The Banking Implosion
I’m sure by now you all have noticed the ongoing meltdown
in the mortgage industry. The cause of this whole mess is a
little bit complicated, rooted in both the structure of the
mortgage industry, and human nature. I’ll try to explain
both factors here in layman’s terms.
How does the mortgage industry work? Most of you have seen
the ever present ads for mortgages, promising low payments,
and low interest rates and no income checks required. Seems
a little fishy and too good to be true, right? Well, for the
most part it is. Let’s go through the whole loan process,
from start to finish. In a perfect world, this is how it works.
First,
a loan is originated. This is the part the consumer sees. You
deal with a loan officer and a bank or broker who takes your
application, and presents the loan programs available to you.
You pick the program you want, and then your file is submitted
to underwriting. The underwriter approves the loans subject
to a list of conditions and you will work with the processor
and the loan officer to get them. You need to get an appraisal,
document your income and credit history, and perhaps show some
assets. When all the conditions are met, you are allowed to
close, and you either get the house of your dreams, or are
able to refinance your previous mortgage.
This is as far as most people have ever seen, but it’s
only the beginning of the fun. Where did the bank get the money
to lend you? Most mortgage banks work with something called
a warehouse line of credit. They actually borrow the money
they lend you. Then, the bank will take your loan, lump it
together with a bunch of other loans and sell it to investors.
This is called securitization. Your mortgage has now become
part of someone’s investment portfolio somewhere. The
bank takes the money it got from selling your mortgage and
pays back the warehouse line of credit, and ideally has something
left over for profit. If a bank makes a $100,000 loan to you,
it would like to turn around and sell it to investors for $103,000
or more. This is why banks like to charge higher rates, because
an investor may decide that the $100,000 is worth $101,000
if it returns 6.5%, but is worth $105,000 if it returns 7%.
The higher the rate they charge you, the more the bank can
sell your loan for. There’s a lot more to it then this,
but this is a good enough understanding for now.
How do investors
decide how much to pay? They analyze the risk of the loans
and require higher returns for riskier loans. They know there
will be defaults, but they will make up the difference on the
loans that do perform at higher rates. If you have an 800 credit
score and make a ton of money and have half a million in the
bank, an investor will consider you very safe and not require
a high rate of return. If you have a 510 credit score, can’t
document your income and have a history of missing mortgage
payments, how will a bank get someone to by your mortgage?
Easy, they will charge you a rate so high that even though
it is risky, someone will be willing to take the risk. That
is called subprime lending. Most subprime loans started with
fixed rates for the first 2 or 3 years, and then adjust upwards
by 3 or more points. Payments can jump by hundreds of dollars.
So
what broke down? Simply put, things went too far. Borrowers
wanted more cash out or bigger homes, so took out loans that
they would not be able to afford later. Banks kept writing
these loans because they are very profitable and they pushed
the risk off onto the investors who bought the loans. This
was an unsustainable cycle.
Here’s a typical story. A gentleman named Charlie I recently
talked to told me that he had been living in his home for about
20 years, but 2 years ago, he ran into some financial hardship
and decided to take out a mortgage to pay for all his unexpected
medical bills. His broker put him into a subprime mortgage,
explaining that since he needed to borrow 95% of the value
of his home, subprime would be best. I don’t know if
that was true or not, since I didn’t see his credit and
income 2 years ago, but it really doesn’t matter for
this story. In order to get the value he needed, the broker
pressured the appraiser to inflate the value. Instead of the
home being valued at $170,000, the value was inflated to $190,000.
This allowed Charlie to take out a mortgage for $180,500, or
95% Loan to Value (LTV). He knew he was borrowing more then
his home was worth, but he figured that in 2 years, his home
would be worth enough to refinance again. On top of that, he
took an interest only mortgage to keep his payment lower. The
initial interest rate was 7.5%, which gave him a monthly payment
of about $1,128. Sounds good, right? Not so fast. Housing prices
in Charlie’s area stagnated, so his home is not really
worth any more now then it was two years ago. On top of that,
the 2/28 adjustable rate mortgage he took out recently jumped
3 full points in rate, and the interest only period ended.
Now, Charlie is stuck in a mortgage where the payment jumped
from $1128, all the way up to almost $1,700. What can he do
now? He can’t refinance because he owes more then his
home is worth. He is quickly going through his saving because
he can’t afford the mortgage payments. How long before
he loses his home? This story is much more common then most
people realize.
Notice the jump in the foreclosure rate? That’s what
happens when people are in mortgages they can’t afford
that they should probably not have been offered in the first
place.
Investors of course noticed this, and decided that the
subprime market was a bit too risky for them and won’t
buy those mortgages anymore. A lot of banks were stuck with
loans that they made, owing the warehouse money, and were unable
to sell the loans they made for even face value. That $100,000
loan from a few paragraphs ago is now only worth $85,000 to
the investor. The bank has now LOST $15,000 on the loan. Multiple
this by several hundred loans, and now we are short one bankrupt
mortgage bank. Now, the warehouse lender takes a hit, and gets
more conservative. They may refuse to lend to other subprime
lenders to avoid taking more losses. This is part of the liquidity
issue we are hearing about, and has caused a number of lenders
to shut down. If a subprime lender can’t borrower the
money from a warehouse line, they can’t lend it to you.
I’ve actually seen a couple of loans be declined in the
last 2 weeks because of this issue. Major lenders like New
Century, Fremont, BNC, American Home Mortgage and many others
have now stopped originating new loans.
What happens to the
investors that own the defaulting mortgages? We are already
starting to see an increase in hedge funds collapsing, and
a large percentage of subprime mortgages have been repackaged
and sold to investors, including American, Chinese and Europeans.
With some fancy financial footwork, B grade securities were
repackaged, bundled and sold as A grade paper. Someone will
be left holding the bag, but I’m not sure who quite yet.
There are billions yet to be lost, maybe hundreds of billions.
What
is the net effect of this? Investors are running away from
the risky loans and rushing to the safe ones. Subprime loans
are almost non-existent now, and rates have shot up on jumbo
and Alt-A loans, which are for good credit people who can’t
document their income. Meanwhile, rates on the least risky
loans, the so called prime or conventional loans, are dropping.
These are the loans made to people with good credit, who can
document their income to qualify, and are borrowing less the
80% of the value of their homes. Investors are rushing to safety.
The other sector of the mortgage industry that I know is doing
well is the FHA sector. These loans are insured by the Federal
Housing Authority (FHA) and are considered safer. FHA is replacing
subprime, since the loans are not dependant on credit score,
but on documentable income and payment history. I’ve
seen borrowers with credit scores well below 500 get mortgages
that are 30 year fixed rates and below 7% interest. And these
are the rule, not the exception.
I haven’t gone into specifics here and I’ve glossed
over a lot of details. There are many more loan programs that
are risky that I haven’t covered. There are intricacies
I felt would just bore most readers, and I wanted to keep this
short and readable.
If you are in an adjustable rate, I urge
you to look into getting into a fixed rate now. I really don’t
know where things will be a year from now, and if housing prices
continue to drop, next year may be too late to refinance. If
you have any questions, please email me at MortgageGuide@yahoo.com.
I will gladly answer any questions you may have and point you
in the right direction to get yourself on a better financial
footing going forward. Be proactive. Don’t wait until
you are drowning to look for the shore.
If you want to keep up on what is going on inside the mortgage
industry, check out www.ML-implode.com. They post news articles
every day related to the ongoing mortgage industry trouble,
and they even have their implode-o-meter counting the number
of subprime lenders that have gone out of business. Dark humor,
sure, but very informative.
Aaron Parker |
