Floyd Norris’ blog post gave me one of the more rare moments of clarity I have experienced in a while in his blog post: Ponzi Squared.

Sometimes we all get so close to following the housing market that we fail to see the big picture. The crazy illogical and insane lending practices that applied to subprime:

* No money down
* No documentation of income
* Initial below-market teaser interest rate
* Negative amortization

…effectively created calls and puts for fledgling homeowners.

Call option
The lender was merely allowing the buyer to have a call option on the house. If the market rose, the owner had a chance to sell. And of course we all know that real estate markets always rise. As markets continued to rise, the rating agency models showed this to be a good risk since the default rates were low (but it was really because the market continued to rise).

Exercising a put option
The seller, who has nothing to lose with their no money down payment, simply turns in the keys to the lender.

Wondering why banks are enjoying such large rate spreads despite the FOMC rate cuts? They need to offset financial damage and mitigate future hemorraging due to mortgage loan losses. And a bunch of it is will be caused by homeowners who should not have been homeowners in the first place by the very same lenders they are handing the keys to.