I’m sure you know by now there is a major crisis in the mortgage industry, but if you don’t really know what the fuss is about other than it’s something bad, here is a layman’s explanation in plain English of what the HELOC is going on.
What Exactly Are Subprime Loans?
First, what is a subprime loan? Wikipedia defines subprime debt as loans to borrowers “who do not qualify for the best market interest rates because of deficient credit history”.
Why would a lender ever want to lend to such a cad?
The answer is simple, When real estate is hot, it doesn’t matter if the borrower gets behind on payments. Why? Since the house is appreciating, the borrowers can simply borrow more by refinancing or getting a second mortgage (even with a record of late payments), OR, the borrowers can sell it very quickly and the lender will get paid off then.
Even if the borrower becomes unable to physically refinance or sell (serious accident, drug problem, deceased with no heirs, etc) and the property goes to foreclosure sale (extremely rare in good markets), investors swarm over the foreclosure sales like sharks in a feeding frenzy to buy the property and the lender gets paid in full.
…this is why 2005 saw one of the lowest foreclosure rates in history for California
…After a few years of making big bucks (really big bucks) in subprime, all the lenders jumped on the bandwagon (read: greed).
This created an “upward spiral” because people who would never qualify for a house were getting approved, which increases demand for houses which causes values to skyrocket, which protects the lenders, allowing then make even more loans……and so on and so on and so on.
Final Answer: 1) There is virtually NO risk (as long as the market is hot!) for the lender because of the above reasons, 2) they get to charge very high fees and interest because the borrower has spotty income or credit.
How exactly does a mortgage company make money?
As the starting point, let’s look at the journey of a typical mortgage.
John and Mary wish to buy a house, so they go to a local lender/mortgage company or broker. A wholesale lender funds and closes the loan, and the borrowers make their monthly payment to this lender.
The loan is barely originated when the mortgage company sells it like a hot potato to replace the money they just lent out so they can lend the money out on another mortgage. They do this over and over.
Fannie Mae and Freddie Mac
Remember how we just said that these subprime loans were returning incredible rates of return and seemed to never go bad because the market kept going up like it would never stop?
..Well, the guys who wear pinstripe suits and work on Wall Street aren’t going to let those kind of returns get by them! Huge investment companies that create investment funds (mutual funds, insurance products, 401(k) plans, etc. – the kind of stuff we’re supposed to invest in for retirement) buy up (sort of, you’ll see) all those mortgages. This is called the “secondary market” for mortgages.
However, can you imagine billion dollar companies trying to buy little $250,000 mortgages and keep track of them? That would be like going to the bank to put $10,000 in savings and having to put $50 in 200 different accounts all with different interest and maturity dates!…it would be impossible!
So, publicly owned (not government) companies called Fannie Mae and Freddie Mac buy these mortgages and bundle them up into big giant mortgages called mortgage pools. These pools usually contain $50 million dollars worth of mortgages in them.
Then, they sell what amounts to big million dollar “I.O.U.s” to those Wall Street guys, and the mortgages are the collateral (these are called mortgage backed securities). Wall Street can then buy, sell, and trade those securities easily, just like a stock.
This makes it possible for big financial companies to invest in (not actually buy- but it amounts to the same thing) billions of dollars worth of mortgages, and that helps us because the competition for our mortgages keep our rates low. Mae and Mac make it possible for the mortgage companies to quickly and easily sell the mortgages off so they can make new ones, and this is a good thing.
Why Then Are Our Mortgage Payments Made To The Mortgage Companies?
That’s because these mortgage companies are actually just servicing (collecting the money and keeping track of payments after they sell them). They really don’t own them anymore (unless they got stuck with it after the meltdown and the secondary market turned its back on them).
What Happens When The Market Finally Stops Going Up? (scary music)
All the factors previously mentioned that made subprime loans “safe” no longer apply. Now, John and Mary cannot take more money out of the house, they can no longer sell quickly, AND if it goes to the foreclosure auction investors are no longer interested. When investors don’t show up to the foreclosure auction, the lender now gets the property back.
In Southern California in 2005, there were 3,000 foreclosure sales, almost none went back to the bank. In 2007, there are estimated over 50,000 foreclosure sales, and MOST of them will go to the bank. (100,000 in 2008?). See a chart of foreclosure sales in Southern Cal by year here:
http://farbelowmarket.com/trustees-deeds.asp
Can you imagine the losses all those Wall Street investors incurred buying billions of dollars worth of those I.O.U.s when the payments stop coming and the mortgages that back them up are becoming worthless?
Why Are So Many People Defaulting On Their Loans And Losing Them To Foreclosure?
Let us count the ways:
John and Mary lied about their income/credit history.
The mortgage companies made it easy for them to lie (i.e. “stated income” loans).
The mortgage company/broker lied about John and Mary’s income/credit history.
Low teaser rates allowed John and Mary to get a really low payment (for awhile).
John and Mary got 100% financing. Half of the first time home buyers had NO down payment…”Can’t pay, walk away”…it’s not like they put their life saving into it.
Fannie Mae, Freddie Mac, and the Wall Street gang all turned a blind eye because the returns were so good, kept buying the loans, which gave the mortgage companies a reason to keep making more and lying about them.
House values stopped going up – no more 2,000 square foot adobe ATM machine.
Very little demand- John and Mary can’t sell. Even with a willing buyer they owe more than what the house is worth so they can’t sell without putting money IN!
What Happens When So Many Borrowers Don’t Pay?
Yikes! (Really Scary Music)
The mortgages become almost worthless, causing massive losses to the investors.
Investors have less money to invest, not just in mortgages (but ESPECIALLY not in mortgages!).
There goes our beautiful secondary market. Wall Street slams shut their wallets.
With no secondary market, the mortgage companies can’t sell their loans to make new loans (well over 100 national lenders bankrupt in 2007).
The mortgage companies can’t make any new loans so families looking to buy a new house need very good credit, regular income, have a big down payment, and be able to PROVE it this time.
This causes the pool of qualified buyers to evaporate.
Lenders get MASSIVE numbers of properties back which they immediately must put on the market. Drastically MORE houses, drastically LESS buyers!
*Banks have no choice but to sell houses for huge discounts to free up cash * (there’s a reason this statement is in red!)
Bob and Sally, who did not go into foreclosure, have to drop the price of their house drastically to compete with the banks.
Bob and Sally don’t feel as rich, so they stop spending (called the “Wealth Effect”).
The massive real estate industry (mortgage brokers, agents, escrow company, moving companies, builders, the workers they hire, the office space demand, their staffs, etc. etc.) take a hit and have less money to pump back into the economy.
As the economy suffers, more John and Mary’s make less income and can’t make their monthly payments!…can you say, “downward spiral”?
Not Pretty. This one is by far the worst. If it wasn’t for the government pumping in over a cool billion dollars, the whole thing would have shut down. If you would have had a house in escrow in the summer of 2007 there is a very good chance it would have never closed.
This cycle feeds on itself until houses fall to such crazy low prices Bill and Steve (Palm Springs) decide real estate looks pretty good- other potential buyers that were on the fence follow suit, demand rises, euphoria ensues, and prices rage out of control as people step over each other to buy real estate (unfortunately not anytime soon!).
Then, anyone who didn’t buy early decides everyone else is getting rich, buys too late and becomes the next John and Mary!!
This may be a over simplified, but it gives you an idea of how the cycle works.
…Next, how to capitalize on what is happening and buy from these deals from the lenders as the great “unloading” begins.
Be Happy and Prosper,
Kurtis
Tags: FarBelowMarket.com, Flipping, Foreclosures, Kurtis and Cindy Squyres, Learn How To Wholesale, REOs
August 11, 2008 at 3:30 am |
Here is a list of Banks that may fail and go bankrupt.
http://bankruptbanks.blogspot.com/
October 19, 2008 at 8:42 pm |
Hi Kurtis,
Oh my gosh you are soooo right on!
I feel this is such a good lesson to all of us, I now am studying the market and know it well at least around my area as well as trying to keep up with the world market.
Speaking of which, I didn’t realize this was not just the US, it is having an effect on so many other countries. As what they have done to loan the US money and in turn if we can’t pay, in turn they have less money to work with in thier country economy.
Did you know there is a country (near Iceland) where their dollar is worth nothing right now, that is scary!
I really feel for those who are hurting right now I was there in 1987, I am exited about the market (is that a bad thing ot say?).
I spend alot of time with my 89 year old Auntie Kitty, who lived through the great depression of 1929, says “you will see this again in your life time, things will go up and things will go down, you just have to make the best of it”. She is so full of wisdom I love spending time with her.
Thank you Kurtis for all your wisdom and spending the time to keep us posted.
Have a great and prosperous day,
Mary