The following is my personal opinion and not a solicitation. Written as a concerned U.S. citizen and not a representative of any company or organization. I have put this together to help people understand what I believe is the root cause of the mortgage melt down and subsequent Wall Street crash. It is critical to understand this because the core problem is continuing and will prolong the bottom. And the current bailout plan does not take these factors into account and sets us up for another wave that could send us over the edge.Â I have first hand real life experience working with families to solve this problem and have read & researched everything I can get my hands on. The problem is found on the front lines. While there are many who could take blame, I want to outline the process and describe everyone’s roll in the process. My belief is that it is the non-traditional mortgages that are at the core of the problem. Read along & see if you agree.
First layer of blame goes to the consumer. There are two areas here. First is lack of financial education to understand how mortgages work in the first place. People hold fast to interest rate & payment being the only consideration when choosing a mortgage. This belief has cost many of them dearly. This is a majority of the population. Just ask anyone how his or her mortgage works or even what his or her note rate is, or how note rate compares to APR. A smaller subgroup of this are those who overextended themselves & bought too much home. These are the people who the media & the experts like to blame. Later I will give detail & examples of what mortgages these people accepted.
Next are the mortgage brokers. This group of mostly unregulated individuals often has just as little understand of the mortgages as their customers. And they were driven by greed. They could make 2 – 3x the commission for selling a non-traditional mortgage to any client. And because of competition they had to offer the product with the lowest initial interest rate. Which excluded a 15 or 30-year traditional fixed mortgage. So prime borrowers got the same loans as everyone else. The Federal Reserve estimated between 2003 & 2006 60% of the mortgages sold were of a non-traditional type. That is everyone who bought new or refied existing homes!
The mortgage companies or banks them selves have to shoulder most of the blame. They created the products in the first place. They developed the compensation structure. They had two objectives. First collect fees for originating as many mortgages as possible. Second set the client up to come back with in five years for a new mortgage, which would generate more fees. They had little or no intent of keeping the mortgages. They were sold to investment banks so the banks held no long-term liability. They gained a short-term profit & hoped to maintain it with a steady stream of repeat business. To increase cash flow & feed hungry investors as the game went on they began to make riskier loans. In addition there has been evidence of inflated appraisals, which then drove up housing prices.
To better understand why I think this is where most of the blame lies you need to understand the products being sold. I will share with you the four major types I have seen the most.
First is the straight up 30 or 15 year fixed mortgage. This has been the norm from the beginning and until the last five years the majority of mortgages. You have a set interest rate & payment for a fixed time period. No bells & no whistles, easy to understand.
Next up is the ARM or adjustable rate mortgage. For this type of loan you would usually have a 1, 3, or 5 year period where the interest rate & payment are fixed. Then the interest rate varies at a set interval of generally 6 months or one year. Sometimes rates adjust every two weeks, based on some index plus a margin. Typically based on the US treasury or the LIBOR, London Banking Index. The margin can be from under 1% to anything, Generally from 2 to 5 points. They also have a floor & a cap. The floor or lowest the rate can be during any period are rarely below the initial rate. Many caps are set at 18%. How generous! The riskier the loan the shorter the fixed period & the bigger the margin added to the index. The challenge to a bail out is the prospect of higher overall rates, which gives a higher index to work from. The real crime is that the difference between a fixed mortgage rate and an ARM was in many cases less than Â½%. In fact at the time of this writing Bank Rate.com shows a difference of only .02%. Not worth the risk of potentially higher rates. Banks like these loans because the risk of higher rates is transferred to the borrower. Where on a 30-year loan they hope the cost of borrowing will remain under the rate you pay for the next 30 years. They are in the business of making & selling loans, most of the money is made up front. Look at how much money goes toward principal reduction the first five years of any loan. Most goes to interest. The plan was to have you refi in five years, start back on the high interest cycle again, and generate more fees. Esp if they sold the loan. I asked one broker why they only sold arms. His response was they would need more clients again in 3 or 5 years. For someone who knows they will be moving for fact in under five years the lower payment might make sense. But that was back before the boom. Now at less than Â½% difference it makes no sense and yet that is the majority of what is being sold right now.
Third is the interest only mortgage. For this loan to borrower is obligated to make only interest payment for a fixed period of time. Then the loan payment would recast to a fixed payment for the remainder of the loan period, in most cases 30 years. I have seen some set for 30 years. The riskier the loan the shorter the period before full payments were due. Let me share an example with you to illustrate the impact of this type of loan. I took a group with me on the spring homes tour 2008. We went to see a $2.7 million dollar home. There were fliers in the lobby from a nationally known mortgage company stating this dream home could be yours. For 20% down, ($ 540,000) you could get a 30-year interest only mortgage with a payment of $10,800 at 6%. In the fine print it showed the interest only period was good for the first ten years. After that you would still have a balance of $ 2,160,000 but with only 20 years to payÂ it off. Resulting in a new payment ofÂ $ 15,474. That is a 43% increase in payment! Now who can take a 43% increase in their mortgage? And is someone with $ 540,000 down a sub prime borrower? The sub prime borrower talk is a diversion. In this case the bank would get $ 540K in equity up front, the borrower pays in $ 1,296,000 in interest with no principal reduction. If they can keep the loan the bank gets an additional $ 1,553,760 in interest dollars. If the borrower refinances, the cycle starts all over again. Of course this assumed a never-ending growth in home values. Also of note is that in this plan the interest rate only remained fixed the first five years and varied annually after that.Â I assumed it stayed fixed in the above example for the life of the loan.
The fourth type of loan is a mix of the second & third called a pick a payment loan or a power option loan. These were & are used primarily in the refinance market and targeted those with the most equity & best credit profiles. All the ones I have seen work in the following manner. A client with a high FICO score & at least 20% equity get a very low interest rate mortgage. They then have an option of four payments they can make. The first would pay the loan off in 15 years & has the highest payment. The second is based on a 30-year payoff. The third is an interest only payment. And the fourth & lowest payment is not even enough to cover the interest charges. Which results in the short payment of interest due being applied to the principal balance. Now which payment do you think most people pick? There is a clause in the mortgage note that when the balance reaches 110% or in some I have seen 125% of the original balance the loan will recast into a payment that will pay the loan in full in the remaining time to 30 years. It generally takes 5 to 7 years to reach that point. These mortgages have not even begun to recast. The rating agency Fitch says the peak of recasts will not happen until 2010! And that the average monthly payment will go up $ 1053. They expect that most if not all of these will result in foreclosure with the decline in home values and the fact that more than 100% is owed from the original loan amount. Certainly these clients were in a position before to afford their homes.
Then you have the investment banks that bought the mortgages. As prices went up and volume increased they were willing to pay top dollar for lower & lower grade mortgages. They packaged the loans & sold them to investors on Wall Street including Fannie, Freddie, & Lehman Bros. Their appetite fueled the greed of the mortgage companies.
Next are the rating agencies that rated the packaged loans. They suffered from a lack of education initially. They looked at the quality of the loan only based on the credit worthiness of the borrower and the loan to value of the house. They never looked at the terms of the loan to see that the terms of a reset could put a payment well above a borrowers ability to pay. Then when defaults began to mount they were slow to sound the alarm.
Wall Street ate these loans up. They spread them out over the entire system. It looked good on the surface. A loan backed up by one’s own house. Who would intentionally bail out on that? And if they did the house could be sold. And private mortgage insurance would cover 20% of the loan value up front. Plus there was the promise of long-term returns from a 30-year loan payoff. They did not due diligence to examine the under lying loan product.
The start of the melt down.
The people who had poor credit or bought too much home got the shortest fixed term on their arms. Even though they were financed later in the cycle because of unbridled greed they began to fail first. This started to drive down home values. The next riskiest mortgages failed and drove prices farther down. Now you have a situation where even prime borrowers cannot refinance out of their increasing payment from their ARM mortgages due to the drop in values. One misconception is that rates are low so the payments would not go up that much or stay down. But the payment is based on an index plus a margin. The rates published for arm loans now are only the initial rate. The actual rate being paid now could be much higher. And the bail out will only aggravate the problem. This bail out promises higher rates, (higher index) as one of the results. Then you have companies like AIG paying out more pmi claims than they had every planned to, part of the cause of their melt down. And the crisis spreads.
All of this could have been avoided if true fixed rate loans had been sold a majority of the time. In most cases the difference in the borrowers note rate was under Â½%. On a $100,000 loan would mean less then a $ 40 per month difference.
The problem is that these very risky loans are still being sold. Ask any realtor what they have been seeing this year. Until this stops the crisis will continue. Because if the Fed is right about the 60%, and from my experience they are, the cost will skyrocket. The mortgage industry isÂ $ 1.5 trillion per year. Over the last four years that is $ 6 trillion. If 60% own the wrong mortgage the risk is 3.6 trillion! And typically after a foreclosure you must have good credit for 7 to 10 years before most companies will give you a mortgage. That alone will slow down any recovery in the housing market.
A possible fix
First off we need to out law these types of loans for the residential consumer. Second anyone who has this type of loan should be offered a new no closing cost fixed rate 30 year mortgage with 30 days before the first payment is due. With 30 yr fixed rates low right now most would be lower than their current arm payment. It would cost way less to eat the closing costs and the profits the higher payments the arm loan offers than to have everyone default. Plus the relief this would give the homeowners could relax spending. This is the only way to stop the slide & have a true bottom.