Saturday, March 8, 2008

Sub-Prime Mortgage Crisis Explained: and It's Not What You Think

So… after 9-11 when the Islamists flew their planes into the Trade Center, the economy went into recession. The economy was already fragile, teetering on the brink for almost a year. In order to combat the recession, the Federal Reserve lowered interest rates, and then lowered them again, then lowered them again, and again, until the effective interest rate was almost “0”. In addition, the Fed also pumped a lot of money into the economy. In other words, it printed up a bunch of dollars and pushed them into the economy through the banks.

That meant that America could go on a borrowing spree, and one of the things for which Americans borrowed money was to buy homes, or houses if one was a speculator. The home builders were glad to do accommodate them, and the housing boom was on.

Not only were the home builders in an accommodative mood, so were the lenders. The banks or mortgage brokers or private mortgage companies were more than willing loan money to folks buying up the real estate. In order to promote loans, the banks offered rates that were extremely attractive based on the artificially low interest rates. There was a “gotcha,” the interest rates on these mortgages would be “adjusted” after a period of years, and those in the know knew that probably meant…up. The borrowers weren’t in the know, and rather than get a fixed rate for 30 years, they bought the adjustable rate which allowed them to add the granite counter top extra to the house package.

Not only were the banks making loans, but the artificially low interest rates created an excessive demand for housing, and the cost of the real estate went up. Using the inflated prices as a means to compensate for the usual 20% down payment….the lenders offered the loans in what turned in to “no money down” deals…like when you buy a car.

Now, in the old days, the lenders carried these loans themselves. But the old days are gone, and the lenders discovered they could make a quick buck by selling the loans to private investors in the form of bonds that were known as a “mortgage backed securities”. So they bundled up a bunch of these loans, and sold them…everywhere….collecting a fee along the way. Hurrah!!

Unfortunately, the lenders were a tad indiscriminate in what loans they put into what bundle. Each bundle contained some traditional types of mortgages of the type anyone over 50 would be familiar with….along with some of these more recent, “interesting” loans that were based on artificially low interest rates and artificially inflated housing prices. The trouble was, no one knew what loans were in what bundles. It’s kind of like buying “the surprise box” for a buck at an auction.

In addition, because the “bonds” were sold over and over again, the sellers didn’t keep good track of the paperwork. So in some instances, one party held the bonds, another collected the money on the bonds, and another party held the legal right to modify the mortgages backing the bonds, but these folks didn’t know each other.

It didn’t make any difference….the bonds were “insured” by private insurance companies which were “AAA” rated, which in turn, made the bonds “AAA” rated. Houston, we have a problem. The net worth of the insurance companies insuring the bonds might be 2 billion dollars, but the value of the bonds they were insuring was 100 billion dollars. Ouch!!

Enter a blast from the past. Remember Enron? After the collapse of the mammoth energy trading company, the accounting rules changed to keep that from ever happening again. Now, if a company doesn’t know what an asset is worth, they have to value it at “0”…zero.

Fast forward to 2007. Interest rates are going up, and so are the adjustable rate mortgages that were bundled into bonds and sold to God knows whom…and the borrowers begin to default because they can’t make the newly increased payments.

Problem 1: As these loans default, nobody knows in which bundle of sold mortgages the defaulted loans are located. So the holders of the bonds don’t know if they are good bonds, mediocre bonds, or worthless. That means the bond holders are screwed.

Problem 2: The borrowers can’t go back to the original lenders to renegotiate the loans because the lenders have sold them to whomever…again with the bundles. That means the borrower is screwed.

Problem 3: All of this puts those insurance companies insuring the bonds at risk. Remember the math: a 2 billion dollar company insuring 100 billion dollars of bonds…so much for the “AAA” rating. The insurance companies are screwed.

Problem 4: Now the holders of the bonds, mostly a lot of publicly traded banks and brokerage houses, not knowing what kind of mortgages are in the bond bundles, not being able to renegotiate the loans with the original borrowers, and now knowing the insurance companies insuring these bonds aren’t so “AAA”, don’t know what these bonds are worth.

These bonds are now required to be valued at “0”. Simply stated, the bond-holders financial statements are now decimated…and those left “holding the bonds” are in trouble. Those of you who owned Mahoning Bank shares and then Sky Bank and now Huntington Bank shares know what that means. The shareholders are screwed.

Here’s the kicker. You know those bonds that are valued at “0”? They aren’t worth “0”. They are worth a lot. The default mortgage rate in the United States is currently .8%. That is less than 1% of the outstanding mortgage loans. 99.2% of all mortgage loans are just fine. When the headlines scream mortgage defaults are up 25%, they mean from .5% to .75%. Kind of stupid, isn’t it?

Are default rates up? Yes. But at the end of the day, the sub-prime mortgage crisis is caused more by an accounting rule and legal barriers than by actual defaults.

The solution is simple. Change the accounting rule….or allow the government to form an entity which would guarantee the bonds, allowing the bond holding institutions to value the bonds at a more realistic rate. The institutions get their capital structure reinstated allowing them to loan money again…hopefully normalizing lending requirements back to the way it was in, let’s say, 1995: 20% down with a realistic appraisal. End of crisis, but in a political year…what are the chances??

PS: On March 11, the Federal Reserve began to move in this direction by allowing the banks to use as capital assets AAA mortgage backed bonds as the basis of borrowing money from the Federal Reserve. The amount of infusion is $200 billion, a step in the right direction, but there is still a long way to go. My sense is that this will be inflationary as opposed to a straight bond guarantee program which would solve the problem.

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