We have all heard about the mortgage meltdown, but what caused it ? It has become enough of a hot button issue that many politicians are talking about a bail out. The culprit, as usual, is greed and players on every level are responsible. The answer, and it may be painful, is to let market forces work through the problem, keep government out of the equation, and educate consumers that too much of a good thing is, in fact, too much.
The mortgage industry has many faces and players. We see it mostly on the consumer level. We go to our bank or mortgage broker, provide copious amounts of information, pay for an appraisal and other miscellaneous items, close, and start making payments. What is behind the mortgage process will astound you. Most have heard off the Secondary Mortgage Markets. They have funny names like Fannie Mae, Freddie Mac, and Ginny Mae. These entities are conduits for lenders to sell that loan you just obtained. This is a good thing. You benefited by securing a lower interest rate and a wider variety of loan choices. The banks win as they can immediately sell the loan for a modest profit, and recycle the money again and again. The secondary markets win because they have amassed a portfolio of high quality (based on their own guidelines) secured loans which create numerous sources of income for them. They in turn pool all these loans into huge bundles (pools), create mortgage backed securities (investment vehicles), which are then sold to investors (insurance companies, banks, foreign governments, etc). The end purchasers treat these securities as pure investments, like stocks and bonds, which yield above average income with little risk and no need to be involved in asset management. It is not FNMA, FHLMC, or GNMA that is in trouble or have caused the current problems with the mortgage industry. It is the non-conforming segment of the secondary market that has collapsed. A non-conforming loan is, at the minimum, one that exceeds FNMA/FHLMC/GNMA loan amount limits, has higher credit risk exposure, or is not fully documented. Why would anyone want to buy non-conforming loans as an investment ? With higher risk comes higher yield (ie. profit). The recent collapse, still unfolding, was beset by "perfect storm" type circumstances.
The residential real estate market in the 90's through '05 was unusually strong. Almost every market enjoyed historically high levels of appreciation, the economy was strong, interest rates were at 20 year low levels, demand for housing was up, and Investors/Wall Street smelled money. The big money would come from sub-prime loans. The conventional wisdom (?) was that the increased yield (higher interest rates, more fees) from the higher risk borrowers would be mitigated by the value of the real estate securing the loan. Suddenly anyone with a pulse could get loans to buy a house. The norm was 100% financing, no mortgage insurance, decent initial interest rates (compared to the 80's), and typically adjustable rate products. Investors created Hedge Funds (non-regulated conduits ) making large pools of money available for these loans. It was so robust that many big investment bankers on Wall Street were leveraging these funds to raise additional money to lend. In theory everything was OK. The problem with leverage is that the smallest ripple can bring everything down. Market interest rates started to rise (Fed policy), appreciation rates leveled off, and many borrowers could no longer make payments on their adjustable rate mortgages once the teaser rate period expired. Investors discovered that, once foreclosed, the collateral was insufficient to cover outstanding loan balances. The hedge funds were using income from the original loans to cover payments on their new fund offerings. When that income stream was stressed, they were unable to satisfy their investors, which meant investors were no longer buying into these hedge funds. With no new money, they couldn't fund new loans, and everything collapsed. They stand to lose badly and rightfully so.
These non-conforming hedge funds are so large that their failure will be felt throughout all financial markets. Is Wall Street responsible for the position they are in? Absolutely. However, there is plenty of blame to go around. Government policy is culpable as they forced Banks (via Community Reinvestment Act Legislation) to make money available to high risk borrowers within their service areas. Sub-prime loans enabled banks to satisfy their CRA requirements and fueled the growth. Sub-prime loans enabled Realtors to sell more houses as loans were now available to borrowers who were previously ineligible. Mortgage brokers loved sub-prime loans as they generated, on average, 2-3 times more income per loan versus a conventional loan product.
While it is easy to blame Wall Street, we are all somewhat responsible. Buyers wanted more house than they could afford, and we enabled them. Realtors promoted 100% loans without explaining the down side of selling in the short term. Lenders subordinated traditional credit underwriting standards and made lousy loans available to the most credit unworthy. Appraisers were induced to certify high property values even when unsupported. Wall Street funded the madness. It is scary to think our government may use tax payer money to save consumers from poor personal decisions or Wall Street from risky business practices. Those in foreclosure are not there because they were unaware of the pitfalls of the loan they secured. Wall Street played fast and loose with unregulated hedge funds in order to realize ungodly profits. Let the chips fall where they may. Taxpayers SHOULD NOT, in my humble opinion, bail out any of the participants.... Whew, I feel better.