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Sub-Prime & Financial Markets
Meltdown |
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Part I of this
2-part commentary examined the politics that triggered Part II takes an in-depth
look
at the lending practices and market events |
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All of a sudden, low-down payment, no-down payment, no-documentation, option and hybrid adjustable-rate, interest-only, balloon payment, negative-amortization mortgages, etc. were approved for sub-prime borrowers with less-than stellar to nonexistent credit; often without verifying stable and adequate income or any income at all. When prime borrowers learned of these new loans, they also applied for them initially or refinanced into them. The relaxed underwriting standards lenders engaged in were accompanied by reductions in the amount of money set aside for bad loans and institutional up-leveraging (financing new expansions/purchases with debt). This led to a record increase in the total number of mortgages issued. Now, anyone in the U.S. who was of-age and alive, could pretty much get a mortgage, so demand for houses increased and prices inflated (Thanks to the Law of Supply and Demand.). All the while, former Federal Reserve Chairman Alan Greenspan kept the federal funds rate too low and publicly endorsed “alternative” mortgages; mortgage rates remained historically low; appraisers over-valued houses; first-time buyers (including illegal immigrants) purchased homes; existing borrowers upgraded to larger and more expensive properties; homeowners used their houses as ATM machines and engaged in annual cash-out refi’s; every-day-average Janes and Joes bought 2nd and 3rd properties; and novice and experienced investors over-speculated. Not all, but many of these borrowers were ignorant about the ins-and-outs of the largest financial transaction(s) of their lives. (No doubt, the U.S. public education system played a part in the real estate and financial ignorance of home buyers. We are encouraged to “live the American Dream” but never taught the ABCs of how to shop for a mortgage and buy or sell a house! But I digress.) While sub-prime borrowers were getting loans and mortgages, most loan originators were not concerned about a borrower’s ability to repay, because they didn’t intend to hold the loans in their own loan portfolios. Instead, the loan originators ensured they made money, stayed liquid, and diversified their risk by selling some of the loans they originated to other lenders (who did hold the loans in their respective loan portfolios), and by bundling and selling many of their remaining loans to mortgage giants Fannie Mae and Freddie Mac and also to Wall Street Investment Banks in the secondary market. There, the loans were re-packaged into complex mortgage-backed securities (MBS) insured by American Insurance Group (AIG), and then resold in slices or tranches on Wall Street to other Banks, Hedge Funds, and Investment Firms all over the world. Because so many troubled mortgages passed through Fannie and Freddie, many domestic and foreign buyers didn’t carefully vet their MBS purchases. They just assumed that the securities would be backed by the full faith and credit of the United States Treasury, because Fannie and Freddie were Government Sponsored Enterprises (GSEs) chartered by Congress. Unfortunately, the mortgage practices of Fannie and Freddie ended up fostering greed and widening the door to the secondary market, encouraging more-and-more lenders to issue and sell more-and-more sub-prime mortgages. Lender-after-lender kept passing the risky loans down the line, only concerned about the fees and bonuses they were earning along the way. If housing prices continued to rise, mortgage-backed securities would remain low-risk investments. This is because if a homeowner got into trouble and couldn’t pay the mortgage, all s/he had to do was resell. In a seller’s market, you can easily sell a house for a profit in just a few weeks. Real Estate is cyclical, however, so when housing prices dropped and a buyer’s market emerged, the securities became high-risk mortgage investments very quickly, and a financial domino effect was triggered. The mortgage-backed securities under scrutiny contain both prime and sub-prime mortgages. The sub-prime mortgages are the wild cards poisoning the securities, because no one knows exactly what they are worth today. We know the mortgages aren’t worthless, but how do you comply with the current mark-to-market accounting rule and peg their value to today’s market when housing values are still dropping? The risk intensifies because, as of this writing, only about 25% of the sub-prime loans have defaulted so far. However, which loans, how many, and when the remaining 75% will default, no one knows. As the financial markets lost confidence in mortgage-backed securities, commercial and consumer credit scaled back and tightened. We are now at the point where banks are reluctant to lend to each other and exchange cash for Securities. Both bank-to-bank and consumer lending are necessary to keep the U.S. debt and consumer economy going. The American people have virtually no savings, yet we need the ability to borrow so we can consume. When there’s no money for people and companies to borrow and lend, a consumer economy shrinks, and retirement accounts, housing values, business inventories, payrolls, employment, GDP, etc. are seriously threatened (until we return to the savings and production economy of our grandparents). The Emergency Economic Stabilization Act of 2008 (HR 1424) is also known as Treasury Secretary Paulson’s $700 billion Troubled Asset Relief Plan (TARP) and Public Law 110-334. The Act was just signed into law on October 3, 2008 and was originally supposed to put money back into the financial system and free up cash for banks to lend and borrow. The plan was for the U.S. government to purchase toxic, illiquid mortgages from large banks and hold them until the real estate market turned for the better and the loans could be sold back to the private sector at a profit. On November 12, 2008, Treasury Secretary Paulson announced that TARP will not be a capital purchase plan after all; instead, the TARP funds are now targeted to be used to strengthen the capital base of our financial system and the asset-backed securitization market that is critical to consumer finance. It appears that Secretary Paulson and members of Congress are figuring out the cure for this financial meltdown as they go along, so expect fund allocations under this Act to change again and again and again... Why did the housing bubble burst in August 2007? Housing prices started to decline because existing and new houses started to exceed demand, thanks in part to the housing construction boom that also occurred while home values were rising. In addition, the low, temporary, fixed teaser rates on ARMs started to reset, causing interest rates to increase, and leaving people with higher monthly mortgage payments they could not afford. All of a sudden, it became extremely difficult to sell without time and equity and impossible to refinance out of an ARM and into a traditional fixed loan without 1) pristine credit, 2) proof of stable and adequate income, and 3) equity in the house. So Homeowners put their houses up for sale and/or went into foreclosure; both of which further contributed to the increasing housing inventory. When you factor in fraudulent securities ratings agencies; arrogant risk managers; an asleep-at-the-wheel SEC Chairman; the easily-manipulated Office of Federal Housing Enterprise Oversight (OFHEO) which is the oversight Agency responsible for the “safety and soundness” of Fannie and Freddie; and a mark-to-market accounting rule which mandates that a company’s assets be pegged to today’s value, you have the makings of a massive housing bubble that eventually burst and triggered a financial markets train wreck. Using a train wreck analogy, here is the bottom line:
The whole situation is really a lot more complex than what I just described but, hopefully, you now have an overview of some of the politics, lending practices, and market events that, at a minimum, contributed to the real estate situation you face today. |
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