What worries me about the whole economy is that the people who were getting fortunes to make clever and/or sensible investments weren’t especially much paying attention to simple logic about whether those investments were any good. What else are they missing?

Economists have known for a long, long time that the real estate market is not an efficient market — this means that it’s prone to bubbles and bursts. So prices swing up way past the real value of a property during a bubble, and fall below when it pops. And just as Econ 101 predicts, when the price of a property falls below the outstanding loan value, the default rates spike, because default becomes an action with positive returns. What’s going on at the individual level is utterly unremarkable.

Now, remember that 1) banks make home loans mostly to homeowners all living in the same region, and 2) prices in a given region are correlated, since they’re part of the same local market. So a burst bubble is very expensive for a bank, since defaults are highly correlated for them.

To break this correlation, since the 1970s banks have been engaging in mortgage securitization. What this means is that they trade their loans for shares of a portfolio of loans. As an example, imagine a bank in Boston, which has a portfolio of 100 loans to Massachusetts homeowners. So, to reduce their risk they trade their portfolio of 100 loans in MA for a portfolio of 2 loans from each state. Since Alaska’s market is hopefully not correlated with MA, they have lower overall risk. Think of a mortgage-backed security as like a mutual fund of loans.

Much more recently — say, the past decade — hedge funds have been trading derivatives based on these securities. Derivatives are a great way of leveraging your capital, and that means that when the market is going up you make a hell of money, and when it’s going down you lose in equal proportion. What has happened is that the market has gone down, and the hedge funds have lost gigantic amounts of money.

Naturally, they’re screaming their heads off about this, and since they’re the richest companies on Wall Street the press has been paying a lot of attention. But me? I honestly couldn’t care less whether Bear Stearns makes 10 billion dollars or not.

But then again, they’re the richest companies on Wall Street, so they’ll probably get bailed out. Annoying, but that’s life.

Not a problem if your salary is stable and you don’t have to move, but anyone who does need to relocate will be selling at a loss (though they’ll be buying at fire-sale prices, I suppose: I’m not sure it really evens out, most of the time).

Another friend who had a family home in Yakima decided he wanted to move to Denver. He took some of his pile and bought a house in Denver because the prices were going up. He tried to sell the house in Yakima and couldn’t move it. So he is now trying to sell the house in Denver and is getting nowhere. He is worried.

Finally, the other shoe that remains to drop is how many hedge funds will be wiped out by this. We don’t know and they really don’t have to tell anybody but their investors. It is a big question mark. It is more than millions, probably billions, but it could be a trillion or two. We just don’t know.

But probably the Fed will do all it can to bail everybody out and spread the damage across the population including people who practiced sound fiscal policy. I say thank heaven for those sensible people for without them, the idiots would all be homeless.