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Who are the winners in the mortgage mess?

Financial markets are pretty skittish these days. But in any market, one person’s loss is often another person’s gain. So where did all those “losses” from bad mortgages go?
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The financial markets are pretty skittish these days as banks and other mortgage lenders continue to report big losses from mortgage loans gone bad. But in any market, one person’s loss is often another person’s gain. So where did all those “losses” from bad mortgages go? And are there any winners in all of this?

Recently you see in the headlines all of the big banks "losing" billions of dollars from their participation in the "subprime" mortgage game. What does it really mean that they "lost" this money. It didn't just disappear. Someone gained on this loss, who?
— Rodney Detroit, MI

There may be some potential winners in the Mortgage Meltdown of 2007, but much of the money now being reported as “lost” will never reappear. In some cases, it was never there to begin with. So think of it as having gone to Money Heaven.

For now, the estimates of eventual losses — as much as several hundred billion dollars — are only estimates. Part of the reason is that the story is still being written. Some 2 million homeowners are at risk of defaulting on adjustable loans in the next year or so when those loans “reset” to higher payments. If those loans can be refinanced at more affordable terms, many of those people will be able to continue making payments and will avoid becoming the next foreclosure statistic. If those foreclosures can’t be avoided, you can expect to see reports of additional losses as more loans go bad and more unsold homes get dumped on an already falling housing market.

So far, the losses are being felt in several different places. The first place they’re hitting is the lenders and investors that put up the money used to fund the big pools of mortgages that Wall Street couldn’t get enough of during the housing boom. With home prices rising, lenders assured buyers eager to own a home that they could afford the big fees and high interest rates.

These investors — everyone from hedge funds to insurance companies to wealthy individuals — were looking for the higher returns they could get from bonds that were backed by the monthly payments generated by pools of bundled mortgages. The value of those bonds — and the price investors paid — was determined largely by computer models. These complex formulas looked at borrowers’ credit scores, historical defaults rates, interest rate impact, etc. and helped assure investors they were getting a higher return without taking on higher risk. On Wall Street, that’s a great deal.

In hindsight, the models didn’t work so well. It turns out they didn’t take into account a major bust in the housing market and a full-blown panic in the bond market. When it came time to sell these mortgage-backed bonds, there were no buyers. Even though the bonds are backed by loans which are backed by real houses with real value, in a falling real estate market, no one is quite sure what those houses are worth. And with no buyers, the bonds aren’t worth much.

So when banks and other financial institutions holding these mortgage-backed bonds  “marked them to market,” they had to report a big loss on their books. Some adventurous buyers are stepping up and buying these bonds at fire sale prices. If and when the market for these bonds recovers, they may be winners. 

The people who wrote these mortgages and then quickly sold them off to Wall Street were also winners. The lenders who originated the loans got paid up front: they collected big fees and then moved on to the next borrower without putting any of their own money at risk. (Some investors are now trying to recover some of those profits in court.)

Homeowners who can’t make their payments are also potential losers: they’ve spent thousands of dollars trying to build equity in a house and will lose all that when they lose their house. When buyers come forward to buy that foreclosed home, they may eventually profit from buying in a depressed market. But they won’t know until the market recovers whether the strategy worked.

Finally, the neighbors of people who lose their homes to foreclosure also lose. Various studies have tried to quantify just how much. But anytime you add a bunch of foreclosed properties to a local market that already has more homes for sale than buyers, the market value of everyone’s house goes down. If you want to identify the winners there, you probably have to look for the home owners who sold during the peak of the housing boom, after years of easy lending pushed prices to unsustainable levels.

What does "write-down" mean?
— Rod Vancouver, WA

Accountants who are concerned with tracking how much a company’s assets are worth often have to face up to the fact that things aren’t worth what they thought they were the last time they looked at the books. To reflect the change, they have to “write down” the lost value of that asset on the books. Companies that sell shares to the public are required to ’fess up once every three months in a financial statement that lays out how things are going since the last filling. There are all kinds of reasons why companies write down assets.

Sometimes the falling value of an asset is expected. A piece of equipment loses value over time, and there are rules for how quickly its value depreciates. (That lost value often can be deducted from income, helping to reduce taxes.)

Other write downs are unexpected. Unsold inventory that includes outdated technology or designs won’t get the retail price for this year’s model. If a company closes down a store or a factory that isn’t profitable, the hard assets (real estate, machine tools, etc.) may be sold for a fraction of the value they hold as a profitable business. So the books have to reflect that lost value. (If the asset is worth nothing, the accountants may decide to write it off the books completely and take a “write-off.”)

Write-downs aren’t necessarily a bad thing: a lot depends on the reason the company gives for taking the write-down. When General Motors recently took a $38 billion write-down for tax credits it said it could no longer use, some GM watchers were left wondering: why are they now worthless? Was it because GM was too optimistic in claiming the tax credits in the first place? Or because the company doesn’t expect to have enough future profit to be able to take advantage of them?

Banks and other lenders have been taking billions in write downs lately because of losses on the value of bonds backed by mortgage loans — no that some of those loans are going bad. Part of the problems is that the value of these securities was originally calculated from a computer model — not from an actual market price from a real buyer or seller. It turns out the computers didn’t count on a market panic; some of these bonds now can’t find buyers at any price.

What’s got Wall Street so rattled these days is that companies only have to fess up to writedowns once every three months. No one is really sure if or when there are more shoes to drop from losses on these mortgage bonds. So it may take awhile before the financial markets are convinced the worst of the mortgage writedowns is over.