Are Collateralized Loans Going To Blow Up The Economy
The great housing boom over the past few years was funded by low interest rates and the use of collateralized debt obligations (CDO). These CDO’s allowed the velocity of money to be applied to the housing market and created a bubble of available cash. Since housing prices were soaring, lenders were eager to use this new found cash to fund all comers to the table.
Now that the market has slowed down, there is a risk of the CDO market unwinding and creating havoc on the economy. I have included the second to last paragraph of an excellent essay by Felix Salmon on the risks to the economy and housing markets by a meltdown of the CDO market. Please read the whole article especially if you are in the real estate business at any level. It will explain a great deal of the fears and potential troubles we may face in the coming years.
But while all the risks are real, the linkages between them all are far from clear, and the different risks don’t necessarily cascade onto and exacerbate each other in this way. They might – or they might not. If investors turn out to have reasonably strong stomachs, they might not want to liquidate at prices well below their entry points. And CDOs themselves, even the ones based on subprime mortgages, might not default nearly as much as homeowners. And without the pass-through mechanism of risks two and three, the vicious cycle loses a lot of its teeth. via Portfolio.com
Hat-tip Instapundit and The Economist
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Comment by Harry Houdini on 29 June 2007:
When was the last time you did something without risk?
When was the last time you crossed the street, drove a car, had sex, bought a stock, boarded a plane, or played sports without risk? This new idea – that everything that carries risk with it is a disaster — is pure idiocy, and ultimately we can not live our lives with such neurosis.
Add the sub-prime meltdown to the Year 2K Disaster, the Housing Bubble Disaster, Black Monday, The RTC Debacle and all the other disasters, financial and otherwise, that never were.
Comment by Terence C on 30 June 2007:
The article does not concern responsible risk in mortgage lending; it’s referring to the lender’s mistake of writing up collateralized debt based on an obvious bubble of inflation–not the holder’s ability to pay off over time.