Understanding the Mortgage Crash

The Mortgage Crash

PART I
What happened: Money was being loaned to people who couldn't repay their loans in the long-run. Only the sub prime loans went bad so far ($212 billion delinquent through May, AP), which are people with poor credit.

What will happen: Option ARMs, Interest-Only ARMs (Adjustable Rate Mortgages) will far exceed sub prime losses. Last year, over 12% (Business Week) of all loans were Option ARMs (these are not sub prime loans!) - much more than sub prime loans ( I think they are around 5% or so - not sure). Jim Cramer said on Mad Money after talking to execs that 7 million American homeowners will foreclose (http://www.youtube.com/watch?v=SWksEJQEYVU)

What are Option ARMs: In short, if you are supposed to pay $2500 - $3000 per month (7%) on your mortgage for a 30 year fixed loan - instead, you pay about $1500 (1% or 2% interest) and that extra $1000 - $1500 adds on to the balance of your loan each month. After a few years, the loan resets and you have a new payment more than double your original. These are worse than Interest-Only, which are bad too. And all are little or no money down.

Who has them: People with good credit who can't afford a normal loan. Like a 25-year old just getting the "American Dream." Up to 80% of all option ARM borrowers make only the minimum payment each month (Fitch Ratings).


Sources:
http://www.businessweek.com/magazine/content/06_37/b4000001.htm
http://news.yahoo.com/s/ap/20070811/ap_on_bi_ge/toxic_mortgages;_ylt=AmQpBPmCcyfR2DdL

PART II

End of easy credit: Banks borrow and swap money from each other, and national bank (Fed, European Central Bank, Japanese recently added $billions to the market to promote "liquidity"). They borrow at low rates (i.e. LIBOR - London Inter Bank Offer Rate or lower using swaps) so that you can be given a loan at a slightly higher rate for a home, school, or whatever. Well, people stopped paying back the loans, investors lost their money, and won't give anymore money for banks to borrow so that you can get a loan. U.S. mortgage investors are all over the world in Europe and a very large percentage in Asia - they were lured by high returns from higher interest rates on these loans (similar to Argentine financial crisis of 2001 where investors bought bad government bond debt with high interest rates and Europeans had no clue what they were buying, http://www.washingtonpost.com/ac2/wp-dyn/A15438-2003Aug2?language=printer). Fed recently put some money in the system - to continue business and the global market (Using "Federal Funds") by having banks borrow and swap federal funds. ...

Risk: Only the sub prime thing has hit. Option ARMs, Interest-Only, and regular ARMs have not hit yet.

• The Option-ARMs will not pay - I guarantee you, I've seen hundreds of those loans and spoken to 50-100 loan officers who sold them. It only takes 1 bad mortgage loan to ruin a portfolio of 10-20 good ones depending on home prices.
  
• Home values have gone way down - people cannot refinance out of these loans. I spoke to someone at Countrywide (20% of all mortgages in U.S. last year) yesterday who confirmed the inability of these people to refinance - appraisal values aren't there. Nobody wants to give a loan for something that is more than it is worth.

Financial Engineering:

• Global GDP (all goods and services for all countries) is between $60 billion and $65 trillion. (Economist, IMF, CIA Factbook). U.S. is about 10 to 12 trillion for GDP and U.S. mortgage industry accounted for $3 trillion in 2003.
  
• Outstanding global interest-rate derivatives and other derivatives are over $300 trillion - 5 times GDP (Economist). Basically, a bunch of international financial institutions and hedge funds wrote loans/paper/agreements worth much more (300 trillion) than actually exists (60 to 65 trillion) with leveraged money.
  
• One mistake hurts a lot more. These include Mortgage-Backed Securities. A small part of leveraged derivatives were sub prime loans and look what happened with a small part of leveraged money when people had to pay up. Int'l banks have more financial power than Federal central bank's whose primary goal is to limit inflation by changing the short term interest rate.
• Google "George Soros" and the Bank of England to understand this.

Who's to Blame (in order): In my opinion:

1. Hedge funds - bundled hundreds of similar mortgages together and sold them to investors. Convinced investors they were good buys and rapidly sold worse and worse loans.
   
2. Mortgage Executives - worked with hedge fund types to do more risky loans because investors kept on buying them. They knew these loans were trash. They made a lot of money.
   
3. Joe Homeowner or low mortgage salesperson - Some people just wanted to buy a house and sell it for a profit in 2 years. Other salespeople misdirected people who didn't know the loan would explode later. But, Joe Homeowner signed it. These low payments caused house values to increase over the past few years...cuz you were only paying half of what you should have been despite increasing interest rates. And the 20 year-old mortgage loan officer was making 20k+ a month.
   
4. Government Regulators - No regulation existed to combat these practices. But, then again, hedge funds are "private equity" firms and are not regulated by definition. Maybe, they didn't know. But, all mortgage lenders are licensed with the gov't.