I share your sense of bewilderment and frustration. Per your question on Mortgage Backed Securities (MBS), my understanding is that they are fully callable bonds. When a investor buys them (e.g., a pension or hedge fund), the portfolio manager needs to factor-in the probability of the bond being called (i.e., mortgage payed off early).
In my opinion, the REIC is very much incented to throw good money at bad by refinancing FBs into new option ARMs since: (1) they avoid default thus keeping the original MBS holder happy, (2) the originator gets revenue from writing a new loan and selling it into the MBS market, and (3) a new fund manager gets to buy new MBS’ to replace ones that have been called. Furthermore, the investment bank maybe able to assemble these refinanced FB option ARMs into larger packages with higher quality MBS to where the fund manager is somewhat insulated from the higher risk…and potentially get a higher yield.
At some point, the music has to stop…probably when the FBs have exhausted their equity, cash and other investments, and they are so far underwater that they can’t refinance or even make the first payment. However, with all the industry players incented to keep the party going, the “creativity” of the financial wizards at the i-banks and sheer inertia of the markets, I’ve given-up on hoping for homes in California to return to rational pricing in the near future.
