When it began, the financial engineering that got us into the current mortgage crisis actually made sense. On a purely mathematical basis, bundling mortgages together is a clever way for banks to reduce their risks while still earning the same expected returns on their investments.

Unfortunately, somewhere along the line, bankers, mortgage originators, and the investors who bought those loans forgot one crucial point: At the other end of a mortgage is a person, who used that money to buy a house. Unlike the stock market, where an incredible amount of information is available about the companies that trade, very little is available about what a home -- or borrower -- is really worth.

Whose skin is in the game?
As a result, banks had traditionally relied on substantial down payments to protect their investment. With a big down payment, a bank can be better assured that:

  • Buyers have their own money tied up in the house, not just the bank's.
  • Buyers really think their home is worth the money invested in it.
  • Buyers had enough financial savvy to save the cash in the first place.
  • If buyers got into hard times, they'd try to keep their houses to protect their own investments.
  • If the buyers paid too much, the bank's investment was protected by the down payment.

Ultimately, those down payments are as valuable to the bank for the information they provide about the borrower's intent and financial acumen as they are for the capital itself. When banks stopped requiring down payments, people with new mortgages stopped behaving the way people with mortgages had traditionally behaved. The rules of the game had changed, housing money had gotten exceptionally cheap, and that cheap money allowed the real estate bubble to form in the first place.

Bubble trouble
The market had been accustomed to people with skin in the game protecting their mortgages. As a result, it neglected to consider that people with nothing invested had nothing to lose by walking away. That enabled virtually anyone with a pulse to walk into a lender and walk out a "homeowner." Is it any wonder that home prices escalated, thanks to weak standards like that?

Not until property values stopped rising astronomically, leaving originators unable to recover their capital in forced sales, did the true risks become apparent. Contrary to popular rumor, even amid this crisis, houses are still selling, and banks are still writing mortgages. But lenders have wised up to the risks they created by handing out cash with no requirement for the borrower to invest one thin dime.

Pop goes the bubble
By tightening their standards, lenders have effectively priced some folks out of the market. Not everybody, mind you -- just the folks who had expected to buy a home with no money down. Unfortunately for people looking to sell their homes, prices aren't set in the market by the average buyer, but by the marginal buyers -- the people willing to pay the highest price.

Removing no-money-down buyers from the picture eliminates a huge chunk of marginal buyers. As a result, there's nothing left to prop up housing prices, which are now finally starting to retreat to more rational levels.

In fact, that's the solution to the subprime crisis. Tighter lending standards, lower housing prices, and homeowners with their own money invested in their homes. That's about the only way to get the dust to settle, entice banks to lend again, and convince investors to buy mortgage-backed securities once more.

Isn't that painful?
Of course, that doesn't sound much like help to the people and companies caught up in this mess. If you can't afford your house payment, the bank will foreclose. If the bank has a choice between holding on to an empty house or selling it for a loss because the buyer had negative equity, chances are it'll sell to recapture whatever cash it can.

And yes, that's painful for the banks, as well. In fact, it's a primary reason why so many banks and other lenders like these have fallen so far off their 52-week highs:

Company

52-Week High

Recent Price

Fall From Grace

IndyMac (NYSE:IMB)

$35.5

$1.76

(95.1%)

Countrywide (NYSE:CFC)

$39.4

$4.86

(87.7%)

National City (NYSE:NCC)

$34.6

$4.5

(86.9%)

WashingtonMutual (NYSE:WM)

$44.2

$6.6

(85.1%)

Corus Bancshares (NASDAQ:CORS)

$18.5

$5.0

(72.9%)

Citigroup (NYSE:C)

$54.5

20.0

(63.3%)

Bank of America (NYSE:BAC)

$52.9

$30.4

(42.5%)

Data from Yahoo! Finance.

In addition, forced selling tends to depress prices even below what would be a rational level of affordability. That's where bargain hunters come in, profiting handsomely from panic in the housing market by buying properties at incredible bargain prices.

Be ahead of the curve
Those bargain hunters are often the first signal of the recovery of any market -- be it real estate, stocks, or artwork. They stand to be rewarded handsomely when the market finally finishes its swing back from the bargain bins toward rational levels. Given a choice, it's always better to be a buyer when times look tough and bargains abound.

Related Foolishness: