Since 2008 there have been numerous films and documentaries recounting the terrible details of the housing crash. What caused the crash? Securitization of mortgages through the packaging and repackaging of risky mortgage bonds that were sold and traded around the globe.
Think of it as taking a mouldy piece of cheese and sticking it in the middle of a burger already packed with average pickles, lettuce, onions, ketchup, mustard, mayonnaise and a near expired beef patty that all looks pretty okay inside a fresh bun. You would have no idea that you’re about to get a disaster burger. Each piece of the burger represents a layer called a tranche. Some layers are good, some are okay and some are just crap. That cheese represents the crappy layer; a risky mortgage bond that is packaged with other risky and less risky bonds to create what is called a mortgage-backed security. Leading up to the recession where things got really messy though was with the more popularized use of the CDO, collateralized debt obligation. This instrument is essentially the same as a mortgage-backed security, except that it was absolutely, completely full of risky mortgages and packaged to look like a safe investment.
So what’s happening now in the housing market? Well, the mortgage system in the US is valued at $26 trillion – and much of that is made up of credit ($11 trillion), due to the amount of sub-prime mortgages that are allowed to be given out. (Sub-prime meaning that the person taking on the loan is meeting very minimal personal requirements, is often at their maximum capacity for borrowing and is given a minimal loan repayment structure.) This is to say that the mortgage system (lenders) is heavily leveraged and has an inadequate amount of capital in reserve to cover mortgage defaults, should economic conditions change and people not be able to pay their mortgages. So I suppose you could say that the market appears to be okay as there hasn’t been real trouble since the recession and some (few) regulations have been put in place.
You may be wondering if defaults are likely to happen again soon? I don’t think there is an easy answer to this question as there would be many factors at play. However, a particular area that seems like it should be of greater concern is that, according to The Economist, federal US law has little in the way of regulation for how much a person has to put down on their loan and in the past several years, 20% of all loans granted were granted to people who only put 5% down on their mortgage. Damn. That is a whooole lot of risk and things can easily go sour when home buyers are that leveraged.
As we saw in The Big Short, the activities that caused the housing and market crisis (largely the misrepresentation of asset-backed securities and their bond grades), still very much persist today. There was a little regulation put in place but not enough to make sure that a similar event doesn’t take place.
Read the original article published by The Economist, August 20th 2016.
Feature image via Entertainment Weekly: Ryan Gosling in The Big Short movie
