A lot of people don’t understand what the sub-prime mortgage meltdown is, why it is happening now, and what it all means. That is not surprising despite the daily media coverage that has been ongoing for months now. I’d like to equate the meltdown to the game of Hot Potato. The kid’s game of hot potato is similar to musical chairs. An item is passed around from player to player while music plays. They player caught holding the potato when the music stops is out of the game. This game of financial hot potato goes like this. People want to buy homes, after all it is the American Dream. Others want to make money building homes, selling homes, and financing homes. All of these folks are players in this game of hot potato. I’ll come back to a few points to fill in the details in a bit. Fannie Mae, Freddie Mac, large Banks, and Insurance companies are the ones who create and toss the potato around. The potato is a bundle of mortgages. These players want to hold them when they are ‘cool’ because they provide a steady source of income for them and they also provide stability and diversity to their portfolio of loans and assets. The bundle of mortgages representing the potato, is in theory, designed to stay comfortably cool because it is also made up of mortgages that represent diversified risk. A few might be bad, but the whole lot should be OK. The temperature of the potato is both a measure of the risk it represents and the difference between the cost of buying it and the value it has. A potato with inherently high risk or that is worth less than it costs is the hot potato. This game of financial hot potato is a little different then the one you played as a kid. First off there are many, many players. So many so that this game has a lot of potatoes being passed around. The potatoes are also going in every direction. At any given time a player can be holding several potatoes. Every potato has a different temperature too and you don’t know whether the ones coming your way are hot or not. Control of the music is given to the borrowers. They also control the heat of the potatoes to some extent since the borrower’s ability to repay the mortgage is the inherent risk and it changes with the state of the economy. The music stops periodically, when the loans with adjustable rates (ARMs) reset to a higher rate. The temperature of the potatoes also change at this point in time because the risk of default on a loan is linked to the size of the jump in the loan interest rate (linked primarily to the rate of inflation via the Feds interest rates) and the growth in the economy (borrower’s ability to absorb the increased monthly payment via low inflation and modest increases in wages). For years this game of financial hot potato has been very boring. When the music stopped, none of the potatoes were hot. Recently, the so called housing bubble has been heating up the potatoes. High risk borrowers were given loans that they should not have. This, in my view, was driven primarily by the greed of home builders, the greed of mortgage brokers who made the questionable loans in the first place, the arrogance of the home buyers who expected the American dream to be their right (as opposed to a goal), and the greed-blinded financial institutions who did not or could not see the true risk. Things did not get really hot until very recently as energy costs rose and began to rattle through the economy. This increased inflation while also reducing jobs – classic stagflation (visible as a prolonged and significant drop in the value of the dollar). This combination creates a budget imbalance for the borrowers. The wages aren’t growing enough to keep up with the daily needs and so the discretionary part of their budget decreases. By itself, this is not enough to heat up the potatoes. The other thing that happened was that the inflation-paranoid Fed under Alan Greenspan was raising interest rates. This increased the size of the resets in interest rate of the ARMs. This added effect was enough to break the borrower’s back (er, budget). Defaults increased and the potatoes started to get hot. This time when the music stopped a few players got burned and they did not want to or could not continue to play. The reduced number of players could not handle all of the potatoes out there so, the number of potatoes had to be reduced. This meant that borrowers could not obtain new loans. Houses took longer to sell, Builders did not need to build as fast, construction workers lost jobs, people who had to move started to sell at a loss, all of this lead to a decrease in housing values and ultimately increased the temperature of the hot potatoes even more through both increased risk of default and the difference between the cost and value of the mortgage packages. The players are all holding several hot potatoes and can’t quit without being burned now.

There is one good thing about the free market system, imbalances return to a balance, although that process is usualy not pretty and not everyone is happy about the way it happens. Returns will eventually properly reflect risk and determine the price/value. The big Banks and Mortgage insurance companies are taking big losses. They write them off and reduce the amount of taxes they pay. The government is going to absorb the losses from Fannie Mae and Freddie Mac. Irresponsible borrowers and lenders will be saved (temporarily) by various bail outs from congress (in order to keep their people happy and thereby keep their jobs by handing out our money). In the end, literally, the taxpayers foot (or is it butt) the bill for this irresponsible behavior. Not all of the bill though, as the game was so much fun that international players begged to get in to play as well. Some of that pain is spread globally. Whether it harms the long-term international investment patterns that are vital to the strength of the dollar and the global economy has not fully played out yet. Strengthening the dollar by borrowing/consuming less and producing/exporting more is the key. This will reduce inflation and allow the Fed interest rates to rise to match the rest of the world which will boost the value of the dollar.