can do is dependent on their asset base.
- When the value of the credit default swaps went down, the value of the asset bases of the banks went down, and they became unable to lend to businesses because their asset to lending ratios were out of whack… they had become too risky.
- Because businesses and consumers haven’t been able to get loans, the real economy has gone into a nose dive. Over 2 million jobs have been lost this year, including 500,000 in November alone.
- These newly unemployed people are beginning to default on mortgages that had never been considered risky and a new round of completely unexpected foreclosures has begun.
- This is going to further impact bond prices, which will increase the risk that bond insurers will default, which will further lower the value of credit default swaps, which will further lower banks’ asset base, which will further curtail their ability lend………..
Now we’re in a death spiral. We can’t get out of it by just riding the current. Yikes.