While Mr. Stansberry is correct in a lot of things he says, he leaves out some very important things.... enough to make his conclusions somewhat suspect. This single biggest one being that the equity parts don't go to zero on a default. All these loans are ultimately backed by real property. So, when a borrower defaults, the equity doesn't go to zero, it goes to what the net proceeds are on the real estate after forclosure and sale. A loss? D3finitely, but not a total one. In fact, there may a tiny silver lining that I haven't seen anyone talk about anywhere yet: if you look back and see my prior posts, I think you are going to see people walk away from their properties more easily these days because they have so little perceived equity. Well, that can be a saving grace: it is possible that this time the bad loans will be not much more than the home values. If that happens, the losses will be much lower than last time around when banks often got 30 cents on the dollar becuase people held onto their homes until things got SO bad that there was huge difference between the loan amount and the property value.
The RMBS he speak of are nothing new, nor are the problems with them. I was consulting for Salomon Bros when they started CMO's (Collateralized Mortgage Obligations) which are the grand daddy of all of this type of instrument. Since it was a public offering, they had to have an offering document, and thus needed to come up with a "valid" pricing model on the securities. So, one thing they had to do was show the risk, and that meant running pricing models under difference scenarious. Remember that some of the risk (at least the percieved risk at that time), wasn't getting defaults, but rather pre-payments of the underlying mortgages because as those get prepaid, your bond starts getting repaid at a more rapid rate than you had contracted for. So, we ran various scenarios of varying rates of pre-payment. But it was bullshit, because pre-payment doesn't really work that way. What happens is that if mortgage rates go up, no one refinances except when they sell, and if mortage rates go down, EVERYONE refinances. So, after not too long, CMO's got repaid too soon, and not only did the bond holders get their money back sooner than they had contracted for, it was in a scenario of falling interest rates, which mean both that even before getting paid off, the value of the bonds went down, and when they did get their money back, they couldn't put it into equivalent instruments and get the return which they had expected to get. Of course, in typical Wall Street style, they just called it something else (there's probably been 5 or 6 itterations till it eveolved to RMBS) and started back up again.
What may be even more important is that the engine that's powered the huge run-ups in house prices is fueled on money: lots of availalbe and cheap money means the engine runs fast. But if we close off the tap supplying the fuel, the engine dies. Well, given the current "crisis", it's pretty clear that this tap is going to be closing, and it's pretty clear to me what the result of a big lender tightening is going to be (with or without higher interst rates; it doesn't matter what the rates are if you're not getting the loan).
