Thought #14
March 2009
Author: Bill Thurston
How the Mortgage Market Works
It starts with you. Your home mortgage is a debt you owe to a
lending business who loaned you money to buy your house. You write a "check"
to the lending business monthly until the term of the loan is completed,
then you own the home.
It then gets complex because your lending business usually
sells your mortgage to someone else. Here is how that works.
There is five parts to the mortgage market.
1. There is you,
the person taking out the loan and enjoying a home that is owned by someone
else until the loan is paid off.
2. There is the
mortgage originator. This is the business that gives you the loan which
resulted in you getting the money to pay the seller of the home. The
mortgage originator now has less money, because of buying your home, but
will make a nice profit from you over the period of the loan. The profit
will come from the fees you were charged when you took out the loan and the
interest you will pay over the period of the loan. The mortgage originator
has several issues to consider after making the loan.
You might default on your loan. Your house might decrease in value.
The mortgage lender has less money to make new loans. But there are buyers
out there that will buy the mortgage from the mortgage originator.
3. These buyers of mortgages are called
aggregators.
Aggregators view your mortgage as a source of money to them as you make your
monthly payments. But the aggregator doesn't want to take on the same type
of risks as the mortgage originator so the aggregator is going to sell your
mortgage again. The aggregator bundles up many different mortgages into
something called a mortgage-backed security (MBS) and sells all or parts of
the bundle to a securities dealer.
Aggregators make money from the difference in the price that they pay for
mortgages and the price for which they can sell the MBS.
4. Security Dealer
buy MBS from aggregators and sell them to investors. Examples are
Independent firms (like Paine Webber, Goldman Sachs, Merrill Lynch!!!),
Freddie Mac, and Fannie Mae. Dealers make money from the difference in the
price at which they buy and sell MBS, and look to make arbitrage profits in
the way they structure
mortgage-backed securities (MBS), asset-backed securities (ABS),
collateralized mortgage obligations (CMO) and collateralized debt
obligations (CDO).
5. Investors
are the end users of mortgages by buying the MBS. These investors generally
are very large businesses. Examples are insurance companies, pension funds,
foreign governments, banks, hedge funds, and Fannie May and Freddie Mack.
Investors make their money by buying the securities and receiving a cash
flow for a specified period of time. The investor is happy when the sum of
the cash flows greatly exceeds the original investment.
That's it!
If you want to be an expert on this market, it gets very
complex but it's just variations on the way mortgage originators,
aggregators, and security dealers slice and dice your mortgages to make
profits.
Some thoughts:
First Thought
Your mortgage provider provides a great service to citizens
so they may buy a home. Few citizens can buy a home with their own cash. The
rest of the mortgage market exists to make money for themselves by skimming
money as they move your monthly house payment to investors.
Second Thought
Investors are making a high risk, high reward decision when
buying mortgage backed securities. When the economy is growing and everyone
is making their monthly payment on their house, very large investors,
insurers, bankers, aggregator, security brokers, and foreign governments are
happily getting richer. When things go bad, and housing prices drop, the
economy tanks, and people don't pay their house payments, the mortgage
market companies and their investors lose massive amounts of money.
Government bailout money to support this market when their high risk
behavior fails them only breeds continuing bad behavior.
Last Thought
How does the government get into the act?
The United States Congress can create corporations called
Government Sponsored Enterprises(GSEs).
We know some of them well by the names Fannie Mae (created in 1934)
and Freddie Mac (created in 1970). Their function is to help lower income
folks on "Main Street" buy homes with money from "Wall Street". These
entities are by far the largest players of all mortgage investors.
Fannie and Freddie are
exempt from state and local taxation and from registration requirements of
the Securities and Exchange Commission. Fannie and Freddie have a back-up
credit line with the U.S. Treasury.
The federal government also allows
Fannie Mae and Freddie Mac to issue corporate debt at yields lower than
other institutions.
The federal government possesses warrants that would allow them to buy
almost 80% of Fannie and Freddie.
Five of the 18 board of directors at
each company are appointed by the president of the United States.
But Fannie Mae and Freddie Mac mortgages or securities aren't guaranteed by
the federal government as stated in the law!
Let's not be silly here. This is one of the best non paper guarantees in the
history of the world. We recently saw the guarantee in action when we, the
citizens, bailed them out. I guess what we really did was to give money so
homeowners wouldn't default on their mortgage loans and by no defaulting on
mortgages, the investors are "guaranteed" their payments.
Last but not least, investors look at a corporations ratings to help them
determine the risk of investing with the corporation. Standard & Poor's ( a
corporate rating company) still gave Fannie and Freddie the highest rating
(AAA) even after they were
placed in conservatorship by their regulator, the Federal Housing Finance
Agency (FHFA).
http://www2.standardandpoors.com/spf/pdf/events/FannieMaeFreddieMac.pdf
.
When looking for the causes of the mortgage crisis, take a hard look at our
own government. When the federal government shores up bad behavior in the
market for an extended period of time, the correction may be delayed but
will still happen and when it does happen it is more severe.
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