Mortgage meltodown & Credit Crisis: Explained in English - Not Banker Talk
George Boelcke CCP
October 11, 2007
Seven years ago, Y2K, or January 1st, 2000, was going to melt down the economy, crash the banking system, shut down the government and every computer on the planet. Well, not quite. OK, how about the warnings a decade earlier that we never use a public bathroom again, because that was a sure way to catch AIDS? Off the mark again.
So right now we have a credit crisis and mortgage meltdown where there just isn’t any money available for mortgage loans? Crisis and meltdown are the two current panic words from many media outlets. Because if it weren’t a crisis, you wouldn’t feel the urgency to “stay tuned.”
Yes, there’s a big correction, and whenever something goes wrong, the pendulum swings too far until things get back to some kind of “revised normal” state. But before we put that into perspective, what happened in the first place to get us here?
Not that many years ago, a financial panic used to be a run on banks where people were physically taking their cash out, based on rumors or financial panic. The 21st century equivalent is securities financed by hedge funds, banks and other large institutions. Mortgage loans are funded, packaged and immediately sold to investors. They’ve provided returns above what other investment vehicles were yielding and investors couldn’t get enough of them. After all, we were in a low interest world and these loan portfolios were high rate returns. Besides, they were rated by bond rating agencies such as Standard & Poor and Moody’s. (Their involvement in rating these package deals is now subject of a huge lawsuit).
Historically low interest rates were also the biggest marketing tool for mortgage brokers. Every company was selling 15 or 30-year fixed rate loans at the best rates in history. But in order to get a bigger market share, they had to become more creative in offering adjustable rate mortgages (ARM), temporary teaser rates and the likes, all arguably marketed to be “better” than the best deals available, often known as “too good to be true.”
CNN’s Glenn Beck compared it to a big drinking binge, commenting that we spent the last few years in a low-interest happy hour. Lenders kept pushing the envelope, getting more and more “creative” because they continued to have a ready market for financing these portfolios at pretty low rates with almost built-in risk premium.
In 2001, the difference between a totally secure ten-year Treasury bond and a junk bond was over nine points. By 2005, that spread was down to four points, making these high-risk loans possible, and by May of 2007, it was down to 2.6 points. (It’s doubled since then).
With thousands of companies looking for business, and having easy access to cheap money, there was another huge group of people that hadn’t been targeted to any great degree. It was the approximately 20% of the population with bad credit, politely known as subprime. Realistically, there was a reason this group didn’t qualify for credit based on their past track record. But the market was really not charging much of a risk premium, so to make some big returns and huge gains in market share, higher rate mortgage loans were made available to these types of clients.
From there it was just a small step to lower down payments, to now down payment loans, to 40 and now 50-year loans and Ninja loans that didn’t require much documentation, no verifications and many stories of fabricated incomes and assets. It became the equivalent of “don’t ask don’t tell” – somewhere between questionable or kinky and fraudulent.
All of these were combined, mixed together, packed up, and sold to investors, including more than 3,000 hedge funds who couldn’t get enough of the big returns these investments were yielding. And investors were doing the same things the mortgage loans were doing: A small down payment and borrowing the rest to create some massive leverage.
The trouble started with the subprime mortgage market. What a surprise when a bunch of these high risk loans started to default. It was the first reality check when investors slowly started to take a realistic look at the risks they really holding in their investments (not just looking at the returns). It became somewhat of a view that perhaps there was way too much exposure and way too low a rate for the exposure in their portfolios.
The questioning and wake-up calls were more about psychology and a mindset of: “What else can go wrong? What else is out there and happening that we don’t know about yet? What are we actually invested in? I’m not getting enough return for the risk. Is there more trouble just around the corner? I gotta get out!”
It became a crisis when a number of hedge funds at major brokerage firms collapsed as investors wanted to cash out. That brought it to the attention of the world. Then in Europe, a huge French bank froze a $2.5 billion fund after it lost $400 million, which piled on to the uncertainties and worries, and markets hate uncertainty.
When these investors, largely through hedge funds, needed to cash out, it meant sell sell sell in order to raise cash. It started by first attempting to sell questionable or low-yield investments. But you can only sell if there’s a buyer, and nobody wanted to buy these high risk loan portfolios. At that point, the market had pretty much dried up when investors realized that the risk they were taking on was too high for what they were being paid. But it was more like every car buyer now wanted to do an inspection before purchasing.
Deals were still being made – it just took some extra steps now. In other words, the days of no documentation, anyone with a pulse can get a loan, or no down-payments to high risk applicants, are over.
In the mortgage market, there is no lack of money and there isn’t an overall credit crunch, or problem getting funding for good quality loans. But we are back to some kind of normal where risk equals rate. You’ll need a decent FICO score, a down payment, and actually have to prove you’ve got a job and sufficient income to make the payments. Doesn’t that seem reasonable? Wouldn’t you want that before you lend out hundreds of thousand of dollars of your own money?
But that leaves two big issues:
Subprime borrowers with no down payment loans are now in big trouble as over 17% are 60 or more days in arrears. Is it better to have owned and lost than never to have owned at all?
According to Fortune Magazine, there are still over $570 billion of adjustable rate mortgage loans which will reset between now and end of 2008. Their average increase in payments will be more than $1,000. It includes prime borrowers who will see their payments increase an average of $450, but the big hit will be the teaser rate borrowers who will see their payments almost double, increasing an average of $1,825. We’ll cover some tips and suggestions for these households next week.
And does create some good news:
Over $1.5 trillion has flowed out of equities and into hedge funds in the last five years. If there’s more risk than return in these funds, it’s likely that a large amount of this money will flow back into the stock market and helping your savings and investments to grow.
You’ll no longer see the late night ads to buy a house with no money down. They’ll be replaced with a new wave of ads on how to make money from foreclosures. If only it were that easy… if only there was high ratio cheap financing…
Amongst the bankrupt mortgage brokers, now out of business, are a whole bunch who really took advantage of families to make some big points, fees and commissions for themselves. Even though that’s small comfort for many families left in a financial nightmare that will last for years.
So right now we have a credit crisis and mortgage meltdown where there just isn’t any money available for mortgage loans? Crisis and meltdown are the two current panic words from many media outlets. Because if it weren’t a crisis, you wouldn’t feel the urgency to “stay tuned.”
Yes, there’s a big correction, and whenever something goes wrong, the pendulum swings too far until things get back to some kind of “revised normal” state. But before we put that into perspective, what happened in the first place to get us here?
Not that many years ago, a financial panic used to be a run on banks where people were physically taking their cash out, based on rumors or financial panic. The 21st century equivalent is securities financed by hedge funds, banks and other large institutions. Mortgage loans are funded, packaged and immediately sold to investors. They’ve provided returns above what other investment vehicles were yielding and investors couldn’t get enough of them. After all, we were in a low interest world and these loan portfolios were high rate returns. Besides, they were rated by bond rating agencies such as Standard & Poor and Moody’s. (Their involvement in rating these package deals is now subject of a huge lawsuit).
Historically low interest rates were also the biggest marketing tool for mortgage brokers. Every company was selling 15 or 30-year fixed rate loans at the best rates in history. But in order to get a bigger market share, they had to become more creative in offering adjustable rate mortgages (ARM), temporary teaser rates and the likes, all arguably marketed to be “better” than the best deals available, often known as “too good to be true.”
CNN’s Glenn Beck compared it to a big drinking binge, commenting that we spent the last few years in a low-interest happy hour. Lenders kept pushing the envelope, getting more and more “creative” because they continued to have a ready market for financing these portfolios at pretty low rates with almost built-in risk premium.
In 2001, the difference between a totally secure ten-year Treasury bond and a junk bond was over nine points. By 2005, that spread was down to four points, making these high-risk loans possible, and by May of 2007, it was down to 2.6 points. (It’s doubled since then).
With thousands of companies looking for business, and having easy access to cheap money, there was another huge group of people that hadn’t been targeted to any great degree. It was the approximately 20% of the population with bad credit, politely known as subprime. Realistically, there was a reason this group didn’t qualify for credit based on their past track record. But the market was really not charging much of a risk premium, so to make some big returns and huge gains in market share, higher rate mortgage loans were made available to these types of clients.
From there it was just a small step to lower down payments, to now down payment loans, to 40 and now 50-year loans and Ninja loans that didn’t require much documentation, no verifications and many stories of fabricated incomes and assets. It became the equivalent of “don’t ask don’t tell” – somewhere between questionable or kinky and fraudulent.
All of these were combined, mixed together, packed up, and sold to investors, including more than 3,000 hedge funds who couldn’t get enough of the big returns these investments were yielding. And investors were doing the same things the mortgage loans were doing: A small down payment and borrowing the rest to create some massive leverage.
The trouble started with the subprime mortgage market. What a surprise when a bunch of these high risk loans started to default. It was the first reality check when investors slowly started to take a realistic look at the risks they really holding in their investments (not just looking at the returns). It became somewhat of a view that perhaps there was way too much exposure and way too low a rate for the exposure in their portfolios.
The questioning and wake-up calls were more about psychology and a mindset of: “What else can go wrong? What else is out there and happening that we don’t know about yet? What are we actually invested in? I’m not getting enough return for the risk. Is there more trouble just around the corner? I gotta get out!”
It became a crisis when a number of hedge funds at major brokerage firms collapsed as investors wanted to cash out. That brought it to the attention of the world. Then in Europe, a huge French bank froze a $2.5 billion fund after it lost $400 million, which piled on to the uncertainties and worries, and markets hate uncertainty.
When these investors, largely through hedge funds, needed to cash out, it meant sell sell sell in order to raise cash. It started by first attempting to sell questionable or low-yield investments. But you can only sell if there’s a buyer, and nobody wanted to buy these high risk loan portfolios. At that point, the market had pretty much dried up when investors realized that the risk they were taking on was too high for what they were being paid. But it was more like every car buyer now wanted to do an inspection before purchasing.
Deals were still being made – it just took some extra steps now. In other words, the days of no documentation, anyone with a pulse can get a loan, or no down-payments to high risk applicants, are over.
In the mortgage market, there is no lack of money and there isn’t an overall credit crunch, or problem getting funding for good quality loans. But we are back to some kind of normal where risk equals rate. You’ll need a decent FICO score, a down payment, and actually have to prove you’ve got a job and sufficient income to make the payments. Doesn’t that seem reasonable? Wouldn’t you want that before you lend out hundreds of thousand of dollars of your own money?
But that leaves two big issues:
Subprime borrowers with no down payment loans are now in big trouble as over 17% are 60 or more days in arrears. Is it better to have owned and lost than never to have owned at all?
According to Fortune Magazine, there are still over $570 billion of adjustable rate mortgage loans which will reset between now and end of 2008. Their average increase in payments will be more than $1,000. It includes prime borrowers who will see their payments increase an average of $450, but the big hit will be the teaser rate borrowers who will see their payments almost double, increasing an average of $1,825. We’ll cover some tips and suggestions for these households next week.
And does create some good news:
Over $1.5 trillion has flowed out of equities and into hedge funds in the last five years. If there’s more risk than return in these funds, it’s likely that a large amount of this money will flow back into the stock market and helping your savings and investments to grow.
You’ll no longer see the late night ads to buy a house with no money down. They’ll be replaced with a new wave of ads on how to make money from foreclosures. If only it were that easy… if only there was high ratio cheap financing…
Amongst the bankrupt mortgage brokers, now out of business, are a whole bunch who really took advantage of families to make some big points, fees and commissions for themselves. Even though that’s small comfort for many families left in a financial nightmare that will last for years.