Some dull banking points on the consequences of 
house price falls:

--- Michael Pollak <mpollak@panix.com> wrote:
Many people have said the ultimate price to be paid for a 
housing crash would be a government bail-out that everyone 
would have to pay for.  But if in fact most mortgages have 
been securitized and sold on to a market that isn't 
government insured, that wouldn't happen.  What would 
happen instead is that the mortgage-backed securities 
market would tank, and the price and supply of such 
securities would be radically revised.  This would result 
in a big jump in the cost of mortgages, a contraction 
of the number of buyers, and an additional source of 
serious downward pressure on housing prices, making 
it that much harder for the housing market to recover.

JG: I don't want to sound too sanguine (I'm very bearish 
on house prices), but the risk has been spread about a lot. 
Banks with low cost of capital (Citigroup, HSBC) don't need 
to securitise, because they can keep them on their own 
balance sheets. And their income is sufficiently diversified 
that declines in one market/asset class are compensated by 
everything else.

Banks with a strong deposit base will fare worse, because 
they also keep mortgages on their own books, but they don't 
have alternative income sources. This may lead to more 
consolidation in the banking sector, but widespread bank 
failure is unlikely, not least because of tight regulation 
and relatively sophisticated risk management even in smaller 
institutions. (I'm not saying that they don't do stupid things, 
and there is certainly systemic risk, but risks in mortgage 
books is relatively straightforward.)

Niche mortgage providers and mid-sized banks tend to 
securitise.  The consequence of widespread mortgage defaults 
would make their lives harder, but there are mitigants.

First, falling house prices doesn't necessarily translate 
into more defaults - people might keep paying for their 
homes, and want to avoid bankruptcy. 

Second, risk of default is only one element of the pricing 
of mortgage backed securities. A unique risk in this 
asset class is that when rates fall, people repay their 
mortgages, and you have cash instead of an interest-
bearing loan. If house prices fall, people will find it 
harder to re-finance, and repayment risk will decline. Thus, 
mortgage-backed securities become more attractive.

Third, Basle II means that banks will have to set aside 
relatively less capital for mortgages. As a result, all 
banks will be able to offer mortgages more cheaply.

Fourth, there is a lot of capital swishing around at the 
moment. Banks are buying one another up at inflated 
prices because they're not sure what else to do with 
their capital.  If there's no corresponding increase 
in demand for corporate lending, banks might just 
accept higher default rates/less security cover/
lower returns on mortgage lending. All this will mean 
that liquidity will be maintained in the mortgage 
market, but it does my bonus no favours.

Finally, a lot of the cost of a mortgage is administrative 
anyway, and changes in the base rate (and futures market) 
are much more important than movements in the securitisation 
market.

--James