Desperate to stabilize the economy after the largest attack in our history, our government set it's sights on righting our economic ship. In order to keep the American economy strong, Americans were encouraged to spend ourselves into prosperity and take us through a very difficult time as we went to war in Afghanistan and Iraq as well on the broader war on terrorism.
The quickest way to infuse money in the economy was to encourage home ownership and home improvement. How was this done? The Federal Reserve lowered interest rates they charged to banks, who in turn, passed on lower interest rates to customers. By lowering interest rates, the Federal Reserve pumped billions of dollars into the economy.
It became easier to qualify for loans. As more money became available for home mortgages, prices for homes rose dramatically. Home prices increased further by increasing the pool of buyers. New loan products such as the adjustable rate mortgages (ARM's) created low introductory rates that dipped to 4%. Buyers were able to afford more home which helped buyers move from their smaller home to a much larger home. Further restrictions were lifted as buyers no longer needed to prove their income (stated income loans). Interest only loans lowered the payments further.
Once the demand increased, home prices began to skyrocket. With the increasing prices, banks came up with a product called a reverse amortization loan, which allowed buyers to pay only a portion of the interest, and place the additional interest on the back end of the loan, the most insane idea of all. For every month someone lived in a home, they owed more than when they moved into the home.
On a dual track, as home prices soared, homeowners were encouraged to take out 2nd mortgages to take out equity from their home up the the new "appraised value." Trillions of dollars of equity was removed--and spent in our economy.
As home prices continued to rise, builders continued to build homes as fast as they could. A speculative component sent home prices even higher. Speculators--people who bought homes and just sat on them became 15% of the home buyers market. Their goal was to hold homes for a year and sell it for the home appreciation profit. These "flippers" had the effect of artificially increasing the price of homes.
All of this is bad, but it gets worse. A new group of loans appeared in our daily lexicon. Sub prime mortgages became the next growth industry further adding to the demand for homes and further increased prices. Sub Prime is a polite way of describing higher interest loans to people with a history of bad credit or who otherwise would not qualify for mortgages.
Finally, the worst mistake of all. Home prices began rising at such a fast rate, banks began to believe that homes were going to appreciate forever--and 100% financing was born. Buyers were stretching into homes that they couldn't afford and were not required to come up with any money for a down payment. This is as far as banks could go to stretch to help people get into homes. Or so we thought. Banks began to refinance loans up to 110% of their value.
And then people began to default on their mortgages and things began to unravel.
But before we look into the unraveling, we need to understand the complicated world of high finance.
When a mortgage loan is written to a home buyer, a long tangled web of high finance begins as that mortgage is sold to a larger servicing bank or packaged and resold to investment bankers on Wall Street who repackages it with a multitude of other loans, creating a mortgage backed security bond, which is sold around the world to huge investment banks and investment groups. These bonds, then were sold and created a value all of their own, often times appreciating in value without connection to the value of the underlying mortgage which it was based.
The best way to explain where a mortgage ends up, lets create an example. I find a home for $100,000. I go to the bank and take out a loan for $100,000 at 7% interest. My payment is $700/month which includes $600/month of interest and $100/month in principle. My bank makes money originating the loan--often between 1-2%, funds the loan and then looks to sell the loan to another institution in order to free up money to make loans to other home buyers.
While not all banks sell their loans, there are several banks that are in the business of servicing these loans, meaning sending out the statements and collecting the payments. Citibank, Wells Fargo, and Washington Mutual are the three largest. So on my mortgage, even though I went to First Bank and Trust, I make payments to Citibank.
But my mortgage often doesn't stop there. Citibank often sell the "rights" to the mortgage (along with a portfolio of other mortgages) to Fannie Mae, Freddie Mac (or other investment banks such as JP Morgan Chase, Lehman Brothers, or Merrill Lynch.) Since Fannie Mae is in the news right now, lets say Citibank has my loan, where they package it together with other loans, and sells the "rights" to Fannie Mae.
Who is Fannie Mae? A good summary exists here. In essence, Fannie Mae is a quasi government corporation which borrows money from the Federal Reserve at a discounted rate, provides liquidity to the mortgage market by buying the rights to my mortgage, provides a guarantee that I will make my $700 payment, and then packaging my mortgage with other mortgages in the form of a bond fund (called a mortgage backed security) and sells these bonds to investment groups such as pension funds, insurance funds or other investment groups. Fannie further provides an avenue for these bonds to be bought and sold between investors, thereby creating liquidity to the mortgage market.
Once a mortgage backed security (MBS) is sold to a company like Lehman Brothers or JP Morgan, who in turn combines several types of bonds and creates three groups of bonds. In essence, these are low risk, medium risk and high risk. These securities are derived from the underlying mortgages such as mine (derivative securities which are called collaterized debt securities) and are bought and sold to individual investors, hedge funds or other investment groups.
In an odd twist, banks began buying these derivative securities and added these as assets to their balance sheets. So banks owned the underlying security--the actual mortgage, and a derivative of that security. If you are confused, join the club. Even banks don't know how this confusion works.
Now let's figure out how things began to unravel.
In 2007, the first shock to the banking system hit when sub prime loans began to see higher default rates. The defaults were, in part due to large increases in the borrowers monthly payments in the adjustable rate mortgages they were sold in 2o04 and 2005. Without the ability to refinance these homes at similar interest rates, their payments rose dramatically. As borrowers began to turn in their keys, banks holding these loans began to get homes back through foreclosure. As foreclosures increased, lending standards began to get tighter. As the the matter got worse, banks specializing in sub prime loans began to be watched by regulators which began to demand stricter lending standards. When these banks couldn't write more loans to outgrow the debt in their portfolio, they collapsed. These banks collapsed in 2007 and became the first domino to fall.
As a result of the sub prime mortgage business collapsed, a large portion of the buying public was taken out of the market. As the bank regulators tightened up lending standards, and adjustable rate mortgages went out of fashion, more of the buying public was taken out of the market. In the fall of 2007, a fundamental shift occurred in the housing market. Home prices reached their peak, and began to fall because of tighter lending rules and less buyers.
Once the prices started to fall, another large segment of the buyers fell out of the market. Speculators no longer could make money in a level or falling market. Fifteen percent of the buyers of new homes withdrew from the market. By the fall of 2007, new home values started to plummet adding to downward pressure on the price of homes. Since builders were building spec homes at record levels, there was an oversupply of homes. In order to keep their sales strong, incentives were offered. By the spring of 2008, home values shrunk 35%.
The loss of home values placed millions of Americans in an upside down position in their mortgage. The new home that was purchased a year ago for $600,000, builders were now selling the home for $500,000. Home appraisals became a large focus of bank regulators. With many people upside down in their mortgages, and in houses with payments they can't afford, homes no longer became a liquid asset like the previous 15 years.
While home values were plummeting and foreclosures increasing, the world of high finance was becoming unraveled. Fannie Mae, you remember, creates liquidity in the mortgage market. As defaults increasing, Fannie was on the hook for guaranteeing half of the mortgages held in the United States. This caused a run on Fannie, and they were not able to keep up with payments.
This sent a shockwave throughout the mortgage industry and the market for derivatives began to dry up. It got to such a point that banks stopped writing jumbo loans over $400,000 for over a month.
So we have a tightening of credit, less home buyers, higher default rates and a liquidity problem in the secondary derivatives market. Add to that rising gas prices, an endless drumbeat of bad economic news and we have a perfect storm that further reduces the confidence in the home buying public.
So there we have it. Millions of Americans are in homes they owe more on that what it is worth. Hundreds of thousands of homes are going through foreclosure and millions more will be on the market because of foreclosure, and banks are going to be on the hook for all of those losses.
The MBS market has dried up as foreclosures increase, and Fannie Mae is on the hook for all of these derivatives. These derivatives are owned by investment companies that run pension funds, insurance funds and billions of dollars of these bonds are owned by investment banks such as JP Morgan, Lehman Brothers and investment companies around the world. Trillions of dollars of these bonds are owned by banks around the world.
American International Group, the company that our Federal Government now owns an 85% stake, is the 18th largest company in the world. It is an insurance company that held many of its reserves in mortgage backed securities, which were supposed to be a liquid asset. Since the MSB's are no longer tradable and are virtually worthless, without the backing of Fannie Mae and Freddie Mac, the Federal Government became a part owner in order to protect the underlying insurance business.
Our Federal Government is now in the security business (US Military and TSA), mortgage business (Fannie Mae and Freddie Mac), the banking business (FDIC and Indy Bank), the insurance business (AIG), the retirement business (Social Security), the health insurance business (Medicare and Medicaid), the energy business (ethanol, wind, solar, coal and oil), the education business (Public Schools), the road building business (Highway transportation fuel taxes), the pension business (Railroad pension fund), the farming business ($300 billion in subsidies) and many others.
What began as a way to keep our economy going in the aftermath of September 11, the mortgage mess we are in highlights the problem we really have--all things go through Washington. And we are headed for a centralized power based in a very powerful Federal Government.
If you think we have looked to the Federal Government to take care of us before, you ain't seen nothing yet.
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