The Mortgage Mess Explained
The economic slowdown (recession) was caused by the current mortgage mess. The crazy mortgage market heights of 2005 turned and now lenders and homeowners have giant losses and the whole economy suffers. The sensationalistic media tells half-truths creating anxiety and panic.
Have the financial companies written down too much? The media is reporting up to $70 Billion in write downs from the financial markets? Before we take this at face value, we need to look at how mortgage risk is spread around.
Traditional loans are sold by mortgage bankers/brokers and bundled for sale to Fannie Mae. I used to work as a loan officer in Phoenix, at a smaller brokerage. Because of our funding and size we transferred all loans at closing, to lenders. We used many lenders at our brokerage, and would shop around for the best combination of rate and terms to fit the needs of our clinets. The difference in the rate our lender would give us and what we’d sell it at is called yield spread premium. This is how money is made, buy wholesale sell retail.
Larger funders of conventional conforming loan would bundle and sell them to Fannie Mae. After bundling they become collateralized debt obligations (CDOs), a type of asset-backed security - a structured credit product. Some of the smaller lenders would bundle the loans they took in and sell them to larger banks, so they could bundle them up and sell them directly to Fannie Mae. If you have a conventional conforming loan, it was probably sold to Fannie Mae within a couple months. Fannie then sells bonds against those mortgages so they’ll have more money to buy more mortgages.
If your home was an FHA, VA loan, or USDA (Farm Home Loan program) it was backed by the US government and sold off to Freddie Mac similar to the way conventional loans are sold to Fannie Mae. Some banks will hold prime loans on their books for one reason or another. Freddie/Fannie may purchase loans they initially rejected; after they show 12 months of on-time payments.
But you write a check to your bank, don’t they own the loan? In most cases no, they purchased the servicing of the loan. I don’t know how much it costs to buy the servicing, but I’ve heard the average mortgage will produce about $30 a month in income. They take your money and send the principle & interest to Fannie/Freddie and some to your impound account for taxes, insurance, HOA, and other stuff.
The next big grouping of loans is called Subprime. Most subprime loans will never be bundled and sold to Fannie or Freddie, as there would be no way they could meet their strict underwriting guidelines. Loans may become subprime due to three reasons; poor credit, lack of documentation, or lack of equity.
Subprime borrowers receive higher rates, 9% to 13% because of the increased risk. The rates on subprime loans were typically set for 2 or 3 years, after which it would climb, based on an index. I’d always spend plenty of time with people to remind them of how important it was to improve their credit, so they can return and refinance to a prime loan before the rates reset.
Subprime loans are typically held by investors, finance companies, and some are bundled and sold to large banks and hedge funds. Pre-payment penalties on subprime loans are typical. The cost to write and sell these loans was much higher than prime loans, and too much money would be lost if people refinanced within the first 12 months. If investors can't make any money or have any guaranteed time frames they would stop investing.
The housing market is collapsing and $70 Billion has been written down so far. The media has led you to believe the sky is falling, and when loans go bad there is nothing left. We know who owns the loans, how they are insured against loss?
Fannie and Freddie loan are insured by Private Mortgage Insurance (PMI) and the government respectively. When a home forecloses PMI or the government will make up the loss on the loan. After foreclosure and eviction the home may be sold at auction. For example a loan is made, defaulted, and foreclosed; let’s say the loan was for $200,000 and at auction it sells for $180,000 for a loss of $20,000. PMI or the government pays Freddie or Fannie the $20,000. Freddie and Fannie only have losses on lost interest from the time payments started to stop until the home was resold, plus foreclosure & eviction costs.
Do the $70 Billion in write-downs take auction and insurance revenue into the equation?
Are the write downs finished? Lawyers are popping up teaching people upside-down on mortgages how to walk away from their homes. Many loans have temporary fixed rates set to expire, and go variable within the next couple of years. Housing sales have fallen for 11 straight months, and the prices of those homes are falling.
I believe many of the financial companies are writing down as much as they can get away with. For example Citi has a new CEO, and I believe he wants to blame as much as possible on his predecessor and write down as much as possible giving the new CEO as much cushion as possible. Other executives at other companies take maximum write downs now, creating as much future cushion as possible for the future.
Media pundits think recent rate cuts by the Federal Reserve that the housing market will come back. I believe folks have been scared from the market.