Vicious Cycle

An excessive demand for housing has resulted in creative financing to meet the needs of the "non-conforming" borrower. As this financing became available, housing prices appreciated. Then as housing appreciated, financing became more widely available. But this feedback loop has now moved in the other direction. The following graph depicts the popping of the housing bubble through the third quarter of 2007:
















This self-reinforcing loop has become more powerful because of the structure of the mortgage market. Instead of holding mortgages on their balance sheets, banks have sold mortgages to pools which securitized the mortgages, creating bonds with the mortgages serving as collateral. These bonds are called mortgage-backed securities (MBS).

MBS are structured so that "tranches" are set up which receive varying cash flows. The tranches with the first cash flows have the highest rating, but the lowest stated returns. Many investors purchased lower rated tranches in search of higher yields. Their purchase was based on the belief that real estate values might flatten out, but would not decline. The following graph depicts the relationship of housing prices to the prices of different tranches. Any decline and investment results for lower rated tranches get ugly quickly.













These graphs also demonstrate why local banks are not crying loudly about the current environment, but the large sophisticated investment banks are. The banks have moved these housing loans off their balance sheet into pools managed by major Wall Street houses. If these declines continue, the erosion of lower tranches will worsen.