Archive for September, 2008
OK, we discussed how the application was received and judged. We discussed the types of mortgages available in today’s marketplace. Now comes the MBA’s and their fancy footwork. They got so fancy that they killed the golden goose.
In an attempt to help various factions of our society, the federal government developed FHA, VA Loans, HUD and other special agencies to help local banks with interest rate discounts and loan security. These efforts were primarily aimed at those prospective home owners who only marginally qualified for the mortgage loans when scrutinized under the established rules of underwriting. This lack of solid qualification could result when considering:
- the value of the real estate in question
- the ability to pay the required monthly payment
- the inability to offer the appropriate down payment
- or the financial stability of the borrower.
Basically this is an issue of welfare estate, but the interested side benefit is that more houses can now be built which helps the economy expand and creates more jobs – artificially. Which is a priority for the government.
This extra boost to marginal borrowers was not quite enough to satisfy the politicians so a clearing house was established. Fannie Mae and Freddie Mac were created as a clearing houses for mortgages, especially mortgages which were marginal. By that I mean, mortgages where:
- the evaluation value of the real estate was not high enough.
- the amount of disposable income available to make the monthly mortgage payments was too low.
- the size of the down payment was too low for the loan required.
- the financial stability of the borrower was not satisfactory.
With all these pieces in place, the federal government in 1999 allowed some deregulation in the financial markets basically allowing more and different financial institutions to market more and different financial instruments. The prime idea here was to increase the competition in the financial marketplace. The main players thought to be affected were banks and insurance companies.This was introduced by Republicans and passed through a Republican House and Senate and signed into law by a Democratic President.
One of the buzz words of the 21st century is financial derivative. A financial derivative is a financial instrument which depends on underlying financial instruments for its value. A typical example is stock options. The wizards of Wall Street have developed new financial derivatives; one of which is at the heart of our current financial situation. When questionable mortgages are bundled with other financial instruments, the quality of the mortgages is somewhat hidden.
The stage is set.
The basic scheme operates as follows: banks and other financial institutions write mortgages with questionable underwriting procedures. To eliminate their risk they sell these mortgages to Fannie Mae and Freddie Mac (for reasons which escape me, Fannie and Freddie seem to be able to take any and all mortgages with no regard to quality or quantity or size). Fannie and Freddie then bundle and sell these mortgages to other financial institutions. Here the mortgages are bundled with other instruments and resold in the financial markets. The payout on the bundle is at least partially depend on the regular monthly payments by the mortgagees. That is how the scheme is designed to operate.
Three critical junctures in these schemes.
- The mortgagee must continue to pay monthly or the whole scheme blows up. But by definition these mortgagees are not as likely to continue paying, they were marginal applicants at the beginning of the process.
- The banks accelerate the approval process and turn a blind up to the deficiencies either in the real property or ability to pay. They do this because they know they can avoid any risk by wholesaling the mortgages through Fannie Mae or Freddie Mac.
- Fannie Mae or Freddie Mac avoid their risk by bundling the mortgages and selling them to financial institutions to further combine them into packages which mask the underlying risk.
To escape from this financial mess, the financial market must shore up the derivatives which contain the questionable mortgages. When they can no longer hide what is happening, then private mortgage insurance is in force. If and when PMI can no longer rescue the situation, then we have a financial meltdown as we have today.
To qualify for a mortgage there are a number of factors. The application often can take several days to complete as you gather information. The saddening part of most mortgage applications is the time it takes for denial or approval, often weeks, sometimes months.
First there is your credit history and credit score. But that really just establishes the interest rate and percentage down payment requirements. The exception to this would be extreme cases. A minimum credit score seems to be about 550 to 600. The higher your credit score, the lower your interest rate. The higher your credit score lower the required down payment.
Second is your ability to pay monthly. In the past, this was typically 30% of gross household income. If there were other time payments (car, cottage, boat), depending on the size and their history, these monthly payments might be included in the upper limit of total monthly payments allowed.
Another filter is the 3 times factor which would set the maximum amount of loan for the individual. This means that 3 times the gross annual income of the family is the ceiling for indebtedness for the family. Depending on the situation, cars, boats, credit cards and so on are included in this total.
The next factor is the down payment. Depending on credit score and type of loan (conventional, special, FHA, HUD, VA) there may be rules which apply, perhaps 5% down.
The next factor is the need for Private Mortgage Insurance. In the past, this was required by the underwriter if equity in the property was less than 20%. The cost of this insurance is dependent on factors similar to the mortgage evaluation.
The last major factor would be evaluation of the property by an independent real estate appraiser. This evaluation would be sourced not only from local similar sales but also from a formula reflecting the features of the home and property.
There are other factors but the point to be made here is that someone is charged with the responsibility of checking out the individual for credit worthiness and the property for true value. Depending on the results a number of punitive conditions apply including:
- higher interest rate
- shorter term
- higher down payment
- monthly payment limits
- total loan amount limits
- private mortgage insurance
That is how the mortgage application business was designed to work.
The financial institutions have become more creative in recent years with:
- mortgages which included interest only and no principal payments,
- mortgages below prime for the initial years which catch up with balloon interest and principal payments after the initial years. Subprime mortgages.
- negative amortization with catch up balloon payments
- and others I am certain of which I either have not heard or do not understand.
OK, that’s how mortgage applications are completed. Here’s a summary of available mortgages:
- simple mortgages with yearly principal payments
- amortized mortgages which reduce the monthly payment by including an additional overall cost in the mortgage.
- amortized mortgages which are 30, 35, 40 years in length.
- creative mortgages with special interest rates, delayed interest payments, no principal payments and so on…
Have you noticed how an authority figure such as scientist, lawyer, banker, doctor or politician, tends to drift into technospeak on most issues these day? Have you also noticed that often you understand less at the end of the discussion than you did initially? Do you recognize that this technospeak is often just a tactic to cover up the speaker’s lack of understanding of the issue. And finally, do you recognize that this technospeak is often a tactic to purposely confuse us to hide the real self-serving purpose of the issue?
This current financial crisis is a classic example of technospeak. I am obviously using that term loosely as the discussion here is actually economic gooblygook.
Secretary Paulson is begging the government to provide $700 billion, billion with a b of taxpayer dollars. He wants this money to prop up some financial markets on Wall Street. Has anyone looked at the Wiki bio on Secretary Paulson. His career prior to the Treasury Department was Wall Street. Specifically one of the prime actors in this current crisis. It is estimated that Secretary Paulson has a net worth of $700 million. Has anyone asked him how much of that is in Goldman Sachs stock or investments? I assume because of his past position at Goldman Sachs in 2005 and 2006, that he had a significant stock position. What is it now?
I do not know the answer, but I suggest that it was liquidated when the stock and stock options were of real value. Why would he liquidate all of the GS assets? Perhaps he did it to separate himself from Wall Street influence as required by his new government position. I wonder why he did not just escrow his assets like most government employees in powerful positions?
I am assuming that Secretary Paulson bailed out of Wall Street. Perhaps I am incorrect. I believe that many of the Wall Street tycoons who have seen the stock in their companies plummet somehow sold out before the crashes over the past couple of years. Somehow they smelled something and bailed. Senator McCain and others brought legislation to committee to revamp the Fannie Mae and Freddie Mac operations in 2005, primarily to institute more oversight and regulation of their operations. This legislation was buried in committee and never came to a vote. Please note that both houses were controlled by the Democrats at that time.
OK, what am I getting at. I complain about transparency and then I am obtuse. Other posts will deal with types of mortgages, how a mortgages is approved and what happened.
To understand which types of mortgages are involved in the financial crisis, let’s have a look at what types are available. In simple English, here is a description of several types of mortgages…
1) Simple mortgage – no amortization:
An individual borrows $100,000 at fixed 5% per annum for 20 years. This loan is repaid as follows – First year Interest of $1250 would be paid April 1, July 1, October 1 and January 1 – Principal of $5000 would be paid every January 1. Each year the interest payment is 1.25% of the outstanding balance quarterly, the yearly balloon principal payment is 5% of the original balance, that is $5000. At the end of 20 years the debt is zero. There are two inconveniences with this type of mortgage. The first year contains the largest interest payments and largest total payment for the year. Secondly, the debtor must be disciplined enough to save $100 a week in an escrow account, so that $5000 is available for the principal payment due on January 1. Please note that the total of the interest and principal payments the first year is $10000. The second year is $9750. The third year is $9500. And so on until the last year which is $5250. The total money paid, interest and principal over 20 years is $152000. This is a simple mortgage and not popular in today’s ‘me now’ society.
2) Let’s compare it to the typical 20 year fixed 5% mortgage with amortized payments in today’s market. Monthly payments are fixed at $659.96. The total cost of the mortgage over 20 years is $158390.40.
3) Here’s the data for a typical 30 year fixed 5% mortgage with amortized payments in today’s market. Monthly payments are fixed at $536.82. The total cost of the mortgage over 30 years is $193255.20.
Accordingly, your reward for paying more per year early in the life of the simple mortgage contract will be $6390.40 when compared to an amortized 20 year deal. That is over 6% of the original loan amount. You must sacrifice some disposable income initially and you must establish some financial discipline. Again, your reward is over $6000. Moving on to the 30 year deal. The reward becomes $40755.20. That’s over 40% of the original loan amount!
The second half of the debate Friday was on Foreign Affairs. As expected, the experience of John McCain was evident. Also as expected but certainly not discussed in MSM, the inexperience of Barack Obama was obvious.
McCain repeatedly demonstrated a very comprehensive understanding of world affairs. Obama often sounded like a sophmore on a college campus.
At one point Senator Obama referred to the fledgling democracy of Poland and Czechoslovakia. I guess we will not be planning much with those countries in the near future. He also said, which he corrected later, that we should go into Pakistan to attack our terrorist enemies. But even more important to me was he complete focus on the past, what was done by whom, who to blame. Myself and the rest of the country would like to hear about how we can resolve our foreign policy problems, not who caused them. It is especially disappointing when he spins the history with his rhetoric and exaggeration for pure political advantage. We have some major issues to deal with, let’s move on toward some solutions.
McCain was drawn into some history debate but most of his discussion was with an eye to the future and how we should be posturing and acting to solve current and future problems. Senator McCain could not help himself and did his share of politicizing as well but overall his time was much more informative.
McCain’s advantage, Obama pretending to have experience is transparent and foolish. Everyone knows that he is a first term US senator. His time in the Illinois senate was a part time job. Just when was he supposed to gain this experience in foreign affairs? His duplicity is far more detracting than his lack of experience.
When I tuned in Friday night I expected to hear proposals, solutions and opinions for our future as ‘everyday’ people and as a republic. The first half was about the economy and the current recession, subprime financial crisis and possible actions by the government.
The very strong impression I received from Senator Obama was that he did not agree with Republican policy for our economy. He talked about what had happened with a tunnel vision that only a true politician can muster. He had little to propose which was different than what has been in the news for almost a week. He spent most of the time trying to impress us that he was acting as if he was already President talking to Secretaries and Under-Secretaries and telling them to do this and do that. The overall impression was a lot of rhetoric and arrogance.
John McCain was only slightly better and certainly did not instill confidence in his vision for our economic future.
My view, persuade private money to manage the bail using the power of the US government as insurance, not funding. There is no possible logic that would justify using the US taxpayer to fund this bail out. In a previous post I talked about the real cause. Bad loans approved by financial institutions. Fix that first.
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