Why the Mortgage Meltdown Matters

If you’ve been wondering how the sub-prime mortgage meltdown could seemingly tank the entire economy, David Leonhardt explains it better than anyone else I’ve read.

Higher returns almost always come with greater risk. But people — by “people,” I’m referring here to Mr. Greenspan, Mr. Bernanke, the top executives of almost every Wall Street firm and a majority of American homeowners — decided that the usual rules didn’t apply because home prices nationwide had never fallen before. Based on that idea, [housing] prices rose ever higher — so high, says Robert Barbera of ITG, an investment firm, that they were destined to fall. It was a self-defeating prophecy.

And it largely explains why the mortgage mess has had such ripple effects. The American home seemed like such a sure bet that a huge portion of the global financial system ended up owning a piece of it. Last summer, many policy makers were hoping that the crisis wouldn’t spread to traditional banks, like Citibank, because they had sold off the underlying mortgages to investors. But it turned out that many banks had also sold complex insurance policies on the mortgage debt. That left them on the hook when homeowners who had taken out a wishful-thinking mortgage could no longer get out of it by flipping their house for a profit.

Many of these bets were not huge, but were so highly leveraged that any losses became magnified. If that $100 million investment I described above were to lose just $1 million of its value, the investor who put up only $1 million would lose everything. That’s why a hedge fund associated with the prestigious Carlyle Group collapsed last week.

And he makes a point that I think is extremely important to understand. Banks and investment firms are now “hoarding cash instead of lending it, until they understand how bad the housing crash will become and how exposed to it they are.” The credit crisis affects all of us because it is changing the way the economy operates for individuals, businesses and government. Whether the current economic downturn reverses itself, becomes a recession, or even a full-blown panic, the way we all do business may have fundamentally changed. Hopefully, knowledge will help us adapt to that change.