Archive for December, 2008

Sub-Prime Primer (Part I)

The following is a surface-level explanation of  several key market and political forces that conspired to create the fertile soil into which the seeds of the sub-prime mortgage market and subsequent credit crisis were planted.   Several links to other articles/wikis are provided if you would like to learn more.


[Note: Wikipedia is provided as a reference source for three of the items below.  The content of Wikipedia is provided by various individuals that collaborate on a given entry.  The site attempts to limit inaccurate or politically-motivated entries but is not always successful at doing so.]


1) Going back to the early part of the 20th century banks were engaging in a practice known as “red-lining”, which was the practice of denying or increasing the cost of certain services including banking to certain geographic areas, often on the basis of the racial makeup of those areas.  This limited the capital flowing into these areas, often keeping them in a blighted situation.


2) In the late 1960’s, Fannie Mae and Freddie Mac were created by Congress to help provide liquidity for the mortgage market.  Prior to this time, banks primarily kept mortgages and other loan on their own books and they were limited by the amount of deposits available to lend.  As a result banks were often unable to fill all of the demand for credit in their markets, even for well qualified borrowers.  Fannie and Freddie provided liquidity to these banks by buying these mortgages, bundling them, and selling them.  These bundles of mortgages are known as Mortgage Backed Obligations (MBOs).  An MBO is one large security made up of thousands of mortgages that is typically purchased by an institutional buyer – for example, pension funds or mutual funds.  The buyer acquires the stream of cash flow generated by all of the monthly mortgage payments associated with the individual mortgages in a particular bundle.  With the new liquidity that was provided by Fannie and Freddie, banks could then continue to originate new loans.


3) In an effort to end redlining and provide certain geographic areas with better access to credit, the Community Reinvestment Act was passed by Congress and signed into law in 1977 by Jimmy Carter.  Six major legislative changes were enacted over the next three decades.  The original intent of the act was to prohibit lenders from denying loans to creditworthy borrowers just because they lived in a certain part of a city (the previously redlined areas).  The legislative changes that followed increasingly put pressure on lenders to proactively attempt to lend into these areas — literally to go into these markets and find the opportunities.  Banks that didn’t comply were hit with penalties including a prohibition against opening new branches until they were deemed to be in compliance.


4) In the late 1990’s the Clinton Administration, banks, mortgage companies, and stockholders were all pressuring Fannie Mae to “ease credit”, meaning to lower their lending standards – all for different reasons but all self-serving.  Very few were opposed to doing so, although there were some clear warning signs in the following article going back as far as 1999:


All of these factors and many more combined to create the fertile soil into which the seeds of the credit crisis were planted.  I will follow up in Part II to describe what came next in more detail but the following is a simplified version of how it started unraveling.


As Fannie and Freddie eased their credit standards slightly (at first) an entirely new group of individuals qualified for mortgages.  This increased the demand for housing, primarily at the lower end of the market which in turn drove prices higher.  With newly found equity, many owners of these houses, selling to newly-qualified mortgagees, took this increased equity and bought houses in the next price range higher.  This process continued right up the line and drove housing prices higher in every price range.


The result:  a historic level of new mortgage activity……..newly qualified mortgagees plus all of the new mortgages for upgraders.  Everyone was ecstatic and everyone was a big winner – new home buyers, mortgage companies, banks, stockholders, politicians, real estate attorneys, and every household that now had surprisingly high levels of equity.


The mortgage market (everyone involved in the process from origination to MBO packaging to selling in the secondary market) was addicted to this huge level of activity and did everything it could to keep the good times rolling.  At a certain point it became obvious that it couldn’t keep rolling forever, unless…………unless we lower the credit standards even more.  Who needs income verification?  For that matter who needs any documentation at all?  Home prices will always keep rising, right?  So what is the real risk?  This type of thinking attracted even more borrowers to the market and artificially kept the party going well past what should have been its rightful end.


So what did cause the party to come to an end???  Again, I’ll go into more detail in a later in Part II but the simplified version is that certain bundles of mortgages started showing very poor results.  This was a natural result of going out too far on the limb with increasingly unqualified borrowers – it is exhilarating to go farther and farther out until the limb finally breaks, which is exactly what happened in mid-2007.


Certain MBOs, even ones that were strongly rated by rating agencies began producing losses much higher than projected (i.e. far more individuals than expected stopped paying their mortgages) leading to huge losses for the institutional buyers who then called for a time-out and stopped their funding of the MBO market.


Continued in Part II………………..


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