Page 2 of 3 Rocking the subprime house
of cards By Julian Delasantellis
Mrs Macklin's house, and a hundred others. Why, you're lending them the money
to build, and then they're going to pay it back to you." [1]
And the banks where the mortgages originated, they were different, too. Sound
and strong buildings occupying the center of town, often adjacent to those
other institutions of worldly authority, the courts and the police; these solid
stone and brick
edifices virtually screamed out their probity and good judgment.
In the US, real-estate lending sure is different today. There are a lot more
lenders these days; banks are in competition for the mortgage market with what
are called "mortgage brokers". These do not occupy the august moneychanger
temples of the past; you might find them at the end of a strip mall next to the
Dairy Queen; in rural areas, you see them in little structures cut out of the
forests on the side of two-lane country roads.
The mortgage lenders are different because the mortgage market is different.
There are no more George Baileys who make and hold mortgages to maturity.
Instead, these days, virtually all US home mortgages are packaged and bundled
together to become what are called "collateralized mortgage obligations", or
"mortgage-backed securities". The bank or other mortgage originator that
constructs these packages sells them to investors, who use them very much as
investment bonds. Thus your monthly mortgage payment, instead of going to the
bank that you write the check to, now "passes through" as a dividend payment to
the investor who bought the package of mortgages that contains yours. Since the
mortgage business now involves far less of a lifetime commitment between
borrower and lender, the way is open for all these new storefront mortgage
enterprises, for all they exist to do is to sell the mortgages they write into
what is called the "secondary" market.
What the investor in these bundled mortgages gets are interest rates, dividend
payments, in between one and two points richer than those available on US
Treasury securities of the same maturity. For all its faults, this system
(along with preferential tax treatment for real estate) has given the US, at
70%, the highest rate of owner-occupied housing on Earth, and it is a system
that many nations, including the formerly communist economies of the Eastern
Bloc, have moved to adopt over the past 25 years.
But, done to excess, everything good becomes bad. Thus the chain of events that
led to last week's stock-market falls.
The one- or two-point spread of these instruments over Treasury yields
represents what highly creditworthy mortgage borrowers pay for their loans.
What interest rate do you pay for your mortgage if your credit status, your
credit "score", isn't quite up to par?
Like if you've had so many cars taken back by the banks you know the birthdays
of the repo man's kids. Or if it has been so long since you made a payment on
your store charge cards that they slam the security gates shut when they see
you.
In the old days it would be easy to calculate what mortgage interest rate these
borrowers would pay - zero. These borrowers would not get mortgages; they would
forever be renters. Then the mortgage industry had a neat idea.
Instead of denying these less than fully creditworthy borrowers mortgages,
let's give them loans, only at a much higher interest rate. Instead of having
them pay 1 or 2 percentage points over US Treasuries, they'll pay 3 or 4. We
can then bundle, or "securitize", these mortgages into high-yield bonds. (Some
bond investors became addicted to the double-digit bond yields in the early
1980s, and over the past two decades have again and again proved themselves
more than willing to "reach for yield", to take on significant extra risk to
get another fix.) Sure, there might be more defaults on these mortgages than
you'd see from high-quality borrowers, but the higher interest rates would more
than make up for a few defaults and repossessions here and there, and besides,
as long as real-estate values continued the meteoric rise of the early and
middle part of this decade, the subprime borrowers could soon use the new extra
equity in their home's values to refinance into more prudent borrowing
arrangements.
Thus all the ingredients were in place for the real-estate frenzy that gripped
the US, and much of the rest of the capitalist world, over the past few years.
With the tremendous new demand from this cadre of buyers now able to get the
housing finance once denied them, and with new supply a lengthy process, there
was suddenly a significant imbalance between demand and supply in the US
housing market. Other mortgage finance innovations, such as low initial
"teaser" rates, interest-only mortgages, or the spread of floating rates,
allowed more and more people to move into properties they couldn't really
afford.
When prices took off, this attracted more buyers, more demand in the market,
and the price-appreciation cycle became self-
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