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The
Mortgage Mess and Why it Matters Mike Haubrich
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We are
stuck in an economic quagmire with the sub-prime mortgage crisis continuing
to drag down financial companies from banks, insurance and brokerage firms. What
set the stage for this financial crisis started five years ago when mortgage
companies started lending hundreds of billions of dollars in risky loans to
borrowers who provided little or no evidence that they could actually afford
those loans. Those
risky loans were bought by Wall Street brokers who then pooled these
mortgages along with other loans into a variety of complex financial
investments. These packaged investments with names like structured investment
vehicles (SIV), collateralized debt securities (CDS), collateralized mortgage
obligations (CMOs) and exchanged traded notes (ETNs) were then sold to banks, mutual funds, hedge funds,
insurance companies and even other brokerage firms-- both domestic and
foreign. Just about every financial institution throughout the world was
buying these high yielding securities backed by mortgages and other debt with
questionable value. Fast
forward to the present – the risky loans that are backing these
complex financial investments are in default as the high risk borrowers
are not making their monthly payments. Home values are plummeting as
foreclosure rates skyrocket. What was represented as fairly safe investments
backed by residential mortgages turned out to be much riskier. At the
same time, the brokerage firms and other financial institutions that manufactured
and now offer market liquidity for these risky investments are facing
challenges that may put their survival in question. The recent run on and bail
out of Bear Stearns (BSC) is an example of what can happen to a market maker/underwriter
of these risky investments. When hedge funds and other institutional clients requested
cash from BSC for these investments, the Federal Reserve (Fed) saw that this
run could spread to other financial firms who were holding these risky
investments on their balance sheets. The Fed stepped in to coordinate a
bailout through JPMorgan Chase (JPM), a Federal Reserve member bank. JPM
borrowed from the Fed and lent the funds to BSC allowing them to make good on
their obligations to clients. Days
after the bail out, JPM put a deal together to buy BSC for around $10 per
share (the closing price for BSC was $60 the day before the run began and
over $150 one year ago). What happened to BSC puts into question the value of
any and all financial institutions that may be highly exposed to these kinds
of risky assets. We can
see how this negatively affects financial institutions, but you might ask,
“How does this affect the rest of the economy and more importantly how does
this affect me?” A decline in the value of financial institutions’ assets has
a direct and a multiplying effect on the amount of loans they can make (this
is what creates the money supply). That is why the Fed is clamoring to find
ways to boost the loan making capacity of banks. Last month, the Fed
announced they would allow certain financial institutions to swap up to $200
billion of their risky mortgages for US Treasuries. In other words, the Fed
would take the risky mortgages off the bank’s books thereby improving their
balance sheets allowing them to continue to make more loans. Without this
swap, banks would have to write off the losses from those bad investments thereby
reducing the amount of lending they could offer to the marketplace. This time
the lenders are going to make better loans using the old qualifying standards
typical from the 1980s -- credit scores, adequate down payments and proof
that borrowers can actually afford the loan. If you are looking to buy or
refinance your home, expect a much tougher experience. If your credit score
is not above 720, you can expect to pay a higher down payment and/or higher
interest rates and closing costs. A score between 700 and 720 may cost as
much as another 0.5% of the loan amount in closing costs. That’s an
additional $1,000 on a $200,000 loan. Another
result of these risky investments is their impact on fixed income mutual fund
returns. If your income funds lost money this past quarter, it is likely that
they were invested in SIVs, CDSs
and CMOs. Mike Haubrich is president of Financial Service Group, a
registered investment advisory firm in |