The problem is the leverage(by mrre1999)

The problem is the leverage. It starts with the home/property buyer orspeculator(house flipper). He buys a $300,000 property with little tono money down. A mortgage is generated through a lender who getsfunding from an outside source. That document is now an interestbearing note. Who buys that note? Someone who borrowed money at 4% orless and buys that note yielding 6% as part of a tranche of morgtages.The differential in the interest creates yet another derivative oropportunity to leverage.

So now we have unkown amounts ofleverage applied to a house that cost 300k. 10:1 leverage, maybe moreis used to enhance the spread of 1-2 points. So what happens when thathouse declines to $250k in value? What risk is there to the face valueof the note? Roughly 16%+ under water, right? Now multiply 10x. Minus160%, right? Hummm, that's a problem. You lost your principal and someof the leverage. That CDO you bought with 10x leverage is not onlyworthless, it's less than worthless. But don't worry, the loans arestill paying interest, so everything is still cool.

Now whathappens when a portion or all of the mortgages in that CDO go intodefault? Now there is little to no yield and the assets are in decline.It becomes a chain reaction. The homeowner stops paying, the mortgagecompany stops getting payments, they can't pay the CDO holder. So nowyou have dead paper that if leveraged, is definitely worthless and youhave lost part of the leverage also. You are not only insolvent, youowe money.

The home buyer has it easy. He walked away from theproperty when he went under water and stopped his monthly bleeding. Hejust stuck the bank for the loan and the bank now has to pick up thetaxes and insurance to protect their position. That costs money. If thebuck stopped there, the bank could liquidate the house for 200k andtake the 100k hit, no problem, it ends there.

But it doesn'tstop there. Some investment banker leveraged the interest differentialand then sold it to a hedge fund that uses borrowed Yen to buy thosenotes to leverage them even more. He just added another level of risk,the $/Yen risk. If the Yen appreciates 4-5%, he is all done. It's ahouse of cards and the parties in the chain are all at risk for farmore than their principal.

I don't think the average personcould even begin to understand how bad this really is. We know that 15%of subprime is in default, roughly 300 billion, 10x leverage means thaton average there are 3 trillion in potential losses. There are 2trillion in subprime loans. That means 1 trillion is owed to those whosupplied the leverage. Yes, they can recover some of the losses fromthe sale of the property.

If 50% of subprime goes to default, losses will be 10 trillion. That's just subprime, how about prime debt