Failed Mortgages

In the currect economic crisis, I have a few thoughts on credit default swaps, the types of mortgage products on the market, and finally, how to save the homes of millions of American families.

First, the credit default swaps that led to banks being over extended need to be regulated like insurance. Because they are insurance.

In short, banks who owned mortgages were putting them together and selling the mortgages as securities. Unlike some bonds, which are just debt, these mortgage-backed securities looked like a good deal. After all, unlike most government or corporate debt (bonds), there was an actual house with an actual person paying the note on that house. But many of the people buying the mortgage-backed securities were weary of this type of instrument. Why? Because if you look at the types of mortgages that are being advertized, you start to wonder if you really want to own that mortgage. For example, people can now buy homes with an adjustable rate mortgage that can balloon up to 12 or 15 APR. Or, they can borrow 110 to 120 percent of the home's value. Or, they can have an interest only loan where both the interest balloons AND the principle gets added in a year or two after the note is signed.

So, back to the nervous investor. The banks who sold these mortgage products cannot hold the mortgage-backed securities themselves because they need the capital to make new loans. I am speculating, but I also beleive that they did not want to hold too many of their own mortgages either. Therefore, they could sell these mortgages to investor only if they gave the investor an insurance policy guaranteeing that if the mortgages go into default, that the bank will cover the losses. But therein lies the problem, if you call this insurance, the bank is going to be forced to keep a great deal of cash on hand to cover the potential losses. Instead the banks call it a credit default swap. That way it does exactly what insurance would do, but the banks did not have to keep enough cash on hand to cover the losses.

Once mortgages started to fail and banks were forced to pay the investors to whom they had sold insurance (credit default swaps), they started to fail. The banks simply did not have enough money to operate after paying off all of the investors whom they had insured.

This is why the credit default swap is insurance, this is why almost every bank in the US got caught with extremely low cash reserves (or deficits), and this is why credit defaults swaps must be regulated.

Next, I would like to address the types of mortgage products on the market today. I am no expert here, but I have done some research since I am a home owner.

When my wife and I bought our first home seven years ago, we were offered a twenty or thirty year fixed mortgage. This seems vanilla in retrospect, because over the last seven years I have seen any number of 'mortgage products' that do not make much sense. The adjustable rate mortgage (ARM) can only go up. I have never heard of someone's mortgage payment going down because an ARM. Intuatively, it doesn't make sense that a bank would ever loan you money and then discount its return later by reducing the interest rate on the loan. So an ARM can only go up, and sometimes that is a heafty increase. For example, if you took out a $200,000 loan at 5.57 APR over 30 years, your payment (not including taxes) would be $1,167 per month. If that is a fixed APR, you probably would be fine. But if this was an ARM and your interest rate went to 12 APR, all of the sudden your monthly payment is $2,057. Almost twice as much. Some ARMs go even higher.

The dirty little secret of the banks selling these mortgage products, however, is not that the ARMs go way up. It's that the debt to income ratio for a potential borrower is based on the initial fixed rate and not on the potential rises in the ARM. So, many families who could afford the six percent rate of their mortgages legitimately qualified for those mortgages. This mortgage crisis is not predicated on families being over-extended because of the initial mortgage rate.

Banks and investors knew that the debt to income ratios were going to be a problems when the ARMs started to increase. After all, the banks selling these ARMs knew that if they ran the debt to income ratios at twelve percent or higher that their models could predict mortgage defaults en masse. To sell these potentially toxic products, the bank had to give insurance.

A number of banks, most notably Bank of America, were sceptical of ARMs. They ran the numbers and knew that it was not a market that they wanted to participate in. As a result, BofA and a few other smaller national and regional banks are actually doing fine in the current climate because they never had to offer insurance/credit default swaps in order to induce investors to buy their mortgages.

The final topic of this entry is focused on how to stop the mortgage defaults. The answer is to unilaterally amending the mortgage contracts to thirty year mortgages and setting the APRs to three, four, or five percent. The percentage rate that the government sets will decide how many people get to keep their homes. The lower the rate, the fewer mortgage defaults, and the more people who benefit. Higher rates mean more defaults, but even at five or six percent, the mortgage default rates would fall a great deal.

The reason the mortgage default rates would fall is simple math. Assuming a $200,000loan is fixed at thirty years at three percent, the payment would be $843 per month. At four percent, $954. And at five percent, a home owner's payment would be $1,073. For hundreds of thousands of home owners around the nation, their payments would go down by thirty to sixty percent.

There are a couple of arguments against the government unilaterally changing the APRs on mortgages that are in default. One such argument is from home owners who are not in default, who did not purchase a risky mortgage that was going to double in two or three years, and who do not want people to get a bailout and have a lower APR on their mortgages. And I see their point, I really do. After all, I am proposing that the government give a lower APR to people in default than I have on my own mortgage.

Similarly, many people who have supported the bailout package by Congress do not support actually helping individuals whose mortgage default is actually creating this financial crisis. This argument is disengenuous, however, because it ignores that fact that individual investors are going to be helped. Unlike the individual homeowner, most forget that there are individual investors who are being helped by this bailout. My best argument here is a rhetorical question: Why are individual investors worthy of a bailout and not individual borrowers?

If nothing is done to ebb the tide of mortgage default, we will have "Suburban Ghettos". There will be entire neighborhoods with many or most of the homes in foreclosure. Once that happens, none of the homes that are not in foreclosure in the Suburban Ghetto will have any real value. So long as the owners of those homes keeps making payments, there's not a problem. But, assuming that home owner ever wants to sell, move, or refinance, the Suburban Ghetto will be devastating even to the homeowner who made his or her mortgage payments. If the mortgages that are in default are not saved, within months we could have empty homes all over this nation that will detract from the value of every other home in every housing economy.

The government appears to be ready to purchase a large portion of the mortgages that are in default. As a result, the government is going to end up owning all of the homes that are empty in the Suburban Ghettos. I have very little doubt that this will increase the government's exposure when the government has to turn around and update, moderize, and fix homes once they've been sitting empty for years on end.

There have been micro examples of Suburban Ghettos in California, Ohio, Florida, and many other states. This trend must be stopped, and the only reasonable means of fixing it is to keep the current home owners in their houses with a mortgage payment they can afford.