I’m mad at President Bush. It isn’t the first time. But never before have I actually agreed with the guy and
been mad at him.
I think this time he’s telling the truth. So why am I mad? Because he didn’t explain to all of us exactly what’s going on in our economy.
I’ve spent the last week answering people’s questions, listening to all the talking media heads, reading and cobbling together any piece of information I can decipher to help me understand. And I think I get it. So I’m going to try to explain.
Once upon a time, not so long ago, we Americans went a little house crazy. Nothing terribly unique there. After all, home ownership is the American Dream. At the same time, in an effort to stimulate the economy, the Federal Reserve kept interest rates low. While this did not directly impact rates on home loans, it did mean the banks were making less money elsewhere. So, they did what any business does when its profit margin is slim (see WalMart
); they concentrated on volume.
Meanwhile, many of the restrictions on lending; either to each other or us were eased. So, the banks were able to offer us more exotic types of loans: loans with no money down, interest only loans, stated income loans, 80-10-10 loans which didn’t require mortgage insurance, and adjustable rate mortgages (ARM). And in many cases, mortgage insurance was no longer required for borrowers with little equity in a property; making the purchase even more affordable.
We liked houses. With low interest rates, and no longer having to scrimp and save for a down payment. Many of us who didn’t think we could afford a house suddenly discovered we could. So we went shopping.
When mortgage brokers and loan officers pre-qualified us, we were likely given two choices. We could select a 30-year-fixed mortgage or an Adjustable Rate Mortgage (ARM) at an interest rate significantly lower than that of the fixed. This ARM was often fixed for a period of time at one interest rate for two, three, five, seven or even ten years. At the end of that time, it would reset to a much higher rate. So while one product was incredibly safe, the other was more affordable.
Many of us opted for the more affordable loan. The thinking was we could always refinance when the note came due. From a historical perspective, this made sense; in the previous 30 years, the average rate of home appreciation in the Twin Cities was six percent. It wasn’t speculative or reckless to predict our homes would be worth more. We’d likely be earning more at our jobs and we’d have no problem refinancing.
Meanwhile, a handful of people were speculating in a booming real estate market. While most of us just wanted a place to live, and perhaps a small investment property, others saw an opportunity to make quick money. On occasion, unethical loan officers helped unqualified people get financing, with the borrowers hoping to hold the property for a short period of time, then sell it for a profit. Others were even less scrupulous. They actually arranged to buy a property at one price, inflate the loan amount to a number astronomically higher, then pocket the difference at closing.
Most, in fact, almost all of us, made every one of our house payments. We paid every one of our bills on time.
The Banks and the Investors
To stay in business, the banks needed to make their profits through volume. But the question is, how can they give all these loans if they have a finite amount of money on hand?
Easy. They packaged your home loan with a bunch of their other loans, put them in a basket, and sold it to an investor. While the original bank continued to monitor and accept your payments for a servicing fee, they passed along the balance of the principle and interest (profit) to the investors.
I know, the investor sounds like some rich guy in a mansion somewhere; taking your money and getting wealthier by the day. But that’s not the right perception.
Most of these baskets of loans were bought by the Government Sponsored Entities (GSEs) Fannie Mae
and Freddie Mac
. When they paid the bank, it had money to turn around and make more loans. Now, Fannie and Freddie don’t have unlimited amounts of money either. So how did they keep afloat?
They sold them. See, often, these loans were purchased as an investment by people with 401ks, pensions and stock portfolios. Some were even bought up by foreign governments, including those of Japan and China. For the average American, however, more often investment bankers (places like Lehman Brothers
and Goldman Sachs
) purchased these mortgage-backed securities for their clients money and invested it. While there was a variety of types of mortgages and levels of risk in each basket, they were backed by the value of the properties each loan was attached to. There was a concrete asset (property) that could be sold in the event of default.
The Change In Lending Standards
Last summer, the folks at Fannie and Freddie became concerned about trends they were starting to see in the mortgage market. While most people were (and are) paying their mortgage on time, the default rate was rising, and foreclosures becoming more common. This alarmed both the GSEs and the investors who ultimately held the loan. So in an effort to stop this, the GSEs told the banks they would no longer buy mortgages unless the borrowers were more qualified, thereby presenting a lower risk.
As a result, last August the no money down programs disappeared, as did stated income loans. The banks suddenly wanted borrowers to have higher credit scores. Fewer people were qualified to purchase homes, which slowed sales. And then the foreclosures started to appear on the market.
Time to Refinance
It was at about this time that many of the adjustable rate mortgages so many qualified people used to purchase their homes in the early to mid 2000s were due to reset. Having made every payment on time, and having a good credit score, this neighbor of yours, or mine, made the reasonable assumption they would have no problem refinancing.
They discovered that yes, they were in fact qualified. But their house wasn’t. Those foreclosures on the market were selling at a discounted price. When the appraiser gathered comps (comparable properties that had sold) to establish a value of the property being refinanced, those foreclosures lowered the value– leaving many responsible, qualified people owing more on their home than it was worth.
Some people, who had fixed rate first mortgages had adjustable rates on their second mortgage. Oh, and so you know? A home equity line is considered a second mortgage in the banking industry. So when that loan reset, and homeowners wanted to refinance into a single fixed rate loan they could not. Again, the home was worth less than they owed.
So why not ride it out? Because that attractive introductory interest rate from three or five years ago was about to reset. When it did, many house payments rose as much as eight or ten percent. Eight percent on a $200,000 loan is $16,000 a year; or, an additional $1333 a month. Not many of us could handle that kind of change in our budgets.
Homeowners were left with three choices: find the money, negotiate a short sale with the bank, or face foreclosure.
What About the Banks?
Ever since the Enron debacle, government asset reporting requires a bank to reflect the actual value of an asset on its balance sheets. If a home they made a loan on was initially worth $200,000, they reported that figure. However, the real estate market changed. Now that asset may only be worth $180,000. The bank is required to put that on the books. This is called mark to market accounting.
Banks know their investors will notice the assets protecting their money are not sufficient to cover their investment. So, in an effort to assuage those fears, the bank needs funds to add to the balance sheet to make things even. So the bank keeps extra money on hand to secure the investment, the $20,000 difference. This is money they can no longer lend.
The people who hold the mortgage-backed securities aren’t blind. They knew that while most of the mortgages in their basket were being paid promptly, the default rate was rising. Their investment was losing money. They didn’t want to buy any more baskets of loans that contained even the slightest chance of additional losses.
Between the two events, the banks now have significantly less money on hand to lend for home loans, car loans, and as short term business loans. Sometimes, store owners get a small loan from the bank with which to use additional inventory to sell during the upcoming season. Sometimes, small business owners won’t be paid on a contract job until it is completed. So they go to the bank for a short term loan with which to make payroll in the interim. If businesses can no longer borrow the money with which to grow, or make their payroll, unemployment will spike. And more of us will be unable to pay our bills.
Enter the Feds
Chairman Ben Bernanke and Treasury
Secretary Henry Paulson recognized the tightening of the money flow. And since Bernake is a well-known scholar of the Great Depression, the alarms he saw in the economy disturbed him greatly. So the two men went to the president with their concerns.
President Bush, Bernanke and Paulson went public with their concerns, offering to Congress a draft of a bill they thought would help increase the flow of money.
None of us is thrilled about adding a $700 billion expenditure to the federal government’s annual budget.
But here’s how it would be put to use.
The $700 billion would be disbursed in stages, with $250 billion made available immediately for the Treasury’s use. This money would be used to buy up some of those baskets of loans from investors and the banks. What then?
Remember the Housing Bill from July? The one with the $7500 first time home buyer tax credit? Well, there was more to that bill than that. There was also an allocation of $300 billion to be used to help struggling homeowners negotiate settlements and refinance their loans through FHA. The hope was investors and banks would be happy to take these off their books, and yet, that demand hasn’t materialized.
The thinking behind the $700 billion was to flat out buy those baskets of loans at a significant discount; good and bad, delinquent and on time. Once the government owned the mortgages, the feds would make every effort to renegotiate the terms of these loans and, when possible, place borrowers in fixed rate FHA loans. The thinking was, if even half of the delinquent notes could be salvaged, the government would make a profit and help keep more Americans in their homes. In the instances when a settlement wasn’t possible, the government could choose to sell the property as a foreclosure; either now or years from now when the market has improved.
The Other Stuff In The Bill
We’ve heard of the other provisions in the bill: restrictions on golden parachutes, an oversight board for this process, and creating the ability of the US Treasury to create an insurance program, requiring risk-based premiums from the banking and investment industry in order to guarantee companies’ troubled assets.
Of course, the new Senate version of the bill now has all sorts of unrelated provisions, placed there in an effort to get the house to come around.
And If We Don’t?
If there isn’t some sort of government intervention in the market, the ripples will be felt globally.
Sure, those with good credit and a lot of equity will be and are still able to get loans. However, the person who wants to buy your house might not be able to; meaning fewer buyers in an already troubled real estate market.
Companies will not be able to get the loans they need to bridge gaps in payroll expenses, or to grow and expand their businesses. And when this happens, people get laid off.
If fewer Americans are earning a paycheck, they are no longer able to purchase goods and services. This, in turn, might effect your business, or that of the vendor your company depends on to be able to keep you employed.
Whether you’re for this bill or against, something needs to be done. Contact your Representative in the House
and encourage him or her to work toward a solution.