How Did We Get Into This Mess? Part 1: The Complexities of the Mortgage Market

As I said in my somewhat coherent post last night, the purpose of this blog is to educate the average person on the historic times we are living through in the financial markets. I didn't pitch in any kickball games while tipping back a 40 of Coors tonight, so I will stick to the economy in this post rather than venting about childish incidents.

In order to understand the implications and importance of the Fed bailout, it is first necessary to have a basic understanding of the banking system in America. We bring money to the bank because it is a relatively safe and convenient way to store our cash. Banks need our money to finance their operations. They pay us extremely low interest rates on our deposits. They then take our deposits and lend them out to other people and businesses at higher interest rates. Banks make loans to individuals to purchase homes, cars, boats, etc. They also loan money to businesses so that the businesses can continue to operate and expand. Depending on the credit of the borrower and the type of loan, banks charge various interest rates on their loans. The riskier the loan, the higher the rate the banks charge. It's a very simple concept and a very lucrative business. Banks are essential to our economy because without their loans, individuals have no way to borrow money to finance large purchases or to grow their businesses. That is the situation we are currently experiencing. Liquidity in the credit markets has essentially dried up.

Tight credit => Less access to capital for businesses => Slower growth in the economy => Job losses for Americans

So how did we get to the point where many banks are going out of business and others are on the verge of bankruptcy? I wish I had started this blog about a year ago, because there are a lot of factors in play. Tonight I will focus on the main factor that has brought us to one of the most difficult times in the history of the financial market: the housing bubble. Hold on to your hat because this is where a seemingly simple topic of taking out a mortgage to buy a house has become extremely complex over the past several years.

Let's say Ted E. Taxpayer goes into a bank, we'll call it Greed E. Bank to take out a mortgage. Banks like mortgage lending because if Ted loses his job and can't pay the loan, the bank is still able to take control of the house and sell it. As long as the bank can sell the house at a decent price, they will not lose very much money. Ted is happy because he has a home. The bank is happy because they are paying, let's say 1%, on their deposits and Ted is paying them 6% for the next thirty years. They also collect fees on these transactions. But the bank would be happier if they had more deposits so they could lend out more money. Well it must be their lucky day because decades ago, the government created Fannie Mae and Freddie Mac. You might have read about them in the news recently. They were privately run companies until the U.S. Treasury was recently forced to bail them out.

So what do these two agencies do and how does it make the banks happier than a pig in shit? A common misconception is that Fannie and Freddie originate mortgages. They do not. Fannie and Freddie buy mortgages in the secondary market from banks like Greed E. Bank. The banks then have more money to lend out. Yippee! Fannie and Freddie will either hold the mortgages on their own books or take similar mortgages (i.e. similar interest payments, similar maturities) and package them together as mortgage backed securities (MBS). These are then sold off to banks, investment banks, private equity firms, pension funds, sovereign wealth funds and other investors. Fannie and Freddie put guarantees on these securities that all interest and principle will be paid to whoever owns the MBS. They are essentially insurance companies. They are able to guarantee this debt by only buying a specific type of mortgage that they deem as safe.

Just in case I've lost you, let's review what has happened so far since Ted went to the bank. Greed E. Bank originated a mortgage so Ted could buy a house. Freddie Mac (or Fannie Mae if that is your favorite one) then bought this mortgage from Greed E. so Greed E. could make more loans and more money. Freddie then grouped Ted's mortgage with similar mortgages, stamped their guarantee on the MBS and sold it to to other banks and investors. A seemingly simple agreement between Ted and Greed E. Bank now involves Freddie and whoever bought the MBS. So if Ted defaults, multiple parties will be affected.

In the late 90s, the governement pressured Fannie and Freddie to loosen their standards on the types of mortgages they could buy. They wanted lower and middle class people to have access to credit as well and to have the ability to become homeowners. Fannie and Freddie obliged and began to buy Alt-A and Subprime mortgages from the banks. Armed with the ability to sell subprime mortgages to Fannie and Freddie, mortgage companies and banks began to aggressively market mortgages to people with terrible credit. A lot of people who should not have been leant money in the first place were so thrilled at the thought of finally owning a home that it was easy for lenders to sell high interest mortgages. Many of these lenders are now facing civil and criminal charges for predatory lending practices. Someone please remind me to discuss this in more detail in a later post.

Greed E. and other banks and mortgage companies made a boatload of money on these mortgages. Fannie and Freddie did as well. Unfortunately, these companies and many individual real estate investors made a critical mistake. They improperly assumed that there could not be a nationwide collapse in residential real estate values. Since they were under the assumption that housing prices would always go up, they did not really worry about defaults on the mortgages. Individual home buyers were also caught in this trap. Even if Ted lost his job, he could still sell his house at the same price or a higher price than where he bought it. The ridiculousness of these assumptions has hit the front page of every newspaper over the past two years. Real estate values around the country have been dropping substantially. The housing market fell apart quicker than Brittany Spears' career.

So how exactly did the real estate bubble form? After the last recession, interest rates were at historically low levels, so millions of people bought homes or used their existing homes to finance the purchase of second and third homes. With mortgages available to practically everyone with a driver's license that could spell their name properly 3 out of 5 times, demand for homes far outpaced supply. Just like we all learned in Econ 101, this caused real estate values to sky-rocket. Then the adjustable rate mortgages began to reset at higher rates. Millions of people became stuck with mortgage payments that they could not afford. The number of foreclosures has skyrocketed. The banks would be able to handle these foreclosures if there were buyers in the market and if real estate values were stable or increasing. Neither is true. As the number of foreclosures increases, the holders of mortgages and mortgage backed securities end up suffering serious losses. A once steady cash flow has now disappeared. Some of the largest holders of these MBS are the banks that people rely on for loans to buy houses. The banks have taken serious losses on these investments, so they have less capital to use to make loans. We therefore find ourselves in the following situation:

-People are losing their homes because they cannot afford their mortgages.
-Banks and mortgage companies are losing money because they own many of these non-performing assets.
-Banks have tightened their lending standards significantly because they don't have the capital to lend out and because they don't want to get stuck with more non-performing assets on their books. They are also stuck owning houses that they either cannot sell or have to sell in auctions at ridiculously low prices.

I could write for hours more on this topic tonight, but sleep is needed. Looks like it will be a busy day again tomorrow as Congress is once again failing us by taking too long to act on important issues. I hope this post gives people a basic understanding as to how we got into this mess. For all you experts reading this blog, I do understand that there is much more to the current crisis. I will hopefully get to more of the factors in future posts. Check back late Sunday night. I should have a post describing the implications of the Fed bailout package and I hope to clear up the Main Street vs. Wall Street debate. As always, comments and questions are encouraged.

See you Sunday.