Good evening Free Money Wisdom readers! I thought I’d change it up a little bit and have a great friend of mine guest post on here. He is far more knowledgeable in the business realm than I am and will be giving his opinion on a wide range of financial topics in the future. Matt is one of the smartest guys I know. When I have a complicated finance question, I go to him. He’s been a great resource. He also runs his own blog at www.templeoffinance.com. His blog’s focus is analysis of the global markets. If you’re interested in more than personal finance, his blog is a great read.

With the after-effects of the mortgage crisis still affecting Americans today, I thought I’d have Matt give some insight into this topic. The following is a guest post on the groundwork that lead up to the mortgage crisis, and lessons America has learned. Enjoy! -JE

GOOD EVENING TO ALL AND TO ALL GOOD LUCK,

As we endeavor to summarize and analyze the economy in 2007 and 2008. Let us explore how, and perhaps more importantly, why financial institutions are so elaborately constructed. Have you ever thought about why you need to tell the manager at your local bank whether you own or rent when applying for a credit card? What other information may be pertinent in seeking a financial product?

What majorly explains this is the fact that banks use every piece of information possible in valuing their customers and making a judgment on the apparent risks presented. Now with our financial light bulbs warmed up, we can start the fun stuff! I feel the most effective way to present the following information based on the various financial institutions involved.

(FI) = Financial Institution

Subprime Mortgages

Let’s start with the mortgage originators. Mortgage originators are the financial institutions (FIs) that initiate the mortgage transaction. Mortgage originators are often not name brand banks such as Chase or Bank of America, but instead work behind the scenes. These mortgage originators work with the consumer (directly or indirectly) to determine appropriate rates and an amortization schedule (amortization = “killing” the mortgage).

In leading up to the mortgage crisis, regulation had become increasingly lax. There existed the idea at this time (1970s through the mid-2000s), that every American had the right to own a home, a part of the American Dream. The slogan of Fannie Mae (a government-sponsored mortgage lender) was “Our Business is the American Dream.” Augmenting this idea was the Fed’s removal of the interest rate cap in the 1980s, which meant mortgages could be charged at higher rates. After this, the Fed created the Tax Reform Act of 1986, which denied individuals from deducting personal loan interest and instead, encouraged the deduction of the home mortgage interest. In the 1990s, mortgage originators started creating the subprime loan for those individuals who didn’t qualify for prime rates. Subprime loans had varying definitions but for the most part shared in common that they were issued to individuals with a FICO credit rating of less than 620. Subprime mortgages typically charged the individual 200 to 300 basis points (2-3%) higher than the related prime rates. Subprime mortgages were often issued to low-income families not capable of fulfilling such obligations. One important aspect of subprime loans is that you could use them to refinance existing loans. This is important because it portrays the idea of overleveraging, a significant factor in the mortgage crisis. It is illustrated as follows;

-You decide to purchase a home and take out a 30 year 6% home mortgage loan

-After paying off the mortgage for 5 years, some of the debt (about 15%) has transferred into equity and you decide to take out another loan: a subprime home equity loan.

-This second loan holds the equity from the first loan as collateral.

-After paying off this loan, which is at a higher interest rate needless to say, you could even decide to get a third loan based off the second.

-This process continues and individuals could become very “stretched out” in this way

As time went on, subprime mortgages increased in number. Most subprime mortgages were based off of a low introductory rate and then transformed into a higher variable rate. In 2005, 72% of subprime loans were constructed this way. By 2006, approximately 20% of all mortgages were subprime and 80% of all subprime mortgages were securitized.

Securitization was the process of attaching a security to the loan or group of loans for the purpose of trading or holding these loans as an investment. Although some mortgage originators could choose to hold on to their issued subprime mortgages, most were sold to investment banks. Investment banks would then take the subprime mortgages and bundle and package them into special purpose entities (SPE) and special purpose vehicles (SPV). Many were bundled into more complex financial instruments, collateralized debt obligations (CDO) and collateralized mortgage obligations (CMO).

*If you saw the new Wall Street movie, “Wall Street: Money Never Sleeps” you will recognize many of these acronyms in Michael Douglas’ speech to the college youth and young professionals. I believe he stated (jokingly) that only 75 people in the world understand what all these acronyms refer to.

Looking back to CDOs and CMOs, these were financial instruments in which the separated the mortgages into “tranches” where there was a small amount, perhaps 10%, of highly rated (AAA) mortgages placed at the top. Then the rest of the mortgages were placed in their corresponding tranches according to their rating. This method of presenting a variety of debt appealed to all sorts of investors since it offered both high risk-high return investments as well as low risk-low return investments. After investment banks bought and packaged these mortgages, they would then sell the bundled products to both domestic and foreign investors: hedge funds, pension funds, et cetera.

The housing market is viewed as a bubble because as all these aforementioned parties profited from the housing market and specifically, subprime mortgages, the real estate market increased proportionately. The Fed could afford to increase interest rates to fight deter against inflation.

The housing market peaked in late 2005. Towards the end of 2007 is where the mortgage crisisstarted or became apparent, although its symptoms may have been predicted before this point. As one might expect with subprime mortgages, many individuals defaulted on their loans. In late 2007, the rates of the subprime adjustable rate mortgages (ARM) had increased monthly payments by an average of 30% compared to their initial rates. Later in January of 2008, 21% of subprime ARM mortgages were 90 days behind or in delinquency. There were even lawsuits taken against mortgage lenders. According to a 2007 Wall Street Journal article, one couple in Michigan filed a lawsuit against a Lehman Brothers broker, claiming to have been “confused and pressured” into signing a loan whose rate would increase to 17.5%. One mortgage broker’s opinion captured some of the ideologies of the time among mortgage lenders, “But legally, we don’t have a responsibility to tell him this probably isn’t going to work out. It’s not our obligation to tell them how they should live their lives.” It should be noted that, though individuals were at fault for imprudently accepting loans outside of their mean of living, they only account for a small portion of the mortgage puzzle.

The defaults first reduced the value of the subprime mortgage-related securities (CDOs). The credit agencies in turn downgraded these mortgage securities and this ended up hurting many parties who had contractual obligations, which I will go into more detail later. The investors who bought the securities ended up having to sell the securities at a loss or take a huge write-down on their investments. With the credit devaluations and the write-offs from investors and banks, this created a double negative effect on the perception of such securities.

New Century Financial

Over 150 prime and subprime mortgage lenders failed in 2007 with the pop of the real estate bubble. One mortgage originator in particular, New Century Financial Corporation, placed immense value of issuing as many loans as possible. New Century Financial sold its mortgages to investment banks at rates lower than the elevated subprime rates issued to individuals. All mortgages lenders were required to hold excess capital for the purpose of repurchasing their loans. The intent behind this was that they could be held accountable for their loans. New Century Financial would sometimes deposit additional collateral to their mortgage securities to offset the apparent, unavoidable risks associated with the subprimes. This process was called, “overcollateralization.”

Looking again at 2007, during January, New Century Financial had miscalculated its loan repurchase reserves since the 2^nd quarter of 2006. Amid a myriad of other problems during 2007 (both effect-related and symptom-related) including postponing its 10-k, failing to satisfy 70 million of 150 million dollars, worth of margin calls, and additional inaccurate accounting records. On April 2^nd, 2007, New Century Financial filed for bankruptcy.

There were many problems associated with New Century Financial. Two very significant ones were in that its loan quality had always been an issue. Employees were pressured to sell as many loans as possible to whomever possible. Management failed to address this throughout the entirety of their subprime mortgage operations. The second significant problem was accounting-related. Its repurchase reserves had been severely overstated, its lower of cost or margin accounting calculation in the valuation of its loans had been defective, and there were problems with its residual interest valuations. These topics are too detailed to be discussed here. The failure of New Century Financial was just another piece of the mortgage puzzle. What I’m stressing throughout this is that there were multiple parties at fault.

Bear Sterns

Bear Sterns was the fifth-largest United States investment bank in the beginning of 2008. In its history, Bear Sterns had developed a culture of being a hard-working bank for the street-smart types. This was supposed to contrast the Wall Street’s “white-shoe” investment banks. During the 1998 bailout of Long Term Capital Management (on which I hope to blog in the future), Bear Sterns was viewed as self-serving in opting not to engage in the Fed-encouraged bailout. It is important to note though that may not have reflected its philosophy at the time, but instead was a competitive strategy. During 2006, many banks bought out a great deal of the mortgage originators in order to be closer to the loan origination. Bear Sterns acquired EMC Mortgage, Merrill Lynch acquired First Franklin, and Morgan Stanley acquired HomEq Servicing. In 2004, 2005, and 2007 Bear Sterns was the leading underwriter of U.S. mortgage-backed securities (MBS). In 2006, it fell 2^nd to Lehman Brothers by a slim 100,000 margin. From 2005 to 2006, Bear Sterns increased its investments in mortgage-related special investment vehicle (SIV) assets by 15 billion dollars. Its financial instruments to be sold increased from 2004 to 2006 roughly by 25 billion a year and in 2007 roughly by 13 billion.

As the mortgage crisis set in, Bear Sterns was very heavily invested in the mortgage industry. It owned and operated two large hedge funds. High-Grade Structured Credit Strategies Fund and High-Grade Structured Credit Strategies Enhanced Leverage Fund. As the name of the second suggests they were high leveraged. These funds were able to borrow 60 dollars of illiquid CDO securities for every 1 dollar of their own money. This is about a 1.67% margin maintenance requirement. Compare this to 30-40% margin maintenance requirement most brokerages use now! During March of 2007, these funds suffered their first losses after their huge earlier returns during the boom. Bear Sterns attempted to transfer this leveraged debt/investment through the unsuccessful IPO of a holding company, Everquest Financial. In February of 2008, approximately 15% of middle-tier mortgages of Bear Sterns were delinquent by over 2 months or already in foreclosure. As investor’s demanded their money back, the two funds ended up going bankrupt in July 2008.

While it’s arguable that Bear Sterns had the chance to get rid of many of its worthless assets at a cheap price, it’s evident that it did not take advantage of this. January 2008 brought a 50% decline in its stock price. In the middle of March, the Fed extended to Bear Sterns a loan through JPMorgan Chase (JPMC) by which Bear would stay afloat. The idea behind this bailout was that letting Bear Sterns collapse quickly was a risk not worth taking, because the consequences were simply “unknowable.”

JPMC

JPMC was created out of a number of mergers over the years. Jamie Dimon was acting in his second year in command at JPMC and was instrumental in strengthening it for the coming crisis. In late 2007, stress test results caused JPMC to increase cash liquid to two years’ sufficiency. Dimon was also a strong advocate of conservative accounting and pushed to defer revenue until recognized, although JPMC sacrificed a few points on its ROE for this. Under management’s vision, JPMC avoided investing in or financing SIVs, which would carry pools of mortgages and other types of liabilities off-balance sheet. They did not believe the return justified the significant risks apparent. JPMC also avoided CDOs and CMOs because of the risks presented. Though JPMC did have some exposure to the mortgage markets through Real Estate Investment Trusts (REIT) and through its retail banking operations, Dimon helped JPMC to manage its risk throughout the crisis.

AIG

American Insurance Group’s role in the mortgage crisis was very significant, perhaps the greatest by certain standards. Speaking before Congress, Bernanke said, “If there is a single episode in this entire 18 months that has made me more angry, I can’t think of one other than AIG.” AIG issued credit default swaps (CDS) to investors to give them a hedge against loan defaults or devaluation of securities for other reasons. CDS works very similarly to insurance. The investor pays the CDS issuer (AIG) a predefined set of payments and in the case of a bad investment, the CDS issuer will refund the value of the investment back to the original party.

CDS were very popular with investors during years approaching the crisis. CDOs engaged in CDS to offset against the subprime risks. It was estimated that through financial modeling, 99.85% of the time CDS would not have to be paid out. In 2005, 20% of CDS were based off of subprime CDOs. During the third quarter of 2007, AIG started to experience problems. As a result of the downgrade of many CDO products by the three credit agencies, AIG had to post a considerable amount of additional collateral as backup to their CDS. This is since AIG’s auditor, Pricewaterhousecooper found a number of internal control problems within AIG, resulting in losses of 4.9 billion in AIG’s CDS portfolio. With the drastic increase in collateral among a host of other aforementioned market-related problems, S&P downgraded AIG three levels on September 15^th, 2008. This downgrade was the killing factor for AIG as they would be required to deposit an additional 14.5 billion in collateral to these CDOs, many of which would go bad. On the same day, the U.S. Government agreed to lend AIG 85 billion to keep it afloat, giving the government a 79.9% stake in AIG (this loan was later increased to 170 billion).

When this bailout is contrasted with the allowance of Lehman Brothers to go bankrupt, the Fed holds that AIG presented a much more systemic risk that would have affected everyone, even on a global level.

In conclusion, the mortgage crisis proved to be a huge learning experience for me. It seems to me that really no ONE party is responsible for the mortgage crisis. Individuals should not have bought unaffordable loans, lenders should not have been so greedy, the Fed should have had rules in place to keep lenders and insurers in line, investment banks should have done more due diligence regarding the mortgage securities, and investors should not have accepted the CDO securities so blindly. I guess all we can do in the future is to think about how people would have reacted in the past to our actions we take.