How They Work and How They Have Affected the Economy
First, of course, the legal disclaimer
Please note that the information
in this guide is not to be used as consulting, accounting, or legal advice. The
following information is provided with the understanding that this article is not
a substitute for professional advice, and is merely for informational purposes.
TheFinanceResource.com is not responsible for the use of any information contained
below or for the factual accuracy of any statements made below.
A mortgage, as we all know, is a
contract between a borrower and a lender that specifies how much money is being
borrowed, the terms of the borrowing, how long the borrower has to repay the loan,
and any other terms (or “covenants”) that must be abided during the course of the
mortgage. This article will explain how mortgages and how the mortgage industry
works. We hope that this article will provide you with some greater insight into
how real estate finance works and why the mortgage industry’s problems have crept
into every part of our economy.
A quick side note: Issues that are
not discussed in this article include the usage of complex financial instruments
such as credit derivatives, credit swaps, credit insurance, and synthetic leverage
devices. These financial products, traded among financial firms, primarily paved
the way for the current financial issues that the world is facing. However, these
are highly complex instruments (and we could write entire books about how each of
these instruments works). This article is meant to provide an overview of the mortgage
market and how it has impacted the economy. If interested, we encourage you to further
research these instruments and the economy. The more you know, the less fear you
have, and the more you are in control to make wise financial decisions.
Years ago, when an individual wanted
to purchase a house, he or she would approach their local bank and apply for a mortgage.
This was the standard course for obtaining a loan until the late 1960’s when the
government came up with a very smart strategy for making homeownership affordable
to most Americans (to be discussed in a moment).
Pre 1960’s, your local bank would
lend you the money for your home, and then they would hold the mortgage on their
books for the life of the loan. For instance, if you wanted to purchase a $50,000
home in 1960, you first needed to have a 20% down payment. Thus, you were borrowing
$40,000 from the bank. Additionally, you needed to have a salary that was equal
to at least 20% of the value of the home. In other words, you need to make $10,000
per year (which was a good salary in 1960). Assuming that you had no other debts,
the bank would lend you the money (which they had from deposits), and then they
would earn the interest that you paid every month on your mortgage. The bank earned
a profit on the interest they charged you (let’s say 8%) and the interest they had
to pay their depositors (let’s say 3%). Additionally, the bank would earn some moderate
fees at closing.
In 1968, the US Federal Government
charted the Federal National Mortgage Association (FNMA) or better known as “Fannie
Mae.” During the Great Depressions similar entities were created, but not on the
scale that Fannie Mae (and subsequent other entities like Freddie Mac and Sallie
Mae) would become. Fannie Mae was designed to buy mortgages from local banks so
that they could create new mortgages. Now, let’s take a trip back to 1960.
In 1960 (using the figures from
the above example), you took out a $40,000 mortgage from Local Bank ABC. This bank
had two branches in your town, and had about 10,000 customers. Let’s also assume
that aggregately, Local Bank ABC had $50 million of deposits. Most banks keep 8%
to 15% of their deposits as cash. There are many regulations (provided by the US
Treasury, the Federal Reserve, Comptroller of Currency, FDIC, etc.) that determine
the amount of cash that a bank must keep. However, for this article, let’s keep
it simple and say that Local Bank ABC needed to keep 10% of all of its deposits
in cash. So, it could lend out $45 million. The other $5 million would be used when
people requested their money, wrote checks, etc.
Now, let’s assume like you, everyone
else in town wanted to buy a $50,000 house. We will also assume that everyone is
qualified (makes $10,000 per year and has a $10,000 down payment). So, Local Bank
ABC lends out $45 million to the residents of
. Now, Local Bank ABC has a bit of a problem. It can’t make any more loans because
it needs to keep the rest of its money as cash. However, everyone pays their mortgage,
and the bank makes a nice profit….but the bank wants to grow. Now, let’s assume
that someone new moves into town, and wants to buy a house. They too are qualified
to make a home purchase. They go to Local Bank ABC, and they are told that “we wish
we could, but we can’t lend out anymore money.”
There is where Fannie Mae (and other
mortgage buyers come in). Fannie Mae would approach Local Bank ABC and ask to buy
all of their mortgages. Remember, a mortgage is an investment for a bank, and like
any other investment, it can be bought, sold, and traded for other assets. Your
mortgage (your promise to pay the same amount of money every month for 30 years)
is worth money. Continuing on, Fannie Mae tells Local Bank ABC that they will buy
all $45 million of their mortgages for $47 million. This is a pretty good deal for
the bank because not only are they going to be able to make new loans, but they
are also going to earn a $2 million profit when they sell all of their loans to
Fannie Mae. You as the borrower now owe Fannie Mae your monthly payments rather
than Local Bank ABC.
This was a major turning point in
finance within the
. Banks could now make loans, sell them to Fannie Mae (and others), and earn fees
from both you (closing costs) and from the sale of the mortgage to a third party.
As such, the nature of banking changed. Banks became less concerned with the interest
that they would earn on loans and more concerned with the profits they would make
from closing costs and selling closed loans.
On a side note, you might be wondering
where Fannie Mae gets the money to buy these loans. The answer: two places. First,
Fannie Mae was taken public via an IPO, and you could buy shares of Fannie Mae (and
you still can – although a very troubled company at the moment) on the stock exchange.
Fannie Mae would use some of their investors’ money to buy loans. Additionally,
Fannie Mae issues bonds (debt) to investment funds, pension funds, insurance companies,
etc. that provide them with the money they need to buy loans. The interest rates
on these loans was/is low because Fannie Mae was a government sponsored enterprise
(or “GSE”) and there was an implicit guarantee that they would not default on their
bonds (which turned out to be true for the most part). Fannie Mae got a vast majority
of its money to buy loans by issuing bonds (just like how the
government finances its operations with savings bonds and treasury bills).
With responsible lending practices
in place, none of these things were bad. Local banks across the country could provide
a steady stream of mortgage financing to qualified people that wanted to buy homes.
Local banks earned profits from closing loans, holding them for a little while,
and then selling them to companies like Fannie Mae. Fannie Mae was happy because
they bought your 8% fixed rate mortgage, and then would pay out 4% to bond holders,
which earned them a nice profit.
Now, let’s fast forward to 10 years
ago. Because banks became less concerned with credit quality (because they could
very quickly sell the loan to Fannie Mae), they loosened their lending standards.
Now, Local Bank ABC might only require a 10% down payment. Additionally, lobbying
groups pressed for lighter regulation on the types/size of mortgages that Fannie
Mae (and others could buy). As such, Local Bank ABC now wanted to make as many loans
as possible so that they could earn fees from closing and selling loans. With the
advent of the internet, the process and time between closing and selling a loan
shortened tremendously. Loans that were given to bank customers could now be transferred
to mortgage buyers like Fannie Mae in a matter of days.
Fannie Mae and Freddie Mac weren’t
the only companies that wanted to get in on the fees related to buying and selling
mortgages. Investment banks like Bear Stearns, Lehman Brothers, Goldman Sachs, Merrill
Lynch, and Morgan Stanley also started buying mortgages from smaller financial institutions,
packaging them into bonds, and selling these bonds (similar to those issued by Fannie
Mae) to pension funds, insurance companies, hedge funds, etc. These investment banks
earned tremendous fees for engaging in this type of business. These fees were similar
to fees earned by Fannie Mae; however these investment banks operated on a much
smaller scale than Fannie Mae and Freddie Mac.
Here is where the problem starts.
Fannie Mae, Freddie Mac, and the investment banks provided guarantees on the bonds
that they issued so that they could get the money they needed to buy loans from
other banks. The thought process behind the guarantees was that yes, a few mortgages
will default, but those losses will be very small in comparison to the profitable
operations of the banks and the mortgages that were current.
Then sub-prime lending grew. Again,
because banks became less concerned with who they were lending money to (because
the loans would be sold very quickly) new loan products entered the market. Interest
only loans, teaser rate mortgages, and no down payment mortgages became common place
over the last ten years. Additionally, people were no longer required to stringently
verify the income they stated on their mortgage applications. As such, banks lent
out A LOT of money to people that could not afford to pay the mortgage for more
than a few months. This became apparent in July of 2007 when Bear Stearns announced
that two of its biggest funds for buying mortgages became insolvent. Then more and
more people who were not qualified starting defaulting on their loans.
At first, most financial professionals
thought that this would be contained to only the people that shouldn’t have received
mortgages (which is actually a very small part of the mortgage market). However,
there was a ripple effect. People that could no longer afford their mortgages began
selling their houses. In places like
, many people saw the values of their homes double in just a matter of two to three
years. Many qualified borrowers also refinanced their homes with new mortgages and
home equity loans so that they could extract some of the equity from their homes
to purchase big ticket items like expensive cars, new room additions, and other
major purchases. Thus, prime borrowers (people who were properly qualified to take
on loans) starting having problems because their home values decreased as sub prime
borrowers began to sell their houses. As their home values decreased, the amount
of money they owed on mortgages began to exceed the value of their homes. This,
of course, happened after they had spent the money on expensive items.
So, now people (both prime and sub-prime
borrowers) are defaulting on their mortgages. The investment banks and Fannie Mae
still owe money to bond holders. So…now the banks are beginning to lose money because
interest payments are no longer coming in, and they still have to pay the people
(bond holders) that they borrowed money from to buy these mortgages in the first
place. If you have followed the news in the last twelve months, major banks have
taken massive losses (tens of billions of dollars) due to the devaluation of the
mortgages they own, and from the interest they still need to pay.
This primarily happened because
of greed. People that were not qualified for mortgages got them because banks quickly
sold these mortgages to other people. Additionally, as housing prices continued
to rocket upward, more and more people began to buy real estate as an investment.
This further led to more borrowing and refinancing. Housing prices, like the stock
market in 2000, reached their peak…and then the flurry of selling occurred as everyone
wanted out. However, unlike the stock market, people used tremendous amounts of
debt to buy these properties. As such, the financial impact on the
and global economy has been substantial. Banks have had trouble selling loans to
third parties (hedge funds, pension funds, and insurance companies) because no one
knows what loans are in these bonds. As such, the credit market froze.
In recent months, governments around
the world have stepped in with plans to unfreeze the market by injecting capital
into banks, buying troubled assets, and providing guarantees on certain financial
instruments so that banks begin to lend again. This has been somewhat of a slow
process, but it is starting to work. Major interest rate indexes (like LIBOR) have
declined substantially in the last two months.
All of this talk of financial crisis
has scared consumers. As such, consumers are putting off purchases like new cars,
clothes, and other items. In turn, companies begin generating less revenues and
profits. Now companies are beginning to lay off workers as a result of less revenue.
Again in turn, people become unemployed and begin to default on mortgages. You can
see how this becomes a downward spiral.
However, there is good news. Again,
the major interest rate indexes are coming down, and banks are starting to lend
again to qualified customers. Housing prices are continuing to fall, but at a slightly
slower rate. The market is beginning to hit its bottom. Many real estate investors
that have a significant amount of cash on hand are beginning to buy undervalued
properties. These are the first signs that the housing market is starting to complete
its correction. However, other economic factors are in play, and anything is possible.
Within the next six to twelve months,
many economists anticipate that the
, along with other governments, will continue to use approved bail out packages
to unthaw the credit markets. Again, there are certain signs in the markets that
this is starting to occur.
There is much political talk about
versus bailing out Wall Street”, but the truth is that we are all very connected.
In short, we are all now living on the same Street. Your auto loan, your mortgage,
your credit cards, and other debts are now all owned, traded, securitized, bought,
and sold among major financial institutions. The “bailout” or “buy-in” (as it is
often called by proponents) of Wall Street is intended to have the same ripple effect
that the sub-prime mortgage market had – in reverse. If banks can begin to lend
again, and bond holders will start to buy bonds again, then local banks, regional
banks, and national banks can continue to make new loans. New loans mean new businesses,
new housing starts (which means more buying of household goods like furniture),
new jobs, and new ways of doing business. Credit is the backbone of any modern economy.
Many people have likened this meltdown
of the financial markets to the Great Depression, and while the tones of this crisis
are similar, we live in far different times now. Governments and central banks,
assisted by speed of light transactions, can now step in and remedy issues with
major market players much faster than they could in the 1930’s. Additionally, information
is compiled faster. Whether a financial remedy is working or not becomes apparent
As such, the way that the US (and
world markets) complete mortgage transactions will need to change, and banks, as
time progresses, will need to focus on providing mortgages to people that are qualified.
Governments will need to issue new regulations to ensure that sub-prime mortgage
practices are curbed and controlled, and that all members of the financial community
take some share of risk for the work that they do.