Quote from capmac:
The problem is the leverage. It starts with the home/property buyer or speculator(house flipper). He buys a $300,000 property with little to no money down. A mortgage is generated through a lender who gets funding from an outside source. That document is now an interest bearing note. Who buys that note? Someone who borrowed money at 4% or less and buys that note yielding 6% as part of a tranche of morgtages. The differential in the interest creates yet another derivative or opportunity to leverage.
So now we have unkown amounts of leverage applied to a house that cost 300k. 10:1 leverage, maybe more is used to enhance the spread of 1-2 points. So what happens when that house declines to $250k in value? What risk is there to the face value of the note? Roughly 16%+ under water, right? Now multiply 10x. Minus 160%, right? Hummm, that's a problem. You lost your principal and some of the leverage. That CDO you bought with 10x leverage is not only worthless, it's less than worthless. But don't worry, the loans are still paying interest, so everything is still cool.
Now what happens when a portion or all of the mortgages in that CDO go into default? Now there is little to no yield and the assets are in decline. It becomes a chain reaction. The homeowner stops paying, the mortgage company stops getting payments, they can't pay the CDO holder. So now you have dead paper that if leveraged, is definitely worthless and you have lost part of the leverage also. You are not only insolvent, you owe money.
The home buyer has it easy. He walked away from the property when he went under water and stopped his monthly bleeding. He just stuck the bank for the loan and the bank now has to pick up the taxes and insurance to protect their position. That costs money. If the buck stopped there, the bank could liquidate the house for 200k and take the 100k hit, no problem, it ends there.
But it doesn't stop there. Some investment banker leveraged the interest differential and then sold it to a hedge fund that uses borrowed Yen to buy those notes to leverage them even more. He just added another level of risk, the $/Yen risk. If the Yen appreciates 4-5%, he is all done. It's a house of cards and the parties in the chain are all at risk for far more than their principal.
I don't think the average person could even begin to understand how bad this really is. We know that 15% of subprime is in default, roughly 300 billion, 10x leverage means that on average there are 3 trillion in potential losses. There are 2 trillion in subprime loans. That means 1 trillion is owed to those who supplied the leverage. Yes, they can recover some of the losses from the sale of the property.
If 50% of subprime goes to default, losses will be 10 trillion. That's just subprime, how about prime debt .
