Reason #64: Home Sour Loan

A tidal wave of debt is hiding in the ledger books, just waiting to flood out onto the market. How long can the bankers and bond traders hold back the rising sea?

The president of my bank told me about a cocktail party conversation he had during the housing boom heyday. A guy bragged to him over martinis, “I bought ten houses this year.” When my bank president questioned the wisdom of taking on all that debt, the guy just shrugged and said, “They either appreciate or I walk.”

By walk, the guy meant default on the loans. In other words, leave his banker holding the bag. For years, lenders handed mortgages to every Tom, Dick, and Harry that came in off the street. Deadbeats like the guy at the cocktail party often didn’t even have to put any money down to get a loan. So if they walked away from the mortgage, they simply gave the house back to the bank and got off Scot free.

Lenders are fine when they can sell foreclosed properties for the same amount or more as a defaulted loan. But what happens when a bank repossesses a house that cost $2 million a year ago and is only worth half as much now? Who eats the million-dollar loss? The bank, that’s who. Now think about this: Foreclosures are already at record highs. People are “walking away” from loans by the thousands. Meanwhile, housing prices are tumbling and they’re only going to fall further.

It’s an accountancy nightmare. Until the bank forecloses on a property, it stays on the banker’s books for its original value. To make matters worse, thousands of mortgages were bundled into massive bond issues and sold on the open market. As far as the bank and the bond owners are concerned, that $2 million house is still worth $2 million, plus all the interest owed-until the borrower walks. Then it’s worth whatever buyers in the current market will pay. Suddenly, the banks are looking at huge losses. It’s like a tidal wave of debt is hiding in the ledger books, just waiting to flood out onto the market. How long can the bankers and bond traders hold back the rising sea? How long until it swamps them? And us?

NEXT: Reason #65: Don’t Pay ‘Til You Graduate