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Mortgage Musings

The Credit Crisis and the "Bailout" -- It's a Wonderful Life

October 1st, 2008 12:46 PM

Here is my explanation of the evolution of the credit crisis and what is behind the bailout, rescue plan, or whatever you would like to call it.

Homebuyers that had trouble qualifying for a loan purchased homes with subprime loans expecting to refinance as their credit improved or to sell the house at a profit in a rapidly appreciating market. Homeowners with credit problems or unable to document their income used the homes they owned as ATMs by refinancing with subprime loans to get money to invest or sometimes just to get by. Mortgage brokers and mortgage bankers originated these loans. Mortgage lenders underwrote and approved them.

The loans were then packaged as mortgage backed securities (MBSs) and sold by Wall Street investment firms to investors (banks and other institutions) worldwide as AAA securities as rated by the rating agencies. Mortgage lenders would be paid to service (collect the payments on) the loans they made while passing the principal and interest collected on to the investors that purchased the MBSs. With their supply of money to lend replenished, the mortgage lenders could then make more loans and continue to build their servicing portfolio, their main source of income.

The flaw in the system was that the default rate on the underlying loans that was used in rating the securities did not take into account the almost unprecedented deflation of property values that has occurred. One key to understanding this mess is to understand how these securities are valued. This is where things get tricky. Many factors influence the value of an MBS. For example, the yield which is the amount of interest paid on the principal affects the value of an MBS. If the interest rate on the MBS is greater than current interest rates, that security might sell at a premium. If the rate is lower than current rates the MBS would need to be discounted or sold at less than face value to be attractive to investors. But this presumes that all the loans in the security are repaid. What if some of the MBS's homeowners don't repay their loans? The servicing lender forecloses on the homeowner and sells the property to try to get as much of the loan's principal back as possible. If property values are increasing then more of the principal of the loan is recovered. Additionally the more property values are increasing the less the number of foreclosures, since if a borrower cannot make their payment they might be able to sell the house at a profit instead of letting the mortgage lender foreclose. When the sale of the foreclosed home doesn't pay back all of the principal, that loss comes out of the investors yield, making that security less valuable.

As property values drop the default rate on the securities increase and the value of the security continues to drop. Not every loan in the security may be in default, but using the current deflation rate in property values predicts that many loans in the security might default in the future. Even then, not every loan will default and those that do will have the property sold to mitigate the loss as much as possible. These are the factors, along with the yield, that determine the market value of the security today. As these factors change, for example a stabilization in property values, the value of the security changes. Just like property values can not continue to go up indefinitely, they can't continue down indefinitely either.

The problem lies in what assumption to make about property values. To conservatively estimate their value today requires using today's rate of decrease in property values in the equation. IF property values were stable or increasing, these securities would be worth more than they are currently.

So based on the presumption that property values will stabilize or increase in the future, these securities are worth more if held to maturity than if an investor had to sell them in today's MBS market. But due to the recently instituted accounting rule called "mark-to-market" an investor holding these securities (say a bank) must put the current value of the security on their books as if they had to sell them today, not the held-to-maturity value. Hence the large write-downs that are occurring. These write-downs can make a firm insolvent based on the premise that IF the firm had to sell the security today and not wait and hold them to maturity, then the firm's assets would not be enough to cover the firm's liabilities and therefore they would be bankrupt, even if it isn't necessary for the firm to sell the securities in today's depressed MBS market to continue operating. One possible solution is to change the mark-to-market accounting rule and let banks and investment firms that hold these securities use the "held-to-maturity" value instead of their value if sold today.

The premise of the so called "bail out" or "rescue plan" is that the government will step in and make a market for these securities by purchasing them from the ailing firms. The firm's (bank's) books look better and a market is created for MBSs making for more liquidity and, just by the law of supply and demand, increasing the value of the securities. As this relieves the strain on lender's books they are able to lend money again and the credit market may return to a more normal state.

The government is not bound by the mark-to-market accounting rules and can either hold the securities to maturity or sell them in an orderly manner in the future as property values stabilize and the market value of the securities increase. This presumes that property values stabilize or increase in the future. Of course the devil's in the details. For example, how will the price or value of the MBSs the government purchases be determined?

So what does this have to do with "It's a Wonderful Life?" Remember how George Bailey, played by Jimmy Stewart, responded to the citizens of Bedford Falls when a financial panic created a run on the Bailey Building and Loan?

http://www.youtube.com/watch?v=Ba8id0Q7UkQ&feature=related

While oversimplified and maybe even a little corny it does point out one important thing, we're all in this together.

What are mortgage backed securities? They are American homeowner's promises to pay back money that they borrowed with their homes as collateral. Who receives the interest paid on these debts? Investors.

Who are these investors? Do you have a 401K? Then you are an investor. Do you have a checking account, a savings account, or a money market account? Then you are an investor. Do you have a pension? Then you are an investor. We the American public are the debtors, but we are also the investors. Maybe George Bailey had it right, let's not panic, but pull together as a community to solve this problem.

Posted by Harlan M. Cooper on October 1st, 2008 12:46 PMPost a Comment (1)