Sunday, September 28, 2008

The Mortgage Crisis: Beginning Of The End And A Look At The Beginning

Looks Like We Are Rounding Third

True to the form in the world of politics (waiting until the final hour), it appears that a consensus between the Democrats and Republicans has been reached, and that a bailout bill in some form has been agreed upon. This will hopefully be the first step in getting the footing back under the banks and will loosen the credit flow that the economy so desperately needs.

As I said about a week and a half ago, hopefully this means that happy days will be here again soon. Problems still very much exist, but this is the critical first step. News of the final details should be out tonight or tomorrow, and we will get an early idea of the reception from the action in the stock markets both overseas and here in the U.S.

How Have I Looked At The Mortgage Crisis?

During this time, I have taken a humorous look at the crisis (Friday, September 19, 2008
The Mortgage Crisis: A Serious Story Viewed In A Very Funny Way), a look at when the seeds of the problem were sown and the fact that it is very much a bi-partisan creation (Saturday, September 27, 2008 A Video On How And When The Mortgage Crisis Really Got Started), but not at the basics of the problem. Now that we are at the point of an initial solution, this is a simple explanation of different mortgage loans and how they work into the process. This article appeared in New York Newsday today:

One of the centerpieces of the prolonged housing slump and the nation's financial crisis is the proliferation and later the implosion of the market for mortgage-backed securities. As the housing market continued booming, investment banks and other institutions began loading up on the securities, reaching full bloom by 2005. But when the housing bubble began to deflate, it created a solvency crisis for those institutions heavily weighted with the securities, leaving them stuck with an investment instrument worth much less - or worth nothing at all - than its face value. A look at what mortgage-backed securities are and how they tanked:

1. A homebuyer takes out a loan. Mortgages are based on different categories of risk:

Prime: For borrowers with stronger financial records; carry lower interest rates. (Prime loans made up 24 percent of mortgage-backed securities in 2005, during their peak.)

Alt-A: Also known as a stated-income or no-doc mortgage, for borrowers with good credit but limited income or ways to document their income through pay stubs and tax returns. (Alt-A loans made up 28 percent.)

Subprime: For borrowers with weak credit histories; carry higher interest rates. (Subprime loans made up 29 percent.)

2. The lender often sells off the loan to either:

The government-sponsored entities of Fannie Mae and Freddie Mac, which pool a group of loans together and turn it into a mortgage-backed security that is then sold to private investment firms on Wall Street or Directly to investment firms, which turn loans into mortgage-backed securities. When a homeowner makes a mortgage payment, it flows through as interest to the holders of the security.

3. Pieces of those securities are sometimes then repackaged into a new type of security, a collateralized debt obligation. This security is sliced into different classes of risk and yield, and sold in pieces to investors. Institutional investors include pension funds, mutual funds and hedge funds. The process allows risky subprime debt to be sold as part of supposedly safer, investment-grade assets:The senior, investment-grade class with the highest credit rating - as high as AAA - is considered the safest but yields a lower interest rate. These investors get paid first.Below that are junior, riskier classes, with a higher rate of return. This group gets the next claim on payments.The lowest, or equity group, carries the highest risk, with below-investment grade credit ratings. They get the highest yield but suffer the first losses.

4. During the housing boom, investors in all the classes made money. And because of the strong housing market, homeowners who defaulted could refinance or sell the property to clear the mortgage, so it didn't cause a serious problem.

5. But when home prices began falling and homebuyers ended up owing more on the mortgage than the home was worth, it became much more difficult to refinance or sell the property. More homebuyers defaulted. The value of the securities plummeted and institutions holding the riskiest pieces of the CDOs were wiped out. The markets for the securities froze because there were essentially no buyers.

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