All are punished

It is not just the poor who are losing out from the housing crash; the rich are also taking a hit. Caliber Global Investment Ltd., a $908 million fund, will close after running up losses in the sub prime mortgage market. The fund reported an almost $9 million loss in the second-quarter. Meanwhile, another London based hedge fund - Queen's Walk Investment Ltd - stacked up a $91 million loss during the first quarter of this year. Again, most of the losses were due to rising defaults in the US sub prime market.

Thus, it would seem that investors have suddenly rediscovered that risk exists in the housing market. Between 2001-06, investors had systematically and wilfully mispriced the potential losses from the US housing bubble. Now, investors are desperately running for the exit, frantically avoiding the investment products that they purchased with abandon during the exuberant years of double digit house price inflation.

Yet, here is the great mystery of today's housing crash - risk is not a difficult thing to understand. If a financial institution gives a borrower with a poor credit history a massive loan to finance an overpriced house, then the probability of default is rather high. In principle, this increased risk should be reflected in the interest rate charged to the borrower. This simple observation seems obvious now, as default rates are rocketing. Yet somehow, this was all forgotten during the crazy hazy speculation of 2003-5.

Unfortunately, mispricing risk wasn't the only stupid thing that mortgage lenders were doing. They were also backend loading interest charges through teaser rates and complex adjustable rate mortgages. In effect, institutions pushed their problems out two years by offering inappropriate mortgages to people who didn't understand the financial products they were buying. It was as if the sub prime industry had designed a marketing strategy that would maximise the chances of a wave of defaults.

Now, losses are piling up, and default rates are undermining any prospect of a recovery in the housing market. Not that the prospects for a recovery were ever going to be particularly high. The market remains fundamentally imbalanced. With inventory rising to all-time highs, and prices falling, the correction has a long way to go yet. Nevertheless, the sub prime crash has the potential to undermine housing finance for years to come. With investment funds abandoning the sub prime market, stung by a large losses, it will take a long time before investors feel confident enough to return. As the supply of funds drying up, the number available mortgages will likewise diminish.

Today's housing market has become one massive wealth destruction machine. The poor sub prime borrowers can't afford the houses they are living in. As they default, they incur personal losses which they cannot cover. These losses end up on the balance sheets of sub prime lenders, whose investors ultimately take the hit. Everyone loses; all are to blame; all are punished.