A Lesson on Exotic Mortgage Lending

Today, I am going to discuss a key cause of the bubble here in Florida and throughout the country - the easy availability of loans that people truly couldn't afford in the long run (or never had intention of paying back).

In the supposedly altruistic notion of converting more people into homeowners (regardless of creditworthiness), all sorts of exotic instruments were employed over the past 5 years. They are collectively known as "sub-prime", and they include:

ARMs (adjustable rate mortgages) - Typically start at a low introductory rate, and then 1 to 3 years later the rate resets to LIBOR (London Interbank Offered Rate) + a small %.

Balloon Mortgages - A mortgage that must be paid in full within a set time, typically 5 years. Often used in cases where refinancing or sale of the property is expected before the balloon is due.

IOs (interest only loans) - Used in conjunction with ARMs and/or balloons, the homeowner only pays interest, and does not build equity during an initial trial period. This makes the initial payments even lower.

Negative IOs - Similar to IOs, but to further drop the initial payments, the homeowner pays less than the actual interest for the trial period. Thus, when the balloon and/or ARM resets, the total amount owed on the property has actually increased. As in all the other above-mentioned instruments, this is not a problem if the property has increased in value faster than the principal.

And the worst of all,

No-Doc (No Documentation required, aka, "Liar Loans") - once used in rare cases where documentation of pay history is difficult (self employed persons), the loan is granted without a credit check or verification of ability to repay. In exchange, this type of loan carries higher interest rates. For obvious reasons, this route is the easiest way to commit fraud, and that's exactly what happened.

It should also be noted that all of the above types of loans carry high fees, which go directly to the mortgage brokers who sold them. Finally, the vast majority of these mortgages are bundled up by the thousands and sold on Wall Street as MBS (mortgage-backed securities), thus freeing the brokers to sell even more mortgages and perpetuate the fee-generating machine.

Two of the largest purchasers of these MBS are Freddie Mac (FMC) and Fannie Mae (FNMA), both quasi-gov’t entities whose purpose is to increase American homeownership (and to make a profit along the way).

Back in the "olden days" (pre 2001), such exotic loans comprised a very small % of overall home-loan volume (5-6%). However, by 2005, it is estimated that 40% of all mortgages were underwritten with sub-prime/exotic riders in them.

All of this combined to generate a proliferation of mortgage companies, all pushing exotic mortgages to get the high fees and then passing on the "hot potato" loans into MBSs on the financial market.

It all worked great, especially as house prices skyrocketed, and valuations generated ever-increasing "paper equity". With so much credit available, people who had no intention of ever living in a house ("flippers" and outright criminals) were also bidding on houses, condos, and pre-build properties, pushing prices even higher.

But there was an issue. Every purchaser of an MBS bundle from these front-line mortgage companies puts various stipulations on the purchase - the most important of which is % of defaults (non-payment in the first 90 days). If this % of defaults (non-payment in the first 90 days) is exceeded, the front-line mortgage company is required to buy the defaulted mortgages back.

This issue transformed into a certified problem when it turned out that many of the flippers and fraudulent loan applicants never had any intention of making payments on their loans. Defaults, defaults, and more defaults.

Furthermore, as time wore on, the ARMs and balloons started to trigger, greatly inflating the payments that honest homeowners had to pay to keep current on their mortgage. Often, this increase in mortgage payment far exceeded the homeowner’s ability to pay.

This resulted in the default triggers being exceeded everywhere, particularly in the exploding-bubble states (Florida, Arizona, Colorado, California). Instead of being able to pass them onto other banks and securities, mortgage companies were increasingly getting "return to sender" on their crap-o-la loan portfolios.

The certified problem then metastasized into an outright disaster. As foreclosures started mounting (the foreclosure rate is still increasing as you read this), the smaller lenders began to implode, and the larger lenders have begun charging off huge losses.

And the worst part of the tragedy: people who thought they were living the American Dream are now experiencing a nightmare as their house payments suck their finances dry. Finally, they "throw in the towel" and get foreclosed on. Their credit ruined, they are pretty much denied the opportunity of owning another home for the next 7 years.

Okay, so we have a serious mess on our hands. You can almost here it on the PA system, "We need cleanup on aisle 3!". Our next post will deal with Freddy Mac's proposals to deal with the situation.

I just wonder if they are a "day late and a dollar short" on their response.