If you want to know what really brought on our current economic crisis and imperiled some of the worlds largest banks, look no further than the recent two hour documentary shown on CNBC and narrated by David Faber on the the networks market analysts. the documentary entitlled "House of Cards" is well titled, as becomes readily apparent once the housing market starts to implode. To explain in layman terms what happened Mr. Faber has chosen two areas of Southern California to drive home the severity of this economic meltdown - Orange County, the epicenter of the subprimet mortgage industry, and Riverside County, one of the areas most impacted by the meltdown. The story begins with a Riverside County deputy sheriff as she makers her rounds serving foreclosure notices on residents who bought more home than they could afford. In cryptic terms, she describes the problem by stating "middle class families buying upper middle class homes, they really could not afford". Add to the problem, homeowners who decided they wanted get into a new hobby called "flipping", and home owners who saw their increased home valuations as a resource for continued borrowing of money through an annual refinancing process. Mortgage companies were only too happy to fuel the borrowing mania because they had a new source of cheap money - Wall Street. Wall Street took the place of Fannie Mae and Freddie Mac as the primary lender of funds to buy or refinance homes. Fannie and Freddie were late to this party because of their regulatory problems, and slowness in abandoning the strict guidelines used to approve conventional home loans.
The normal approval process for getting a home mortgage, the process that most people are familiar with, went right out the window, once a flood of cheap money came in from other countries, looking for a safe haven to park their money. Wall Street banks invented a new financial instrument called collaterized debt obligations (CDO's), that had as underlying colleteral, home mortgages that were packaged into these CDO's and then sold all over the world. The proceeds from these CDO's were used to fund even more home loans. The profits were enormous to banks who took a nice commission on all of these sales. Wall Street began to pressure the mortgage companies to fund more loans, so they started promoting no documentation loans also known as stated income loans or "liar loans". These loans were usually variable rate loans with low "teaser" interest rates that reset to higher rates, and some loans even included negative amortization, where the monthly loan payment was so low, it did not cover the interest owed; the balance on the loan started going up each month.
An enabler of these CDO obligations were companies called rating agencies, such as Standard and Poors, and Mooney, which rated these CDO's as "AAA investment grade", which signified to investors that these obligations were almost risk free, and guaranteed a very nice rate of return. The rating agencies graded CDO's using a risk model that presumed that homes would increase in value 6-8 percent per year forever.
In 2006, the first cards in the house of cards started to fall. As interest rates on these subprime mortgages started to reset to higher rates, homeowners found they were having difficulty making the payments. Adding to the problem was the general economic downturn which led to job layoffs, which fueled the mortgage payment problem. As mortgages went into default, warning signal went up on Wall Street, and investors started pully back from CDO purchases. This dried up the funds available for mortgages, and now potential home buyers were having difficulty getting loans. The glut of foreclosures started to adversely affect mortgage company profits and many mortgage companies went out of business throwing thousands of employees out of work. As these foreclosed homes started coming back on the market, the home inventory glut started to depress overall home prices. Recent buyers of homes found they were "upside down" on their homes - they owned more on their house than it was worth. Many just stopped making payments and mailed the keys back to the lender. The result was even more houses coming back on the market further reducing prices.
Fast forward to 2008, and the mortgage crisis is now humbling investment giant like Bear Sterns and Lehman Brothers, Citibanks, Countrywide Mortgage, Wachovia, Merrill Lynch, and even Bank of America are in serious financial difficulty. Not only has this financial meltdown hurt our country, we also exported this toxic mess to countries around the world who purchased these CDO's based on their "AAA investment grade" rating. This worldwide economic problem will exacerbate the U.S. recession and we find it more difficult to get other countries to buy our exports.
"Sixty Minutes" the muckracking popular television show focused on one organization that serves as a microcosm of how we got into this mess. The company is World Savings, now part of Wachovia. World was owned by Marian and Herb Sandler, long time respected members of the mortgage lending community here in the San Francisco Bay Area. They were known for their frugal no nonsense business practices and high integrity in lending practices. However they too got caught up in the lending frenzy brought on by the flood of money from Wall Street and started bending their own lending rules. They started offering the stated income loans and new approaches such as the "pick a payment" feature which let you pay less each month than the amount necessary to amoritze principal. This meant interest not paid each month was added to principal thus increasing the amount owed. It did not take long for unsuspecting homeowners to find themselves "underwater" on their loans once housing prices started to decline. The Sandlers were smart and sold their company to Wachovia for over 2 billion dollars. Wachovia and Wells Fargo Bank are now stuck with these non performing loans, which has hurt Wells Fargo shareholders.
Now we taxpayers will have to help homeowners who were caught up in this "predatory" lending to save their homes through mortgage resets and other subsidies. The rules are strict however - only conforming loans are eligible, and the loans limit is restricted to 31% of income, and 105% of the homes current value. This won't help many California homeowners who took out jumbo loans. This program coupled with the bank bailout TARP program will help to ameliorate the housing situation but it will take a very long time to housing to approach anything close to the normal house appreciation we became accustomed to in the last decade. Those days are over until we work off the glut of foreclosed properties and banks become financially healthy once again. There will be no more "no doc/stated income loan" and no down payment loans. We will be back to the prudent lending standards that we should have kept in the first place. Shame on us and shame on our leaders for allowing "greed" to get the better of us.
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