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The Banking Implosion

I’m sure by now you all have noticed the ongoing meltdown in the mortgage industry. The cause of this whole mess is a little bit complicated, rooted in both the structure of the mortgage industry, and human nature. I’ll try to explain both factors here in layman’s terms.

How does the mortgage industry work? Most of you have seen the ever present ads for mortgages, promising low payments, and low interest rates and no income checks required. Seems a little fishy and too good to be true, right? Well, for the most part it is. Let’s go through the whole loan process, from start to finish. In a perfect world, this is how it works.

First, a loan is originated. This is the part the consumer sees. You deal with a loan officer and a bank or broker who takes your application, and presents the loan programs available to you. You pick the program you want, and then your file is submitted to underwriting. The underwriter approves the loans subject to a list of conditions and you will work with the processor and the loan officer to get them. You need to get an appraisal, document your income and credit history, and perhaps show some assets. When all the conditions are met, you are allowed to close, and you either get the house of your dreams, or are able to refinance your previous mortgage.
This is as far as most people have ever seen, but it’s only the beginning of the fun. Where did the bank get the money to lend you? Most mortgage banks work with something called a warehouse line of credit. They actually borrow the money they lend you. Then, the bank will take your loan, lump it together with a bunch of other loans and sell it to investors. This is called securitization. Your mortgage has now become part of someone’s investment portfolio somewhere. The bank takes the money it got from selling your mortgage and pays back the warehouse line of credit, and ideally has something left over for profit. If a bank makes a $100,000 loan to you, it would like to turn around and sell it to investors for $103,000 or more. This is why banks like to charge higher rates, because an investor may decide that the $100,000 is worth $101,000 if it returns 6.5%, but is worth $105,000 if it returns 7%. The higher the rate they charge you, the more the bank can sell your loan for. There’s a lot more to it then this, but this is a good enough understanding for now.

How do investors decide how much to pay? They analyze the risk of the loans and require higher returns for riskier loans. They know there will be defaults, but they will make up the difference on the loans that do perform at higher rates. If you have an 800 credit score and make a ton of money and have half a million in the bank, an investor will consider you very safe and not require a high rate of return. If you have a 510 credit score, can’t document your income and have a history of missing mortgage payments, how will a bank get someone to by your mortgage? Easy, they will charge you a rate so high that even though it is risky, someone will be willing to take the risk. That is called subprime lending. Most subprime loans started with fixed rates for the first 2 or 3 years, and then adjust upwards by 3 or more points. Payments can jump by hundreds of dollars.

So what broke down? Simply put, things went too far. Borrowers wanted more cash out or bigger homes, so took out loans that they would not be able to afford later. Banks kept writing these loans because they are very profitable and they pushed the risk off onto the investors who bought the loans. This was an unsustainable cycle.
Here’s a typical story. A gentleman named Charlie I recently talked to told me that he had been living in his home for about 20 years, but 2 years ago, he ran into some financial hardship and decided to take out a mortgage to pay for all his unexpected medical bills. His broker put him into a subprime mortgage, explaining that since he needed to borrow 95% of the value of his home, subprime would be best. I don’t know if that was true or not, since I didn’t see his credit and income 2 years ago, but it really doesn’t matter for this story. In order to get the value he needed, the broker pressured the appraiser to inflate the value. Instead of the home being valued at $170,000, the value was inflated to $190,000. This allowed Charlie to take out a mortgage for $180,500, or 95% Loan to Value (LTV). He knew he was borrowing more then his home was worth, but he figured that in 2 years, his home would be worth enough to refinance again. On top of that, he took an interest only mortgage to keep his payment lower. The initial interest rate was 7.5%, which gave him a monthly payment of about $1,128. Sounds good, right? Not so fast. Housing prices in Charlie’s area stagnated, so his home is not really worth any more now then it was two years ago. On top of that, the 2/28 adjustable rate mortgage he took out recently jumped 3 full points in rate, and the interest only period ended. Now, Charlie is stuck in a mortgage where the payment jumped from $1128, all the way up to almost $1,700. What can he do now? He can’t refinance because he owes more then his home is worth. He is quickly going through his saving because he can’t afford the mortgage payments. How long before he loses his home? This story is much more common then most people realize.
Notice the jump in the foreclosure rate? That’s what happens when people are in mortgages they can’t afford that they should probably not have been offered in the first place.

Investors of course noticed this, and decided that the subprime market was a bit too risky for them and won’t buy those mortgages anymore. A lot of banks were stuck with loans that they made, owing the warehouse money, and were unable to sell the loans they made for even face value. That $100,000 loan from a few paragraphs ago is now only worth $85,000 to the investor. The bank has now LOST $15,000 on the loan. Multiple this by several hundred loans, and now we are short one bankrupt mortgage bank. Now, the warehouse lender takes a hit, and gets more conservative. They may refuse to lend to other subprime lenders to avoid taking more losses. This is part of the liquidity issue we are hearing about, and has caused a number of lenders to shut down. If a subprime lender can’t borrower the money from a warehouse line, they can’t lend it to you. I’ve actually seen a couple of loans be declined in the last 2 weeks because of this issue. Major lenders like New Century, Fremont, BNC, American Home Mortgage and many others have now stopped originating new loans.

What happens to the investors that own the defaulting mortgages? We are already starting to see an increase in hedge funds collapsing, and a large percentage of subprime mortgages have been repackaged and sold to investors, including American, Chinese and Europeans. With some fancy financial footwork, B grade securities were repackaged, bundled and sold as A grade paper. Someone will be left holding the bag, but I’m not sure who quite yet. There are billions yet to be lost, maybe hundreds of billions.

What is the net effect of this? Investors are running away from the risky loans and rushing to the safe ones. Subprime loans are almost non-existent now, and rates have shot up on jumbo and Alt-A loans, which are for good credit people who can’t document their income. Meanwhile, rates on the least risky loans, the so called prime or conventional loans, are dropping. These are the loans made to people with good credit, who can document their income to qualify, and are borrowing less the 80% of the value of their homes. Investors are rushing to safety. The other sector of the mortgage industry that I know is doing well is the FHA sector. These loans are insured by the Federal Housing Authority (FHA) and are considered safer. FHA is replacing subprime, since the loans are not dependant on credit score, but on documentable income and payment history. I’ve seen borrowers with credit scores well below 500 get mortgages that are 30 year fixed rates and below 7% interest. And these are the rule, not the exception.

I haven’t gone into specifics here and I’ve glossed over a lot of details. There are many more loan programs that are risky that I haven’t covered. There are intricacies I felt would just bore most readers, and I wanted to keep this short and readable.

If you are in an adjustable rate, I urge you to look into getting into a fixed rate now. I really don’t know where things will be a year from now, and if housing prices continue to drop, next year may be too late to refinance. If you have any questions, please email me at MortgageGuide@yahoo.com. I will gladly answer any questions you may have and point you in the right direction to get yourself on a better financial footing going forward. Be proactive. Don’t wait until you are drowning to look for the shore.

If you want to keep up on what is going on inside the mortgage industry, check out www.ML-implode.com. They post news articles every day related to the ongoing mortgage industry trouble, and they even have their implode-o-meter counting the number of subprime lenders that have gone out of business. Dark humor, sure, but very informative.

Aaron Parker