Tuesday, June 2, 2009

The US Mortgage Crisis and why it's going to get worse (Part 1: Subprime Explained).


A chilling report was issued yesterday by T2 Partners titled "An Overview of the Housing/Credit Crisis and Why There is More Pain to Come". If you want to see the actual report, click here.

Tomorrow I am going to hilight the key points of the report, but before I do let's cover some background leading up to the current situation. I had several questions about the whole subprime issue and how it came about so let's look at it.

So much has been made of the subprime mortgage implosion that you would think it was almost totally responsible for the economic collapse, and that once the subprime problem was fixed then the worst would be over.

Unfortunately nothing could be further from the truth. But what was 'subprime' all about?

After the dot-com collapse of 2000/2001, a dramatic wave of inducements entered the financial markets to resusitate the economy. Led by the US Federal Reserve under Allan Greenspan, interest rates were dropped making money cheap to borrow at the highest levels of the finance world. Thus began the greatest campaign in American history to get you - the consumer - to borrow money.

When you opened your mailbox in the United States in 2004, 2005, you could barely go a day without all kinds of people pressing on you all matters of schemes in which to expand your personal debt and mortgage debt.

Perhaps the most amazing aspect of this was that you could borrow more than 100% of the price of a house under these schemes with the most fragile of financial bonafides.

One of the mortgage products offered in this atmosphere was something called subprime loans, meaning less than prime quality.

The borrowers that were targeted by these products often had sketchy credit, were financially strapped or lacked sufficient income to qualify for a standard mortgage. The key component of these loans was that after a year of artificially low payments, the interest rates on subprime loans jumped all the way to 10 or 11%.

So why would anyone in the right mind take one of these loans?

Two reasons, primarily. The first (incredibly) was you could actually MAKE money taking out a loan. Yes, you could actually get paid to buy a house!

In many cases people were getting loans in excess of 100% of the value of their property. In this way people were actually putting a little bit of money in their own pocket at close of escrow. You bought the house with nothing down and then were given extra money on top of that for buying the house.

To understand how this was possible, you have to understand what Wall Street was doing with mortgages.

Almost all of the people involved in a mortgage transactions made huge amounts of money arranging the loan, then they passed the risk on to somebody else.

Instead of keeping dicey loans in their own portfolios, the big banks and giant mortgage companies that originally underwrote them resold the mortgages to big New York investment houses.

Firms like Bear Stearns and Merrill Lynch then sliced the loans into little pieces and packaged them up with other investments, then sold them to their best customers around the world as high-yield mortgage-backed securities, turning sows' ears into silk purses, all with the blessing of rating agencies like Standard & Poor’s.

And at every step of the way, somebody has his or her hand out, getting paid.

The broker who arranged the mortgage got paid. He or she was happy. The lending officer, ditto. The rating agencies who assessed home values and the worthiness of the mortgage got paid for passing judgment on these securities. They, too, were pleased, and their stockholders were happy. And on and on.

Because of this 'securitization process', those who instigated the loans were eager to make the loans happen. Therefore whatever a buyer wanted to state for their income, the bank would accepted that at face value and made the loan based on that ficticious income.

You would literaly apply to a bank, or a mortgage broker for a loan. When you filled outthe loan form, you would say, "I have an income of, oh, $150,000 a year." They say, "You do? Fine. Just sign right there." And they would nod, and because they were being paid, not by the veracity of the information, but by the consummation of the deal, not further investigation was necessary.

Next the lending office would say, "Ah. You have verified this?" And the bank would say, "Why, yes, we have." And the lending officer would say, "Great. So do I." Then they would get paid.

Next it was passed on to Wall Street to be bundled up and sold in packages, with Wall Street reaping huge commissions for those sales.

This 'easy money' created a housing frenzy from 2002-2008 unlike anything ever seen.

Easy money started bidding wars for properties and housing values skyrocketed. As the frenzy intensified, Wall Street's hunger for more and more mortgages to securitize grew by leaps and bounds.

Enter the subprime mortgages.

In it's gluttonous lust for more and more mortgages, products were crafted to offer loans to borrowers with sketchy credit (or to offer to those who lacked sufficient income to qualify for a standard mortgage). These subprime mortgages came with artificially low monthly payments in the first year of the mortgage, but then the interest rates jumped after that all the way to 10 or 11%.

People would take these loans because they didn't have to put any downpayment on the house. Then, by getting false assesments about the true value of the house, they would pocket the extra money from the mortgage immediatly (thus getting paid to buy the house).

These false assesments about the true value of the houses were rationalized within the real estate frenzy. Property values were climbing by 10-20% every year. If the house wasn't really worth that now, it would be in a matter of months.

Meanwhile borrowers didn't worry about the interest rate resets after a year because they could afford the initial payments and planned to refinance the mortgage before the interest rate jumped to 11%. Home values would have risen and the mortgage would now represent a smaller percentage of the assessed value of the house. Plus borrowers would have equity in the property (based on the new 'value' after a year of prices booming) and would therefore qualify for a standard mortgage instead of a subprime mortgage.

Real Estate ownership was a licence to print money.

That is... until the bubble began to burst in the most bubbly cities in Florida and California.

It wasn't a big drop. But it didn't matter, a small drop is all it took. When the value of some of these homes dropped in 2007, a ticking time bomb was activated.

And the subprimer's were the first hit.

When the subprimers went to refinance their mortgages after one year, they couldn't do it because the value of the house had fallen below what they owed on the mortgage. So when those 11% interest resets kicked in, it was game over - and the defaults/foreclosures started.

The first wave of defaults triggered a greater drop in housing values as foreclosed properties started to flood the market.

A small drop became a sizable drop. And the dominos began falling.

To the subprime mortgage holders, it really wasn't a big deal.

The subprimer's were never really invested. Most of the people who lost the houses didn’t lose any money because they never put any money down. Though their credit is damaged, and they could face legal action in some circumstances, they got to live in a new house for a couple of years, and some of them even managed to get some money with home equity loans or by refinancing.

And when the crush came, people just said, "Take the house. Good-bye. I'm leaving." And the cascade of foreclosed homes really began flooding the market (furthing driving values down).

Prior to this housing boom, loans were made by your local banker or building and loan associations or savings and loan. They had a stake in the risk of the loan. But as mortgages became securitized and Wall Street became involved, mortgages became very transactional and there was no relationship built with the borrower and the lender.

Lenders failed to act to make loans to credit worthy borrowers, and borrowers were willing to simply walk away from their obligations to a face-less Wall Street entity.

It was greed on both sides of the table, lenders and borrowers with everyone was gaming the system. Warnings were issued, and ignored, by the likes of Nathan Roubini, Schiller, Peter Schiff and Ron Paul.

This hitler inspired parody of the crash lampoons all these factors and has become a classic comic representation of the entire housing crisis...

Ultimately subprime was a very small fraction of the overall mortgage market. But the impact of subprime on the market was like a giant, first domino that triggered a cascading effect.

And with home values plummeting, and the housing sector - one of the largest and most vital parts of the American economy - grinding to a standstill, America was pushed towards recession.

Wall Street and foreign investors were stuck with millions of distressed properties. The unsold condos in Miami, the unfinished apartments on the Vegas Strip, the developments in Atlanta, and the collapsing California dream, it was all interlocked in a giant real estate ponzi scheme.

That’s the fascinating part of this whole debacle. Mortgages are sold in mortgage backed securities, so they’re pooled. The pools are part and parcel of those high-yield mortgage backed securities everyone gobbled up a few years ago, and are now stuck in the windpipe of the world's financial system.

No one wants to buy them, so no one can sell them.

Bonds marked triple-A are now quoted at 50 cents to the dollar, 40 cents on the dollar. Some of them, much less. Some are worth nothing on the dollar. And nothing on the dollar is the worst thing that has happened to Wall Street in a long time.

How many of these securities are out there? A trillion with a T-plus.

But the worst of the subprime fiasco is past, as you can see by this graph (click on image to enlarge)...

As you can see, the huge wave of subprime mortgages resettings from "teaser" rates to market rates has virtually ended.

The problem is that subprime mortgages were never a significant part of the mortgage industry.

Looming on the horizon is a gigantic wave of regular mortgages whose terms reset after 5-7 years. With the value of real estate having plummeted over 40% in many areas of the United States, these homeowners represent a catastrophic mass of mortgages that cannot be renewed because of their current negative equity position.

Tomorrow we will look at that and the impact it will have on the economy.


Email: village_whisperer@live.ca
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