Why are foreclosures still coming?

What is the deal with the residential real estate market?  Why are experts still concerned with foreclosures, see here?

Aside from the fact that we are still experience a high level of employment, currently around 9.7 percent, the bottom line is the mortgage mess is still that--a mess.  Let me provide a brief explanation of mortgage backed securities (MBS).  Banks created MBS--also known as collateralized mortgage obligations (CMOs)--to generate revenue and increase profits.

The banks first used a process called securitization to create bundles of mortgages, which generally included three types of mortgages (also known as tranches).  The first tranche--the senior tranche--consists of high quality mortgages (the kind made to people with high credit scores and stable incomes).  In theory this tranche has a very low risk of default (i.e. these people are likely to make their mortgage payments).  The second tranche--the mezzanine tranche-- consists of mortgages that are still investment grade, but not the highest quality.  Although the risk of default is higher then the senior tranche, it is still relatively low when compared to the next tranche.  The junior tranche is essentially junk mortgages, those provided to subprime borrowers who have a high risk of default.  By combining the tranches the banks created a bundle of mortgages that had a risk of default higher than the senior tranche, but significantly lower than the junk tranche.

The banks would then create a shell corporation and "sell" it these bundles.  The entity, also known as a special purpose vehicle (SPV), would receive the mortgage payments from the homeowners.  The SPV then sold slices of these bundles to various investors, usually through bonds (a type of securities).  These securities are known as collateralized mortgage obligations (CDOs)  The SPV would then use part of the collected mortgage payments to pay interest on the bonds to investors.  Thus, the SPV was making money off of both the mortgage payments and by selling the bonds to investors.  Most of this revenue went back to the bank.  In sum, the banks were able to create revenue in addition to the mortgage payments by selling securities that were based on those mortgage payments; thereby hitting two birds with one stone.

The problem is banks vastly underestimated the risk of default.  They thought the risk was virtually none existent, and maybe it was low in some MBS bundles.  But rating agencies artificially inflated ratings on the mortgages, so the safer, senior tranches were eventually composed of lesser quality mortgages (in some cases junk mortgages).  As exotic mortgages to subprime borrowers started to reset at very high interest rates, these borrowers began to default.  As the default level increased (i.e. banks were not receiving all of the mortgage payments) the banks were unable to pay the bondholders and bondholders couldn't sell their securities, which meant the MBS were worthless.

Eventually the banks were stuck with bundles of mortgages they couldn't sell and investors were stuck with worthless securities.  The banks needed to raise capital and, additionally, they tightened lending standards.  This effected lending to businesses, which ultimately slowed the economy and raised unemployment.  This in turn increased the number of borrowers who couldn't afford their mortgage.  The result was a vicious cycle that saw real estate markets drop to their lowest point in decades. In the end the entire world suffered from the Great Recession.

To combat the vicious circle, the U.S. government--and other governments around the world--started injecting taxpayer funds into the economy (think bank bailout and stimulus packages).  This undoubtedly helped ease the pain.  Unfortunately, the government is starting to end some of its programs, such as the Federal Reserve's program of buying these now toxic MBS, see here.

Now the banks are going to have to face reality (even though they are still trying to collect on worthless home equity lines of credits, see here).  They need to write down some of their losses, which could again cool the credit markets and make it more difficult for individuals and small businesses.  At the same time, the increase in foreclosures is the result of a second resetting of exotic mortgages to very high interest rates, see here.

As the number of foreclosures increases, the foreclosed properties will drag down the value of surrounding properties.  This may force more borrowers underwater (i.e. they'll owe more on their house then it is worth).  People may questions whether it's worth making that monthly payment, although I suspect most people will continue making their payments absent some other factors--such as unemployment.  At the same time, banks will get less money for their foreclosed properties and these loans will continue to turn sour on their books, which will require them to keep more capital out of the economy.

The bottom line is we are not out of the woods yet.  Just like the back-to-back snow storms that struck the nation's capitol last February, we are in for another serious smackdown.  In the second snow storm all of the government's resources were still busy trying to dig out from the first storm.  Similarly, this second wave of foreclosures will find less government resources to ease the pain.  It's now time for the banks to take their lumps.  Hopefully the government will allow them to take their beating so the economy can start to recover.