Financial Marketplace

Killing the golden goose.

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.

  1. 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.
  2. 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.
  3. 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.

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Monday, September 29th, 2008 2008 Presidential Campaign, economy debate No Comments