Reader Sammy Provides a Simple Illustration of the State of the Market

I imagine that many of us writers and readers of this blog have lately been answering questions from friends and relatives about what has happened to the markets recently, especially since those friends and relatives remember us claiming there was a problem for a long time now.

Reader Sammy sends along this simple illustration of the problem…

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A mortgage securitized is nothing more than a bond. Here is a nice bond valuation model in which you can input values. (Scroll down to the bottom of the page.)

I suggest you use the following inputs to describe a “normal state”:

1) Principle amount $200,000
2) Coupon rate 6%
3) Years to maturity = 30
4) Required return 6% (mortgage backed securities historically extremely safe)
5) Hit “Find Bond Price” button
6) Value of Bond = $200,000

Now imagine a situation where, because of unanticipated collateral losses (mortgages no longer low risk) investors now:

4) Change their “Required return” to 10% (input into model)
5) Hit “Find Bond Price” button
6) New value of bond = $124,283.

Since mortgages have been historically very safe, investors have been able to leverage their holdings substantially. At 10:1 leverage, $20,000 equity supported the $200,000 bond. Well, the value of the bond has just declined $75,000, wiping out the equity several times over.

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This illustration of the problem came from Sammy.