Hello, my name is Jason Dragon. You may be a long time reader of my blog, or like many people you may have found this simply by doing a search, if that is the case then welcome. I plan for this blog entry to be one of the largest in scope of any entry that I have every done. We are going to talk about the current Mortgage Crisis. I will talk about it in 4 areas.
- The Boom
- The Bust
- The Current Situation
- The Way Forward
If you are wondering, I do have a degree in Business and I spent a lot of time studying economics. For a short time I even sold mortgages. I will try to keep the text as simple as I can, I want you to not get bored and to read the entire things. Some of this will be my educated opinion, but most is simply fact.
At the start of 2000 there was a bust in the stock market, millions of people pulled out a total of billions of dollars. When 9/11 came they did so even more. All of these people needed a place to put the money and the new trend was to put it into Real Estate, housing prices started to rise. By 2003 and 2004 many real estate gurus arrived on the scene, showing common people how to make money in real estate. It was a great time. Prices were going up each month.
To add to this information, for the first time, was easy to get and compile. It was easy to find a good deal on a house online, you could even find out the estimated value of your house or any other by going to sites like Zillow. It was also easy to get a loan. Because home values were expected to keep going up you could get a house for $150,000 and get 100% funding because by the time you get close to closing it was already worth $175,000.
The housing market was a great investment, it is one of the only investments that you can get almost total leverage in. Figure this, you buy a house for $150,000. You only put $10,000 as your down payment, you get a tenant in the house and they pay for all the expenses giving you a zero cash flow but no expenses. Now you sit, wait a year in this market and the price of the house goes up by 10%, BUT your return was not 10%, because the price goes up on the whole value of the home, not just your down payment. You now have $25,000 equity in the house, a return of 150%. This is the reason that investors flocked to houses, huge returns.
For many people, the more passive kind who usually invest in bonds and such this was way too risky for them, so they decided they would simply buy mortgage backed securities. 100’s of billions of dollars flew into these. What these were was baskets of mortgages, and you could buy shares in this basket just like a stock, they had sold and predictable returns. If you were used to getting 2% on your money in a CD or government bond, now you could get 5% on your money by buying one of these. It was great for pension funds and foreign banks to sock away money because it had a higher yield and was still considered very safe.
The reason it was considered so safe was because of the very low default rate in mortgages caused by a booming housing market. Most people would simply sell their house for a nice profit before they went into foreclosure. The investment banks reduced the risk even more by bunching 1000’s of mortgages together. They would then break them up into different levels. If there were any defaults the investors at the lowest level would be wiped out first, and the investors at the highest levels would still receive their full returns even if 20% of the mortgages defaulted. It was a great system. The investment banks bought up over a 100’s of billions of dollars worth of mortgages using this process, and they charges a hefty fee for all of it, making them some of the most profitable companies in the world.
For almost 70 years there was been a set of two companies, founded by the US government to facilitate the flow and resell of mortgages, these are Freddie Mac and Fanny Mae. Basically these were huge companies that would buy mortgages from banks. If a bank could not resell the mortgages they would need to get deposits to cover all the mortgages that they wrote and that would be nearly imposable. About 92% of all mortgages are resold. Freddie and Fanny purchased over half of them. They would buy them from the bank, the price was set by the value of the house, Credit of the home owner, zip code of the house and a few other factors.
This created a great system for the banks. They would sit there and advertise that they can get you a great deal on a mortgage, they would help you with all the paperwork, they would send your information to underwriting, where they would basically see what was needed to make your loan sell for the highest price to Freddie/Fanny. They had some rules such as the first mortgage could only be 80% of the value of the house, or else the homeowner would need to buy PMI (Private Mortgage Insurance). The bank would then take your entire mortgage packet and find out how much they could get. On a $200,000 loan at 6% there is someone making $12,000 in interest every year. The buyer of the mortgage would pay a premium for the loan, but they wanted to make sure they would get their money back. So what the banks did was to get the home owner to sign a pre-payment penalty clause. Basically this was a clause saying that the bank would get 2 years worth of interest from the customer, that the customer would still have to pay 2 years of interest even if they sold or refinance the house before 2 years was up. So on that $200,000 mortgage at 6% interest the holder of the mortgage was guaranteed $24,000 in interest payments. Because this $200,000 mortgage was really worth $224,000 for the first 2 years they would offer to buy it for $215,000 from the bank. The bank where you got your mortgage made $15,000, paying some of that out as a commission to your mortgage broker. They also usually would agree to service the loan, meaning they would send out statements and collect the money on behalf of those who owned the mortgage. If a loan had a longer pre-payment penalty the bank would get more money, if they sold it for a higher interest rate they would also get more money. The more income they could show for the client the more they would sell the loan for. The interest of the bank and mortgage broker was to get as much from the client as they could so that the resell value would be as high as possible. A few banks even started to lie about some of the details to drive up the price.
Mortgages were sold almost instantly. This allowed banks to generate mortgages as fast as they could. It was a great deal, get someone to come in and fill out some paperwork, show that paperwork to the mortgage buyer, get the buyer to agree to fund the deal and then you close on the whole deal and walk away with huge profits. Do this a few times a day and a little office with a handful of people can make millions per year. And that is exactly what happened. The banks had every incentive to get you into a mortgage, and they would do whatever was needed to do so. It was easy to get a loan, even if you had no money to put into the deal, they simply would do a 20% second mortgages, or even if you really had no income, you could just do a stated income loan. People were buying houses who could not pay for them. Their main plan to pay as little as they could each month, and refinance when that 2 years was up and they would have a ton of money due to the value of the house going up. It was a great system that worked for millions of people.
All of this easy money was causing housing prices to sky rocket. I live in Phoenix Arizona and between 2003 and 2006 prices for most of the city doubled, people were bidding against each other in attempts to get houses, simply because the house was a good investment.
Where was this money coming from? Well as I said much of it came from people who got out of the stock market, and needed a new place to keep their money, a large chunk came from foreign companies. Remember we are buying at least 700 billion dollars more of stuff each year than we export. So many nations, China, India, Saudi Arabia have billions of dollars that they need to invest somewhere. They want us to keep buying to they make it easy for Americans to buy things on credit, then we buy more and they sell more. It is a great spiral that put America in huge debt while at the same time sending millions of jobs all over the world. The is the greatest transfer of wealth in the history of the world, but more on this in another blog.
In mid to late 2006 the prices started to get very high, and there were signs of problems. Some of these no money down investors who bought on stated income loans started to not pay their mortgages and the prices were not going up fast enough to still leave the buyer of the loan with a profit. The buyers of these loans started to change their guidelines on who they would give money to, they started to make it harder. This was a sign to many investors to start to sell, and the number of houses for sale started to go up.
Some of the hottest housing markets were Southern Ca, Phoenix Az, Vegas Nv , Atlanta Ga, and Miami, Fl. These markets saw some of the largest gains, they were all nice warm places to live and people have been moving here for decades. But they also had something else in common, they were all major places where Illegal immigrants would flock. In late 2006 and early 2007 there was a huge national debate about Illegal Immigration, and many of those here illegally owned houses but decided to simply leave, they dumped their houses, many others just borrowed as much as they could and walked away. And the prices in these markets started to fall.
Once prices started to fall it changed all the numbers for the banks and the buyers of the mortgages. If you get that same loan for $200,000 the buyers have more risk now, they don’t have a security of the house itself because the value will likely be less than $200,000 if the customer defaults. So they said that they would only take the best and most qualified borrowers. No more stated income loans, no more loans to people with sub-prime credit. Suddenly most Americans could not qualify to buy a house. All of these people were pushed out of the market, demand for houses plummeted, and when demand goes down price is soon to follow.
To make matters worse some of the Sub-Prime loans started to default. Many were from investors who were upside down on the loan, they borrowed in a corporate name so there was no ill effects to them to simply walk away and give the house to the bank. So thousands of them did just that, it was smart for them to do so. The people who used the system the most were mostly the smartest and best at it, and when things started to go down they were the first to get out.
Most of these banks only put a 1-3% budget in for losses and some are getting much higher losses than that. These foreclosed houses had to be sold so the banks simply dumped them on the market. But banks are not in the business of selling houses, and they do a very poor job of selling houses. They are risk adverse so they only want buyers who they feel will actually close the deal. For the most part they sell the house as-is. They do nothing to make the house look good and nothing to try to sell it. For most buyers, buying a REO (Real Estate Owned)(Bank Owned) house is not appealing. People with good credit who can buy a nice house want that house to be ready, and come with a warranty. So these houses sat on the market for a while and the only choice for the banks was to keep slashing prices. This was the main cause for housing prices to plummet. This caused even more people to realize that they are upside down on their house and more of them simply walked away. From the middle of 2007 until now this process has been happening, and it keeps getting worse.
These banks then saw their stock start to melt down. Imagine a company that has 250 billion in mortgages but they owe 200 billion in debt on those mortgages, lets call them Mega Bank. It was great for them in the boom time, they borrow money at 3% and loan it out at 7%, making 4% on 200 billion dollars, or 8 billion per year. They had every inventive to do this as much as they could. This company would have a value of 50 billion dollars or so in book value, the stock market almost always prices your stock well above book value so the Market Cap (The total value of all stock of the company) may be 100 billion or so. With earnings of 10 billion or so it would be at a Price to Earnings ratio of 10, something that wall street loves to buy. This company would be a star. Now what happens if there is a ton of risk in the mortgages that the company owns, the company figures out that 5% of their loans are defaulting, but for one loan that is a total loss it wipes out the profits from 10 other loans. So their accountants do figure out on average how much are all of the loans that they company owns worth. If that number is lower than what they currently value the loans at they restate the value of these loans and do a write down of these impaired assets. If you have 250 billion of loans on the books your accountants may feel that they are only worth 200 billion. 50 billions dollars, on paper, just disappeared. Some companies bought insurance for such a thing to happen, the largest company that sold such insurance was AIG, they have as much as 300 billion dollars of insurance losses out there that may be paid. So if you are Mega Bank the value of your company just went down by 50 billion dollars, but in reality all the rest of your assets you owe so your stock crashes, your market cap is no longer 100 billion but maybe more like 10 billion, or even 1 billion. Investors on the stock market don’t know what to do, all they know is that they can’t value your stock.
The Current Situation
At the start of 2008 there were 5 major investment banks in the US, and three banks acting as mortgage clearing houses. These were the banks that were selling mortgages to investors. The investment banks took most of their profits by keeping some of the most high risk and high profit mortgages for themselves. 4 of the 5 investment banks saw huge losses, and all three mortgage clearing houses saw major losses. 1 of them went out of business, Indy Mac, they simply took so many losses that they could not pay depositors any longer. Freddie Mac and Fanny Mae lost almost all of their stock value and had to be propped up by the government to stay alive.
Of the 5 investment banks Bear Sterns was the first to fall, they went from a 100 billion dollar company one week to being bought out by JP Morgan Chase for only 1.1billion the next. The next to fall was Lehman Brothers. They lost billions in sub-prime mortgages. Their book value was negative. They has a lot of really good assets though and tried to sell to a bank in Korea, but it did not work and in September of 2008 their stock went almost to zero. They declared bankruptcy On Sept 13th, and are being sold in pieces to different companies, stock holders will probably get nothing. On the same day the third Investment, Merrill Lynch was purchased by Bank of America for $50 billion. Bank of America stock fell 15% that day because investors thought that they had over paid. That only left two Investment banks, Goldman Sachs and Morgan Stanley. On September 22nd 2008 these two bank, under new government requirements converted to traditional banks.
None of this was helped by the hedge funds, these are basically large pools of money that often bet that something will fail. These hedge funds helped drive the price down of many of the companies I wrote about today. But many hedge funds also lost money on the mess.
The government has decided that for the most part they are going to bail out many of these companies, they are also considering a new govenment agency that will, for a short while, buy up this bad debt for pennies of the dollar, allowing the banks to write off these losses and move on.
During this whole time it has gotten harder and harder to get a loan, basically unless you put 30% down, have perfect credit and tons of income you are not getting a loan. The government put in a program to help some home buyers which helped out a bit.
Even with all of this going on our economy is still fairly sound. Employment levels have only gone down a bit, and many other parts of our economy are still stable.
The Way Forward
I have always been a free market guy, I think that the system works best when there is freedom to be successful and freedom to fail. The government is really taking the failure and greed of these companies and helping them out. They are doing this to save the normal people and the economy as a whole and to fix our broken mortgage system. The government, and our President have seen how large this problem is and that they only way to fix it is a huge government bail out, and I AGREE with them. The bail out will put stability into the system, it will prop up all the banks, and it will resolve the credit crisis allowing money to start flowing again. They are looking at up to 1.5 TRILLION dollars in loans, and buy outs.
I think that we need to do this, if we don’t our economy is sunk, but this is NOT a progam that I think will cost the taxpayer any money, in fact I think it will make our government the highest profits that we have ever made. Think of it this way, they are not just giving money away, they are going to be buying mortgages at the low of the market, the current talk is to buy them for 50-60 cents on the dollar. If they do that they will set a low in the market, these mortgages are still backed by the actual real estate and the economy will turn around. So one of three things will happen to each of these mortgages. They will either get forclosed on and the government will sell off the house, most houses are still valued at over 60% of the value of the mortgage so they will still make a bit of money. Option two is that later on they may sell back the mortgage for a profit, maybe 70-80 cents on the dollar. The last thing that will happen to some of these loans is that the home owner may sell or refinance the house, and the government will get 100% of the value of the house, basically doubling their money. I think that if the government does this that they will make at least a 20% profit on the money. They are talking about buying 700 billion in mortgages, making them about $150 billion.
For AIG they are giving them a 2 year loan for $75 billion. In the termns of the loan the government gets a 11.25% return each year AND they get stock options where they can buy 80% of the company at a very low price. The company was worth over $200 billion last year. If it goes back up to even 100 billion the government will make almost 80 billion from their stock options, and still make about $17 billion from the interest on the loan. This bail out could make the government almost 100 billion dollars. The owners of AIG see how much they will loose if the Government loans them the money so they are still looking for other lenders to help them out.
Almost everything that they are doing is set up in such a way, this whole bail out system as a whole, will probably cost out government nothing and make us at least half a TRILLION dollars in the next 2-3 years. This could wipe out our deficit and radically change our government balance sheet. It is not enought to totally wipe out our deficit but it will reduce it a lot. If the economy really picks up so will taxes and the government has a good chance of being in the positive. Of course this positive change will not happen until 2009 and if a democrat wins as president will probably say that it was them that made this change and that they are the reason that the government is suddenly so profitable, but we know the truth.
On a side note the President does very little to effect the economy. Most of what is done is done by congress or the treasury department. Also anything that the president does do takes 2-3 years before it really goes into effect. Such as the losses in 2000 were not caused by Bush, he just took office. All I know is that I would never vote for someone who thinks that raising taxes in a time like this is a good idea.
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