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Tuesday, February 1, 2011

Understanding Securitization & Mortgages clearly

I was looking back at some of the previous postings and noticed that under the blogpost "Economics 101", when attempting to define what Securitization was, that I still left a confusing impression upon the reader.  So I reflected upon it and finally it dawned how to clearly explain what happened with the whole mortgage lending crisis for many years up until 2008 and compare it to the present in a way that is easy to understand.

Most people have the impression that banks lend mortgages. This is incorrect.  Banks are middlemen, helping to facilitate the lending process by bringing borrower and true borrowee together. A bank is a 'front'.  They 'lend' to others with the purpose of getting immediate reimbursement & fee from another entity after the $$ is lent out.

Start with a bank- ABC.   For many years prior to the 2008 crash, customers in need of a mortgage would go into ABC bank. For this example, a couple seek a $100k mortgage. It will be a 30yr mortgage and ultimately they will be paying $200k by the time the last payment is made. So they fill out necessarily paper work, proof of income, etc. and are approved.

Now in the past, ABC would then give the $100k to the couple, then package that mortgage with other recently handed out mortgages, and sell them to pools of investors at say $120k per mortgage. (This is what collateralized mortgage obligations {CMOs} are).

 The bank would make an instant profit and not be on the hook if the borrowers defaulted.  The investors would assume the risk but they'd be making the larger profit- the full $200k from the borrower. (This is the mortgage backed security {MBS})  The bank's responsibility to the investors as part of their fee, would be to screen out the borrowers properly to make sure they could re-pay and in addition collect the monthly mortgage payments in the investors' behalf.

Sometimes investors would package their investments and sell to other investors at a quick profit, who would turn and do the same, meaning many entities were now collecting payment on the mortgages but would be on the hook financially if the payments stopped.

But back then, banks like ABC didn't feel like doing due diligence. There was a big push from people like President Bush and Congressional Banking Chair Barney Frank- Mass (D), to allow anyone who wanted home ownership to be able to obtain it.   So it was more profitable to get as many mortgages done as possible by closing their eyes to warning signs, robo-signing documents, and then sell them off quickly to collect a 'fee' per mortgage while assuming no long term risk.  So banks approved just about anyone..  and Everyone was happy.

Then some of the people who shouldn't have gotten mortgages in the first place based on income and credit history started missing payments.. lots of payments. This was due mainly to adjustable rate mortgages (ARM) that may have started low (like say 2% interest) then after 24 months spiked to 6-8% and higher, raising the monthly mortgage to levels too high to pay.   And investors were losing lots of money.  And home prices began falling dramatically so that investors could not recoup their losses via foreclosure without having to take a steep loss.

Then Lehman Bros fell, and market tanked, and the US government stepped in. They bailed out Everyone, making sure the investors did not lose a penny, and that banks could continue giving out mortgages.  But now the investor pools had been burnt and in no mood to get burnt again.   Who was going to step in and fill the void??

Answer- Freddie/Fannie Mae.

Now, when a couple applies for and receives that $100k mortgage, the bank instantly takes it and 'sells' it to Freddie/Fannie Mae for a profit.  The bank still assumes no long term risk- they just continue acting as a middleman and collect the checks for Freddie/Fannie Mae.   The government forces the banks to do the due diligence they should have done prior to 2008, and ends up holding 100% risk.

They take the losses when people stop paying, sometimes intentionally because their home value is less than the totality of their mortgage, i.e. 'underwater'.  Freddie/Fannie Mae loses billions of dollars quarterly- intentionally- purposely.. because besides being a backdoor bailout for banks, it is the Only entity willing to assume the risk of mortgage in a deteriorating market. Without it, the entire housing industry Stops!

Very basic example:  April borrows $100 from John.   April agrees to repay John the total of $150 in two months.  John doesn't feel like waiting-- so he sells the debt obligation immediately to Tom for $110.  John has no risk if April never pays and made a $10 profit in minutes.  He is still responsible to collect the $150 directly from April but this $$ goes directly to Tom who will make a profit of $40 on the deal.

Now after awhile, Tom is getting burnt because John lent to many "Aprils" who had no ability to repay and didn't bother to double-check since John just wanted to increase his $10 fees.  So Tom drops out of the lending game and Gov. has to step in to fill the void, otherwise John will not lend to anyone and Gov. can't lend directly.

~  The finance sector intentionally and purposefully makes this complex- you are not meant to understand these tricks. And outside of this blog, "Ants & Grasshoppers", not many finance sites will take the time to explain it to everyday people.  I do hope this helped...

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