Just How Did We Get Into This Mortgage Mess?
April 23rd, 2008 categories: Mortgages & Finance
My office hosted a luncheon today with Bill McCue of McCue Mortgage. Mr. McCue, in the mortgage business for longer than I’ve been alive, had a lot to say about the mortgage mess we find ourselves in.
In case you’ve been in a hole for the last year, the mortgage mess is as follows: No or low down payment loans almost non-existent, no subprime loans, no stated income loans and increasingly stringent credit and income guidelines coupled with increases in rates of foreclosures/defaults/short sales and housing prices on the decline nationwide. A big pot of yuck.
If you’ve scratched your head in wonderment then I have some answers, thanks in part to Mr. McCue. Caveat for you economists out there - this is a simple man’s explanation. I am only a Realtor, after all:)
A long time ago, if you wanted to buy a home, you went to your local bank. You opened up an account (or already had one) and a local loan officer qualified you for a mortgage. Unless you were borrowing money through FHA or VA, which guaranteed loans in the event you defaulted, banks wanted to ensure you did not default and you had to meet pretty stringent guidelines.
This was back in the days of double digit interest rates, when you needed 20% for a down payment, and your qualification was entirely dependent upon your ability to repay. Home ownership rates were lower than they are today - 62% in the 1970s and around 64% in the 1980.
In the early 1980s, it became legal for banks to charge higher fees and offer variable and balloon type mortgages, which they offered to subprime borrowers. However, the market for subprime loans was still a small percentage of the marketplace.
From a paper by the Federal Reserve Bank of Dallas,
“Traditionally, banks made prime mortgages funded with deposits from savers. By the 1980s and 1990s, the need for deposits had eased as mortgage lenders created a new way for funds to flow from savers and investors to prime borrowers through government-sponsored enterprises(GSE). Fannie Mae and Freddie Mac are the largest GSEs, with Ginnie Mae being smaller. These enterprises guarantee the loans and pool large groups of them into RMBS (residential mortgage backed securities). They’re then sold to investors, who receive a share of the payments on the underlying mortgages. Because the GSEs are federally chartered, investors perceive an implicit government guarantee of them. Fannie Mae and Freddie Mac, however, haven’t packaged many nonprime mortgages into RMBS.
Lacking the same perceived status, nonagency RMBS—those not issued by Fannie Mae, Freddie Mac and Ginnie Mae—faced the hurdle of paying investors extremely large premiums to compensate them for high default risk. These high costs would have pushed nonprime interest rates to levels outside the reach of targeted borrowers.
This is where financial innovations came into play. Some—like collateralized debt obligations (CDOs), a common RMBS derivative—were designed to protect investors in nonagency securities against default losses. Such CDOs divide the streams of income that flow from the underlying mortgages into tranches that absorb default losses according to a preset priority.
Having confidence in the ability of quantitative models to accurately measure nonprime default risk, a brisk market emerged for securities backed by nonprime loans.”
From the St Louis Federal Reserve Bank,
“In addition to changes in the law, market changes also contributed to the growth and maturation of subprime loans. In 1994, for example, interest rates increased and the volume of originations in the prime market dropped. Mortgage brokers and mortgage companies responded by looking to the subprime market to maintain volume. The growth through the mid-1990s was funded by issuing mortgage-backed securities (MBS, which are sometimes also referred to as private label or as asset-backed securities [ABS]).”
In part because mortgage lenders were not going to hold the mortgages they wrote, credit standards began to loosen.
Beginning around 2000, several other things began to happen that broadened the impact of subprime mortgages.
-Interest rates were low, caused in part by the dot com bust
-Home prices began to tick upward
-The ranks of lenders and Realtors began to swell with amateurs flooding the business who did not know how (or chose not to) counsel clients on wise financial decisions
-Homes became investments, not a place you can raise your kids (lost money on your Pets.com stock? Don’t worry, you can park your money away safely in real estate!)
-The availability of home equity loans enticed many people to spend their home equity on purchases
And like a snowball rolling down a hill…
-Subprime borrowers are defaulting at a higher rate, causing an increase in foreclosures & short sales on the market, depressing real estate prices
-Prime borrowers are affected by depressed home prices when they have to sell or refinance, causing some to default or do short sales
-Credit is tight, locking out buyers who could buy the excess inventory
-Interest rates are likely to rise because of inflation further depressing real estate prices
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