Economic Crisis – The Players and the Initial Factor
We now have a rescue plan that’s been voted on and approved by House and Senate and signed by the President. You can find people on all sides of the debate from those who think it was an absolute necessity to those who are against the idea of intervening in any way. I fall somewhere in the middle, believing that the action was necessary, but also that the bill is far from perfect.
Since we have a bill in place, I’m not going to debate the merits of the plan, but rather try to examine how the bill became necessary. Because of the enormity of the situation, I plan to cover this in a series of posts. In this post I’ll provide an overview of those involved and how it became a crisis.
The Players
I’m sure by now that most have read that real estate is at the root of what’s going on around us. You have probably also heard that sub-prime mortgages are one of the many factors that allowed the bubble to grow even larger. Now you might be wondering who was involved and who’s really to blame. Is it really Wall Street versus Main Street?
In my opinion the blame belongs on both sides of the street with everyone who participated in the process. Below, I’ve listed a brief overview of the primary players involved:
- The individual who borrowed more than they knew they could afford.
- The broker who was focused on the transaction, even if he knew the loan didn’t make sense for his customer, because he was focused on the commission.
- The mortgage firm that wasn’t worried about the loans their brokers were originating because they were going to sell the loan ASAP.
- The investment banks that packaged the loans into mortgaged-backed securities.
- The ratings agencies who rated the packaged loans as high-grade loans with low default risk (Note: These agencies are paid by the same banks that are packaging the loans. Can anyone say “conflict of interest?”.)
- The buyers (mostly institutional buyers who should be knowledgeable investors) who competed to buy the mortgage-backed securities even thou they didn’t know the true underlying risk of the asset and therefore ended up overpaying for the assets.
- The investment banks — including many of the same that packaged the loans — that sold unregulated and unfunded credit default swaps.
- o Credit Default Swap - basically an insurance contact between two parties that says the seller will pay the buyer if the underlying mortgages default above the negotiated rate.
There were many levels of fallout that created the crisis that we’re currently in. The first was the real estate market.
The First Layer
Eventually all overheated markets reach a peak and begin to decline to a state of normalcy.
As interest rates declined early this century, buyers were able to buy houses that they previously couldn’t afford. This pushed real estate prices up. In order to enable individuals to continue to buy these newly revalued properties lenders started selling loans that weren’t based on standard lending requirements. In some cases borrowers didn’t even have to prove that they had the income to support the loan. In others, the borrower could just barely afford the loan payments that were based on an artificially low initial rate. And as we all know, if something seems too good to be true… it probably is.
As is typical in an overheated market, people overestimated the true value of the asset and mercilessly bid-up home prices. But eventually the price stretched too far, sellers started having trouble selling at the sky high prices, and a rush for the exit began. This sent housing prices tumbling and scared many potential buyers out of the market. Now we find ourselves in a waiting game, hoping that new buyers decide to reenter the market and help stabilize prices.
So now you know who participated in the crisis as well as the first layer of how it developed. In the next post, I’ll take a look at how mortgage backed securities, the second layer, have impacted the situation. Feel free to post a comment if you have any questions or if you would like to add more information on the situation.
Scott H
October 13th, 2008 at 2:07 pm
You list a number of contributing factors but does it not all come down to the unregulated credit default swaps. The latest statistic I have seen still indicate that 95% of mortgages are being paid on time. That means that there is a dfault rate of less than 5%. Once companies realized the the credit swaps were worthless — didn’t that mean that the banks had to come up with additional equity. It was trying to raise that additional equity that was the trigger for the spiral. UBS is the example I read about where they had a 1.5 Billion worth of loans they had purchased a credit swap contract for and found out when they went to collect the company had nothing to pay them with. So now under the law they have to have the capital in place to guarantee what they already thought they had guaranteed with the swap.
Then the second problem of course is the decline in the housing market meant that any equity that had been built up in the loan port folio was now totally gone. i.e. The people owed more than what was secured by leans on the property, which meant even more equity had to be raised to meet the banking requirements. Then the third shoe was the uncertainty about the value of the mortgage packages and the subsequent evaporation of the market. Accounting rules say you have to value them at the current market price — without a market there is no price or it is difficult to determine a value. What are they worth? So now banks have to remove them from equity which means they have to shore up more capital so they can continue in opperation.
Ultimatrley if the credit swaps had been funded properly, those people would be losing money and not the financial institutions that purchased them. IMHO it is those credit swaps that were the underfunded were a fraud. People under wrote them with the clear intention of never paying off. As long as the good times rolled they were happy and making huge profits. Many of these were held by hedge funds, who have taken it the worst this month. I hope they get what is coming to them and some sanity returns to the market.
October 15th, 2008 at 10:18 am
Tom, you beat me to the bunch. When I started writing about the situation I realized how much there was to say. At that point I decided to write several posts about the subject, starting with a quick overview and then moving into the factors that, in my opinion, enlarged the crisis. The next post will deal with mortgage backed securities and the third will deal with credit default swaps and the lack of liquidity in the credit markets.
October 15th, 2008 at 10:36 pm
I haven’t heard much about this point, but for mortgage holders that pay PMP insurance (if they’ve put down less than 20% of the loan amount), this PMP has proved 100% worthless during the mortgage market train wreck of late.
How do mortgage holders best appeal for refunds of premiums for this PMP?
Will the criminals responsible be held to account?
October 20th, 2008 at 6:24 pm
Dan,
I believe you are talking about PMI or Private Mortgage Insurance. This an insurance contract between the lender and the insurance company. In theory the contract protects the lender in the event that the borrower defaults (stops payment) on the loan and the lender is unable to recoup 100% of the loan after foreclosing and selling the property. The insurance is often required when the borrower is putting down less than 20% of the value of the house, as you point out, and is typically paid for by the borrower.
What I think you are describing is when the property is foreclosed on, the lender is unable to recover 100% of the value of the loan and the lender is then unable to collect the difference from the mortgage insurer. In this case the it would be a dispute between the lender and the mortgage insurer. The individual borrower will have lost the house before this occurs and to my knowledge will not be subject to any additional penalities than they will already face because of the default.
For this reason, I don’t think the average borrower who pays for PMI will be able to apply for a refund of the payments they have already made.
As far as who will be held accountable… I’m unsure at this point who, if anyone, will be punished.
October 22nd, 2008 at 2:03 am
While PMI insurance may be a contract between the lender and the insurance company, the borrower is the one paying the premiums for it. Not to mention that the fed has made it an insurance premium that is tax deductable as of a couple years ago.
True enough, if someone is defaulting or is otherwise loosing a house, the PMI supposedly protects the lender from loss and the borrower is no doubt realing from other headaches as well.
So why are there millions of mortgage lenders crying that they’ve lost out… the 80%+ borrowers don’t even have a choice in the matter; money was paid for PMI premiums in their escrow accounts.
In short, a lot of banks are crying they’ve lost on defaulted mortages, yet even in the wild-west days as recently as a year ago, the mortage companies, while not even requiring proof that a borrower could service a mortgage, did require that borrowers getting mortgages for 80%+ loans on their houses had to get PMI.
Where did all the coverage go?
If PMI, as an insurance vehicle in general, can default on its obligation to policy holders, what’s to say other types of insurance don’t follow suit?
Aren’t insurance compaines required, by state law, to have, on an escrow-type, ultra-conservative deposit, certain %’s of every policy they write to avoid just such a fiasco as we all saw a few weeks go?
If you haven’t gathered it allready, I’m not a big fan of insurance, for this very reason. All the premiums were made off with and the insurance companies were left to go under while grossly overcompensated Joe CEO basks on a warm sunny beach.
This is not really an investment issue either, I just have not heard any other folks bringing this topic up.
Probably has nothing, at all, to do with retirement investing. But it is an issue I see a need for resolution to.
We’re talking billions of $’s in premiums.
Thanks for replying.