I'm reading "My Life as a Quant", by Emanuel Derman. It is an autobiography of a relatively successful physicist who joined Goldman Sachs and became a relatively successful quantitative analyst. Emanuel worked with Fischer Black to modify the famous Black-Scholes options pricing model to work for treasury bond options.
In the book, Emanuel is hired away from Goldman to work at Salomon Bros. to help model adjustable rate mortgage investments. While reading today (Derman was explaining the complexity of mortgages), the current uncertainty in the housing market hit me like a ton of bricks. I never understood what a house of cards the market really was. Here is an excerpt.
"Banks who lend to homeowners own the mortgage, the claim the the homeowner's future monthly repayments. Periodically, the banks turn around and sell the mortgages they have acquired to GNMA, FNMA, and FHLMC, government agencies that act as financial intermediaries by pooling together vast quantities of similar but not identical mortgages into more standardized securities. They then resell these pools to large investors--mutual funds, pension funds, insurance companies, hedge funds, and the like--in search of interest-bearing investments. This process of asset acquisition, pooling, standardization, and subsequent sale provides a liquidity that frees the savings bank to make more loans. As a result, the percentage of residents who own their own homes is greater in the US than anywhere else in the world.
Mortgages are messy, though it takes only a little careful high-school math to work out the monthly mortgage payment that will draw the loan down to zero over 15 years. But that's just the start. Everything about an adjustable rate mortgage pool--the interest payments, the principle repayments, and so on--varies with the future level of interest rates, so an adjustable rate mortgage (ARM) is really a complex option whose payments are contingent on interest rates."
I never appreciated how interconnected the housing market was. When all of these lender companies start going under the losses are really going to mount. The first dominoes have already started to fall. Who's next?