Author: Aldon Hynes
Last Friday, I wrote about understanding the global financial crisis. Now, a new bailout plan has been presented and we should look at the heart of the matter, the housing crisis. I would like to start off by going into a little more detail about how the mortgage market now works. As I noted in my previous article, I worked with software to analyze various forms of mortgage-backed securities for many years on Wall Street.
It used to be that when a young family wanted to buy a home, they would scrape together what they could, and then head down to the local savings bank and ask a man like George Bailey for a loan to help cover the cost of buying the house. People like Mr. Bailey would look at the young couple. He knew their parents. He knew the house they wanted to buy. He loved the town the house was in, and he knew that if he made a bad choice, it would hurt the town, it would hurt the young couple, and it would hurt him personally.
Okay, perhaps that is over idealizing the process a little bit. The important part was that the local bank would hold on to the mortgage and a default would hurt the bank and the person who issued the mortgage. These mortgages were short-term loans and the borrowers had to put up forty to fifty percent of the cost of the home.
During the Great Depression, many people were unemployed and unable to make their mortgage payments. There were many foreclosures and the housing market plummeted.
To address this, Congress passed the National Housing Act of 1934. This created the Federal Housing Administration (FHA). The FHA provided insurance on mortgages, that is, investors could receive insurance that timely payments would be made on the mortgages. With this insurance, banks could issue mortgages and sell the mortgages to other areas where there was more cash available.
In 1938, the Federal National Mortgage Association (FNMA), commonly referred to as Fannie Mae, was created to buy FHA insured mortgages, thereby creating a secondary market where these mortgages could be traded. In 1944, this authority expanded to include buying loans guaranteed by the Veterans Administration.
Then, in 1970, Mortgage Backed Securities were created. Instead of trading lots of different mortgages as whole loans, mortgages that were similar were bundled into pools of mortgages. They pools of mortgages could be traded more easily.
In 1983, Wall Street started cutting up the cashflows from these mortgage pools into different tranches. An investor could but the first cashflows of a set of mortgage pools as a short term investment or the last cashflows of a set of mortgage pools as a long term investment. Additional innovations included the ability to buy just the interest payments or just the principal payments of various cashflows, the ability to buy only as much of the interest as was tied to a floating short term interest rate, or the cashflows that had the least amount of prepayment of the principal.
Of course, with this, other types of cashflows were left over, the most risky cashflows. Suffice it to say that the innovations did not stop there and even more complicated financial instruments ensued.
So, how large is this mortgage market? According to the Federal Reserve Board, in the second quarter of last year, there was $13.98 trillion in total mortgages outstanding in the United States. According to the Board of Governors of the Federal Reserve System, there was an additional $1.02 trillion in home equity loans outstanding in 2006. Also of note, according to the Mortgage Bankers Association, in the second quarter of 2007, 5.12% of mortgages were delinquent in the United States.
That works out to be about $768 billion in delinquencies based on numbers from 2006 and 2007. This number may be much higher by now. However, it is worth noting that when a homeowner loses a house in foreclosure, the bank does not lose all the value of the mortgage. They sell the property, typically at a lose, and recover at least percentage of the value of the loan.
In addition, various analysts believe that housing prices may still be 10% to 20% above historic norms, so an additional $1.5 trillion to $3.0 trillion may get eaten up as housing prices decline.
This raises serious questions about whether or not the proposed bailout will be large enough to stabilize the markets.
Who’s Getting Bailed Out
Remember all those weird mortgage securities we were talking about? So far, the discussions seem to be about buying those securities whose values have declined most in value, the leftovers, or what people on Wall Street sometimes referred to as toxic waste.
In doing so, this ends up having little to no effect on the pools of mortgages themselves, and even less on the actual mortgages or the mortgage holders. No, this bails out the investors.
However, I don’t want to paint this as a Wall Street versus Main Street dichotomy. Many of the investors are large financial institutions. They are the mutual funds and the retirement accounts for many people on Main Street. So, for those who have retirement accounts, either stuck away in an IRA or 401(k), or through some company or government retirement account, this bail out could be helping you.
Yet it does nothing for the homeowners struggling to get by.
What about the underlying issues?
Besides being concerned about whether or not the bail out is large enough, and whether or not it is helping the right people in the right way, there is a larger question. How do we make sure we do not end up here again?
In the 1980s we had a Savings and Loan crisis and the Government stepped in to bail out failing institutions. Now, we have a housing crisis and the Government is again stepping in. There are important parallels and there are important differences, and I won’t go into them right now.
However, a few key things need to be addressed. Are we learning from past mistakes and is there sufficient accountability to prevent such mistakes from happening again.
It will be interesting to see what types of oversight, accountability and checks and balances are incorporated into the proposed bailout that will be argued in congress this week.