40 year old David Thomson, a librarian at the Fort Lauderdale Public Library, slowly shuts the door of his 3 bedroom bungalow, for the last time. The house, in a largely middle class suburb of Fort Lauderdale City has been home to him, his wife and 2 children for the last 5 years. Behind him, the CTS Bank official is nailing a Foreclosed Sign on the front lawn. The Thomson family immediately becomes a statistic: one family out of the 1.2 million residential home foreclosures so far in 2008. 3000 miles away on Wall Street, Bryant Weill, a hedge fund manager at Bear Stearns, shuts the door to his corner office for the last time following the financial collapse of the X year old firm. He drives back to his $1 Million mortgage free home in his S Class Mercedes Benz to tell his wife that he is now jobless. David and Bryant have never, and will probably never meet each other in their lifetime, but their lives are inextricably intertwined in a financial web so convoluted as to almost bring the global financial wheels to a halt.
The US mortgage market is multiple strata cake, beginning with the mortgage borrower such as David Thomson, who walks to his bank that forms the first layer termed as a primary mortgage provider, CTS Bank. David’s bank has one principle objective: to make money and by lending money to David, ties up valuable liquidity in a long term loan. To release this liquidity to enable more lending, the bank goes to the second layer, a secondary mortgage provider (such as Fannie Mae), who buys its mortgage loan book at a discount. A simple example would be $100m worth of mortgage loans would be sold at $90M, a price of 10%. The bank sells the right to receive the interest and principal on these loans to the secondary mortgage provider and in return receives $90M of cash that it can use to lend out again.
Enter the ubiquitous Wall Street Players as the third layer. Investment banks take a number of the mortgage loan books that the secondary mortgage provider has purchased and packages them into a security known as Mortgaged Backed Assets (MBAs). Wall Street monetizes the credit spread between the original mortgage taken by David Thomson and others like him and the yield demanded by bond investors through the bond issuance of the MBAs. The MBAs will therefore have several thousand underlying mortgages that have been packaged into the instrument. The icing on this jelly based cake are the institutional investors such as banks, hedge funds and insurance companies who have bought the Mortgage Backed Assets
The pricing of these assets takes a variety of elements into consideration such as the underlying borrower credit risk (in this case David Thomson’s capability to repay the loan), interest rate risk – the very real risk that if interest rates drop David Thomson will want to refinance his loan at a lower rate of interest, and prepayment risk – where David, in a lower interest rate environment can get a lower fixed rate loan from another bank and uses this to pay off (prepay) CTS Bank. To compensate investors for the prepayment risk associated with these bonds, they trade at a spread to government bonds. By first quarter of 2006 there were $6.1 trillion of traded MBS in the market.
So how did the cake start to sink? The financial innovation of the American retail financial industry led to the creation of sub-prime mortgages that were encouraged during the Clinton administration which began to put pressure on secondary mortgage market players such as Fannie Mae to expand mortgage loans to low and moderate income borrowers, who did not necessarily have a good credit history. Sub-prime borrowers are individuals who have a weak credit history and the lending bank does not perform verification of assets or income when lending. Subprime borrowing was a major contributor to an increase in home ownership rates and the demand for housing. The overall U.S. home ownership rate increased from 64 percent in 1994 (about where it was since 1980) to a peak in 2004 with an all time high of 69.2 percent.
Between 1997 and 2006, American home prices increased by 124%. Some homeowners used the increased property value experienced in the housing bubble to refinance their homes with lower interest rates and take out second mortgages against the added value to use the funds for consumer spending. U.S. household debt as a percentage of income rose to 130% during 2007, versus 100% earlier in the decade. Overbuilding during the boom period eventually led to a surplus inventory of homes, causing home prices to decline beginning in the summer of 2006. Easy credit, combined with the assumption that housing prices would continue to appreciate, had encouraged many subprime borrowers to obtain adjustable-rate mortgages (ARMs). These were mortgages that would have low teaser rates for borrowers, some even offering zero interest for one year. What was hidden in the fine print was that the loan repayments would triple and in some cases quadruple by the time the second year of the mortgage arrived. One borrower moved from paying $350 per month for her house to $1500 per month by the second year! Many homeowners were unable to re-finance and began to default on loans as their loans reset to higher interest rates and payment amounts.
The numbers are simply mind boggling. In a $12 trillion mortgage market by August 2008, 9.8% of the loans were in default and over 8.8 million homeowners had seen the value of their houses drop below the mortgage value. With over 1.7 million mortgage foreclosures in 2007, housing prices continued to tumble in 2008. The situation was further exacerbated by re-adjustments of Adjustable Rate Mortgages as per the fine print, and loan repayments shot up beyond borrower’s disposable incomes. David Thomson and many like him chose to walk away from their houses, finding it easier to pay rent than to pay a mortgage for $500,000 when the house was valued at $250,000. The institutional investors (both American and international) that had bought the mortgage backed assets suddenly found that they were holding useless securities, as there were no payments being made by the borrowers thereby ensuring that the interest –and most likely the principal- payments would not be received. The global inter-bank market subsequently imploded as Banks did not know each other’s exposure to the assets and whether the borrowing bank would have the liquidity to repay the inter-bank loans.
Without liquidity, banks cannot lend to their customers and they began falling like dominoes, 150 year old Washington Mutual declared bankruptcy in September 2008 and the US Government paid over $85 billion dollars to acquire a 79.9% stake in the world’s largest insurer AIG that had significant exposure in mortgage related securities. Investment Banks such as 80 year old Bear Stearns and 158 year old Lehman Brothers, who were the arrangers and underwriters – banking speak for guaranteeing the sales of- the securities had their entire capital bases wiped out as institutional investors furiously back pedaled and demanded their money back. This resulted in the investment bank’s shotgun purchases by competitors. And for the first time since the Great Crash of 1929, capitalism took a beating and Western governments beginning with the US, followed by the UK and Germany, stepped in to bail out and some may even say nationalize cornerstone institutions. Karl Marx must have rolled in his communist grave with vindication!
So as Bryant Weill starts forming the conversation in his mind that he will have with his wife about how they now have to live on his $5m savings made from his bonuses from superb sales of mortgage backed assets, David Thomson, whose savings were wiped out to pay off a paltry amount of the mortgage, drives away to his 2 bedroom rented apartment berating himself for the umpteenth time for listening to the smooth talking mortgage advisor at CTS Bank, who promised that the Adjustable Rate Mortgage would not change his life. And by August 2008, financial institutions globally had chalked up over $501 billion in losses. The Goliath global financial industry was brought down to its knees by the mwananchi David who only aspired to own his own home.