I have a question, and who better to ask than you. ...something isn't adding up.
I keep hearing that mortgage defaults are what is bringing down many financial institutions, and the the default rate in some particularly bad mortgage pools is up to 50%. Because housing prices are down about 20%, financial institutions can still regain 80% of the value of those loans, no? Actually the real value is probably a bit better, as most loans will be partially paid off. At any rate, doesn't this imply that even in the worst loan pools, there is only a total 10% loss. And most financial institutions will have some higher quality loan pools also, and stocks, etc. So the total effect is going to be smaller than 10%, unless financial institutions were all constructing some sort of horrible options based high risk bets on housing prices, but I doubt this would happen except in some risky hedge funds.
Is this reasoning correct? If so, I don't understand how our system can be so fragile that a few percent drop would bring everyone down. Of course everyone holding a share of these funds will have a small portfolio dip, but this happens every few years anyway.
Your calculations are reasonably correct (see comments for more detail). So why the crisis?
1) Leverage. Many I-banks had 30:1 ratios, so a small movement in value of a subcomponent of their portfolio could wipe them out. It's like a guy who puts 10% down on his house, who can lose everything if the price goes down by 10%. Of course this only matters if he is forced to sell, or, in the bank case, if shareholders and counterparties start losing confidence. This is happening simultaneously in financial markets due to the second factor...
2) Complexity. No one knows who is holding what, who has sold insurance (credit default swaps) to other parties and is on the hook, etc. So trust is gone and credit markets are paralyzed -- no muni bond issuance, no short term loans to businesses, no car loans, etc.
The efficient functioning of our economy is built on trust -- I have to trust that the grocer will give me food in exchange for a dollar bill, that I can get my money out of the bank, that my employer will pay me at the end of the month, that its customers will pay it, etc.
We are nearing a dangerous point. Confidence, once destroyed, is very hard to rebuild.
Relative to the size of our economy, the amount of money involved is not that great. If we had perfect information we could solve the whole problem with about $1 trillion. (About the cost of the Iraq war; not bad for a bubble that involved housing -- our most valuable asset.)