It's Not Just About the Bubble

"Plenty gets written about the vast scale of this real estate bubble, the world of pain that housebuilders, realtors and overstretched buyers are finding themselves in and the likely impact that falling prices will have on the American consumer's willingness to run up debt at the mall.

What's sometimes overlooked is the other end of the equation: the huge amount of risky loans that have been issued to fuel this bubble and the question of who will be left holding the baby when it all blows up...

In the modern mortgage market, loans often don't remain with the bank that issued them. Instead they're parcelled up into bond-type structures called mortgage-backed securities (MBSs) and sold on to investors. The buyers range from hedge funds and pension funds to the Chinese government diversifying its dollar assets away from Treasuries.

This process - called securitization - looks like a winner for all involved...[But] the problem is that when the housing market or the broader economy turns down, delinquencies (late payments) and default rates on subprime mortgages shoot up. And that seems to be what's happening now. Investment bank UBS reports that nearly 4% of subprime mortgages issued and bundled into MBSs this year are 60 days or more behind on their payments. While that may not sound too alarming, it's the highest rate in over a decade - almost one percentage point higher than in the 2001 recession - and the economy as a whole isn't even officially in trouble yet."

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