Mortgage Crisis Analysis Who Caused the Mortgage Crisis?
Aubrey Clark
September 26, 2008
What caused the mortgage crisis? If you ask most consumers they will say, "Greedy mortgage brokers that made bad loans to good people". Perhaps they did play a part in the chain of destruction that America is in today, but they were only one link in a very long chain. The truth is, the mortgage crisis was facilitated by consumer demand, ignorant politicians, spineless banks, and yes, the small brokers and lenders. All of these institutions lacked the "moxy" to stick to sound underwriting principles in the face of tough competition spurred by escalating property values and a good economy.
I give you the anatomy of a mortgage. There used to be three types of mortgages: Government (FHA); Conforming (Fannie Mae and Freddie Mac); and private subprime lenders, which were mainly owned and funded by the larger banks, operating under a different a name. Each one of these lenders established guidelines that outlined the terms in which they would "buy" the loan from the small brokers after the loan closed. Every program had a different set of guidelines that catered to a different segment of the market. That market included people with good or bad credit, and consumers that could or could not prove their income.
Once the loans closed with the smaller brokers, the large banks (i.e. Chase, Bank of America, and Countrywide) would buy these loans. They would then arrange these loans into portfolios by a risk class and were earmarked to be sold on Wall Street. Once these portfolios reached a certain dollar amount, the large banks would sell them to investors so they could replenish their lending capital. Each of these portfolios was priced and sold according to their perceived performance and default rates.
Portfolios that were not insured by Fannie Mae, Freddie Mac or FHA were the sub-prime loans, which would fetch lower prices on the open market, due to their higher default rates. The problem is, these sub-prime portfolios were over-valued because their value was dependent on skyrocketing land values. Meaning, if the large banks loaned money on a home and had to foreclose, chances are that house was worth more than the money they loaned on the house. Therefore, the portfolios were considered a lower risk, and as a result, over-priced.
Hereīs the rub...
The investors on Wall Street treated these portfolios as assets to leverage capital (borrow money on) for other investments with hopes of selling the mortgage portfolios in the future for a profit. When the proverbial bubble burst in the housing market, houses stopped increasing in value and began depreciating. This meant the mortgage portfolio that was once worth $10 million was now only worth $8 million, due to the rising default rates and a market slow down. When the market slowed down, investors stopped buying mortgage portfolios and the companies left holding them were in deep water. Not only couldnīt they sell their portfolios, they couldn't afford to take the loss on them if they did.
Welcome to the subprime mortgage crisis.
Now that the "big boys" on Wall Street couldnīt sell these mortgage portfolios, the flow of money came to a screeching halt. This meant that the large banks couldnīt raise money to loan as well. Which, in turn, stopped the smaller lenders from selling their loans to the larger banks. This bankrupted the smaller lenders and dried up resources for brokers aggravating an already unstable mortgage market.
Through all of this, Fannie and Freddie (former government programs that privatized) were taking major hits on the loans they had insured , due to market conditions. Unlike FHA, which is backed by the government, Freddie and Fannie relied heavily on the ability to push and pull money on their portfolios in the market as well, thus the bail-out.
So, the next time you hear an "expert" on TV, (who probably canīt spell m-o-r-t-g-a-g-e), blaming the small brokers and lenders for the mortgage mess, just remember this chain of events:
The land values drove investors. Investors demanded money. Large banks supplied the money. The huge demand for money led to lower rates. Lower rates encouraged builders. Builders borrowed money from the large banks. Builders employed architects, surveyors, lumber companies, paint companies, subcontractors and real estate companies to build and sell their products.
Real estate agents turned to small lenders and brokers to get their clients financed because of poor service from the large banks' retail end. Small brokers began to compete for market share. This increased the demand for "retail money", for which they looked to the large banks. This created competition between the large banks for the retail money market.
This competition caused each of the large banks to create niche products that had lower underwriting guidelines for brokers and small lenders, their de facto retail outlets. These lower standards are what created the sub-prime market, which was mostly owned by the large banks. Then the large banks paid lobbyists, who paid politicians to look the other way, who in essence were fiddling while Rome was burning.
I give you the anatomy of a mortgage. There used to be three types of mortgages: Government (FHA); Conforming (Fannie Mae and Freddie Mac); and private subprime lenders, which were mainly owned and funded by the larger banks, operating under a different a name. Each one of these lenders established guidelines that outlined the terms in which they would "buy" the loan from the small brokers after the loan closed. Every program had a different set of guidelines that catered to a different segment of the market. That market included people with good or bad credit, and consumers that could or could not prove their income.
Once the loans closed with the smaller brokers, the large banks (i.e. Chase, Bank of America, and Countrywide) would buy these loans. They would then arrange these loans into portfolios by a risk class and were earmarked to be sold on Wall Street. Once these portfolios reached a certain dollar amount, the large banks would sell them to investors so they could replenish their lending capital. Each of these portfolios was priced and sold according to their perceived performance and default rates.
Portfolios that were not insured by Fannie Mae, Freddie Mac or FHA were the sub-prime loans, which would fetch lower prices on the open market, due to their higher default rates. The problem is, these sub-prime portfolios were over-valued because their value was dependent on skyrocketing land values. Meaning, if the large banks loaned money on a home and had to foreclose, chances are that house was worth more than the money they loaned on the house. Therefore, the portfolios were considered a lower risk, and as a result, over-priced.
Hereīs the rub...
The investors on Wall Street treated these portfolios as assets to leverage capital (borrow money on) for other investments with hopes of selling the mortgage portfolios in the future for a profit. When the proverbial bubble burst in the housing market, houses stopped increasing in value and began depreciating. This meant the mortgage portfolio that was once worth $10 million was now only worth $8 million, due to the rising default rates and a market slow down. When the market slowed down, investors stopped buying mortgage portfolios and the companies left holding them were in deep water. Not only couldnīt they sell their portfolios, they couldn't afford to take the loss on them if they did.
Welcome to the subprime mortgage crisis.
Now that the "big boys" on Wall Street couldnīt sell these mortgage portfolios, the flow of money came to a screeching halt. This meant that the large banks couldnīt raise money to loan as well. Which, in turn, stopped the smaller lenders from selling their loans to the larger banks. This bankrupted the smaller lenders and dried up resources for brokers aggravating an already unstable mortgage market.
Through all of this, Fannie and Freddie (former government programs that privatized) were taking major hits on the loans they had insured , due to market conditions. Unlike FHA, which is backed by the government, Freddie and Fannie relied heavily on the ability to push and pull money on their portfolios in the market as well, thus the bail-out.
So, the next time you hear an "expert" on TV, (who probably canīt spell m-o-r-t-g-a-g-e), blaming the small brokers and lenders for the mortgage mess, just remember this chain of events:
The land values drove investors. Investors demanded money. Large banks supplied the money. The huge demand for money led to lower rates. Lower rates encouraged builders. Builders borrowed money from the large banks. Builders employed architects, surveyors, lumber companies, paint companies, subcontractors and real estate companies to build and sell their products.
Real estate agents turned to small lenders and brokers to get their clients financed because of poor service from the large banks' retail end. Small brokers began to compete for market share. This increased the demand for "retail money", for which they looked to the large banks. This created competition between the large banks for the retail money market.
This competition caused each of the large banks to create niche products that had lower underwriting guidelines for brokers and small lenders, their de facto retail outlets. These lower standards are what created the sub-prime market, which was mostly owned by the large banks. Then the large banks paid lobbyists, who paid politicians to look the other way, who in essence were fiddling while Rome was burning.
Aubrey Clark is an Author and editor for Direct Banc, which features a credit card with airmiles directory. Aubrey is a financial expert who has spent over twenty years working and training in financial markets. He current project is an airline miles credit card tutorial for business travelers.
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