Effor.com

It was all over the headlines yesterday - existing home sales rose 5.5% (seasonally adjusted) from August.  The median price dropped too - down 9% to about $191K.  Good news right?  It IS good news except for one minor detail absolutely no one reported.  Here it is straight from the press release that everyone’s story is from:

http://www.realtor.org/press_room/news_releases/2008/ehs_rise_on_affordability
“Compared to a fairly small share of foreclosures or short sales a year ago, distressed sales are currently 35 to 40 percent of transactions.”

Oops - it seems that foreclosures are counted as sales, and foreclosures and short sales are about 35% of all sales right now.

A short sale is where the bank agrees to the sale and take less money than you owe on the mortgage as payment in full.  For example, if you owed $100K on your house but you could only sell it for $80K, the bank would take it.  Why would they do this?  Because getting 80% of the money it better than getting none and having to go to the expense of foreclosure.  Then the bank is stuck with it and they’ll still need to reduce the price to sell it.

So a short sale cuts out the foreclosure process - but it’s the same result:  The bank didn’t get paid back in full, so they need to writedown that loan and take the loss.  Then the CDS’s (Credit Default Swaps) that were written on that loan need to be written down and taken as losses, and the “Traunches” (pieces of mortgages packaged together for resale to investors) need to be written down, then the “Super Traunches” (bundled groups of Traunches) need to be written down, etc.

Look at the example in this Wikipedia article: http://en.wikipedia.org/wiki/Tranche
(From what I’ve read, this example is a simple simple one, but it illustratates how one debt is packaged and repackaged.)

CDS’s, Traunches, Super Traunches and dozens of other alphabet soup abbreviations are all forms of derivatives, and this is why just a few percent increase in foreclosures (or short sales) can cause hundreds of billions (we’re at about $1 trillion now) in writedowns and losses.  And that’s why we’re nowhere near seeing the end of huge losses, and that’s a big reason the stock market is tanking.

To give you an idea of the size of the writedowns (losses) that need to happen, it’s estimated that the derivative market totals about $500 trillion.  The total GDP of the entire world is about $55 trillion.  These debt instruments have been repackaged and resold and repackaged and resold so many times that they total about 10 times the entire world ecomony.  That’s why Buffett (Warren, not Jimmy) called them WMD’s.  And unlike the ones in Iraq, these actually exist,and they will go off.

gk