RebelCapitalist: Financial Information for the Rest of Us | Massive Meltdown: A primer on the Economic Crisis of 2008

Massive Meltdown: A primer on the Economic Crisis of 2008 - Part 1

Sep 20, 2008 | By: Mr_Blue | Tags: financial crisis, mortgage crisis, economy, subprime

This is Part 1 of 3.

Author note: This story will be divided into three parts in the interest of being thorough and because of the importance of the issue.

How did we get to where we are at today? Financial institutions are failing. Lehman Brothers (159 years old) bankrupt, American Insurance Group (AIG) bailed out, Fannie Mae and Freddie Mac bailed out and now our government is going to bail out the entire mortgage industry.

That will cost us, taxpayers, at least $700 billion. We need to understand how we got into this mess because it appears we never learn from history.

This mortgage crisis, turned financial crisis, turned absolute economic crisis, did not begin over night but has been brewing since at least the late 1990’s. This crisis was instigated by a convergence of factors: low interest rates, increased subprime lending, popularity of mortgage-backed securities (MBS), corporate greed and deregulation.

Cheap Money, Low Rates, Gobs of Money to Lend

In 2000, the Federal Reserve, the interest rate leader, began cutting the Fed (Federal) Funds Rate:

May 2000	6.50%
May 2001	4.00%
Dec 2001	1.75%
Jun 2003	1.00%
Sept 2008	2.00%

This meant the cost of borrowing money became cheap. The Fed believed that economic activity was slow so it cut the Fed Funds Rate in the interest of increasing business activity which would increase economic growth. At least that was the theory behind these rate cuts.

So what was happening in the mortgage market at this time? Mortgage rates are determined by several factors including demand for mortgages and longer-term interest rates such as 10 year U.S. Treasury Note. But where were interest rates (average) for a 30 year fixed mortgage during this time period:

May 2000	8.52%
May 2001	7.15%
Dec 2001	7.07%
Jun 2003	5.23%
Sept 2008	6.48%

Average mortgage rates were definitely lower than their the peak of 8.52%. These mortgage rates made for a very attractive lending environment. Just look at the numbers:

Amount of Home Mortgages Outstanding (Billions of Dollars)

2002	6,036.2
2003	6,887.1
2004	7,845.4
2005	8,875.8
2006	9,872.9
2007	10,542.7

Source: Federal Reserve, Z1 Release, September 18, 2008

Mortgage loan activity increased ever year between 2002-2005. At the end of 2007, U.S. households were carrying $10.5 trillion of mortgage debt. The home mortgage market was huge. But the increase in mortgage activity certainly was not the sole reason for the mortgage crisis. The quality of the mortgage loans, particularly subprime mortgages, was a big problem. Subprime mortgage market exploded between 2003-2007.

Increase in Subprime Mortgages – too much of a good thing?

Subprime mortgages are “high-cost to borrower and high-risk to lender” loans intended for people with weak or bad credit. Subprime lending does provide much needed capital to an underserved market. It gives people with less than stellar credit an opportunity to create wealth. But at what cost to the borrower and the community at large? Was the number of subprime mortgages too much of a good thing?

Subprime mortgages cost more than a prime mortgage in terms of fees and higher interest to the borrower. For example, a prime fixed-rate mortgage rate maybe 6.0% but the mortgage rate on a subprime loan could be anywhere between 8-11%, depending on the credit score and the amount of down payment by a subprime borrower. Then there are fees – origination, application and others. The fee structure for a subprime loan is higher because more loans applications are rejected and higher marketing costs which means higher overhead for subprime lender. These fees and interest rates are designed to compensate the subprime lender for the risk it is taking making these loans.

These loans usually come with a prepayment penalty clause, something that is extremely rare in the prime mortgage market. That is correct – a subprime borrower may have to pay a penalty to pay-off the mortgage! In most cases it is thousands of dollars that must be payed by the borrower if they pay off the mortgage within a minimum of 2 years of closing. I personally have seen prepayment penalties as high as 3% of outstanding loan balance or 6 months of interest.

Why the prepayment penalty? In theory, it compensates the lender for “prepayment” risk but the penalties also make these subprime mortgages more valuable when the lender tries to sell these types of loans to Fannie Mae, Freddie Mac or an investment banking firm. Bottom line: lender can get more for a subprime mortgage with a prepayment penalty when it sells the mortgage loan.

A common loan term structure in the subprime mortgage loan market is 2/28 Adjustable Rate Mortgage (2 year fixed period/28 year loan ARM). This means that the mortgage rate is fixed for 2 years but after 2 years it jumps or resets to a much higher interest rate – in most cases the reset is equal to an index (ex. prime rate) plus a fixed margin. For example, a subprime borrower has an initial rate of 8% mortgage but at the of 2 years the mortgage resets and if the index is 3% (prime rate) plus a margin of 7% then the mortgage rate will reset to 10%.

The theory behind 2/28 ARM is that the borrower will work on improving their credit during the two years then refinance to a lower rate mortgage. The problem is that there is typically a prepayment penalty to pay-off a loan before 2 years (in some cases more). So, a subprime borrower is stuck in this loan, which now has a much higher interest rate.

The subprime mortgage market was a very lucrative industry in early 2000s. There were independent mortgage companies such as Ameriquest Mortgage, Countrywide and New Century Mortgage Co. Even the big money center banks like Wells Fargo and Bank of America, through subsidiary companies, got a piece of the action.

According to the Center for Responsible Lending (CRL), in 2003 the amount of subprime loans outstanding was $322 billion and in 2007 the amount outstanding was $1.3 trillion. Subprime mortgage loans increased 292% between 2003 and 2007. In 2007, 7.2 million families held a subprime mortgage. It gets worse: CRL projects that $164 billion of home equity will be lost through foreclosure by families holding subprime mortgages.

This is too much risky loan activity. By 2007, about ten percent (10%) of outstanding home mortgages were subprime mortgages. But did anyone care – mortgage lenders/brokers were making money and banks were making money. Besides, there were gobs of money to lend.