Wall Street's Take on the Housing Bubble

Two recent Salon.com "How the World Works" columns demystify credit derivatives and spell out how Wall Street feels about  the housing market. In the first article, "Brother, Can You Spare Some Credit?," Andrew Leonard explains:

"A very simple way to understand a credit derivative is as a kind of bankruptcy insurance policy. A bank loans money to an institution, let's say, just for fun, General Motors. The bank then turns around and pays another institution to assume the risk that General Motors might default on that loan. If G.M. doesn't default, the institution selling the 'protection' pockets their fee and everyone is happy. But if G.M. does default, the seller of the credit insurance policy has to make good."

The theory is that by spreading the risk, a major downturn in one sector of the economy won't lead to a system-wide credit crisis. Sounds like a plan … until you consider that in 1998, there wasn't a market for insurance against credit risks. Yet by 2005, there was over $16 trillion worth of credit derivative contracts out there. As Andrew Leonard puts it, "From zero to 16 trillion -- now that's a growth economy."

So what does this have to do with the housing market?

One of the reason banks buy credit derivatives (read: protection money) is to cover their losses in case borrowers default on mortgages. With less to lose, lenders can afford to offer more and riskier loans. But it is going to cost them ... and therefore us ... a lot more to insure those loans. Between September and December of 2005, the price almost doubled for credit derivatives on subprime ARMs.

In "Wall Street Bets on a Housing Bubble," Andrew Leonard cuts through the jargon and explains:

"The smartest players on Wall Street see the housing market about to implode. So they're loading up on cutting-edge financial instruments that will theoretically protect the buyer from exposure to millions of homeowners suddenly beginning to default on their loans. And for the moment, they're making money hand over fist as the value of those derivatives rises with every new data point about slumping housing sales, slow housing starts and rising interest rates."

No one knows what's going to happen when the defaults start rolling in on the subprime ARMs and the sellers of those derivatives have to pay up. "But any prospective homeowner thinking right now about jumping into the market with a no-money-down, adjustable-rate mortgage might want to think twice," Leonard suggests. "Wall Street is betting against you."

Andrew Leonard's articles provide an excellent intro -- as well as leads on where to turn for more more information on this complicated subject. Highly recommended, even if subscription or ad viewing is required on Salon.com.

What do you think about housing market? Should borrowers be worried or is it all hype? Share your feedback in the comments section below.