How exactly did the banks lose money?

BY busadmin  August 1, 2008 at 4:36 PM EDT

Wachovia bank; AP
Question/Comment: My question about the mortgage crisis is this: how exactly did the banks lose money? It seems that people who put deposits on the loans that were foreclosed upon lost their money, not the banks. The banks just kept reselling the homes for more mortgage deposits. In fact, their accounting should show massive profits from the quick turnover of mortgage loans, which increased the price of homes to the point where they were unsalable. Can you explain for me please?

Paul Solman: Say there’s a bank: P&G (for Paul and Gloria). It lends money to Gordon of Ithaca to buy a home. Gordon loses his job. He can’t afford his mortgage payments. P&G forecloses (albeit reluctantly; Paul and Gloria are both kind-hearted people and Gordon, a faithful NewsHour viewer, is the last person they’d want to stiff). But business is business.

Problem is, it’s not just Gordon who loses. If his house has dropped in value by more than Gordon put down on the property, P&G won’t get all its money back. Say we loaned him $200,000 on a “$250,000 house.” But now, it’ll fetch only $180,000 on the open (and troubled) market. Gordon’s out his $50,000 down payment (assuming he didn’t borrow that money, too, via a second mortgage). We’re out $20,000 — the difference between what we loaned and what we can now get — not to mention other costs to us, such as the cost of selling the thing. Plus there’s the possibility that Gordon or vandals have stripped the place of valuable fixtures or, say, copper flashing and left it in a terrible and costly state of disrepair.

True, we at P&G may well have sold the loan into the secondary market as one of those MBS’s you’ve heard so much about: “mortgage-backed securities.” So we passed off the risk, right?

Well, not necessarily. Because banks like ours have to put our depositors’ money to work somehow. Our business is paying the depositors X percent and then investing the money at X-and-a-little-more percent, so we’ll make a profit.

And some of the highest-paying, “lowest-risk” investments out there were – you guessed it: mortgage-backed securities! So banks like P&G often wound up putting much of our money back into the very same, very dicey mortgages we ourselves often helped originate. Same for the investment banks that packaged the mortgages and took fees for doing so: they invested in the MBOs, too. The MBOs have plunged in value. We’ve all lost money as a result.