A Crash Course in Mortgages
How they Work, Why they Failed, and What Consumers Should Do Now
Jun 29, 2007
Consumers looking for new loans or looking to refinance old loans will now have even more hurdles to climb. Recent loan news has been downright terrible. Two Bear Stearns Hedge funds almost collapsed under the weight of bad subprime loans. Furthermore, in the last couple of days the government has asked banks to tighten their lending standards on all loans. For consumers this spells trouble.
A Crash Course on the Mortgage Market
The mortgage market is far more complex than many consumers might think. While the process begins with the consumer obtaining a loan from the bank, it does not end there. The bank takes that loan and a bundle of others and sells them at a discount to investment banks (like Bear Stearns). Investment banks then package those loans into bonds, which they sell to investors looking for higher interest fixed returns.
When this process works smoothly it is a win for everyone. Consumers win because they get easy access to capital at fairly cheap rates. Banks win because they pass off their loan risk to investment banks. Banks also can lend more because each loan they sell provides capital they can lend to someone else. Investment banks win because they get a healthy fee from banks and investors for providing their service. Investors win because they get high rates of steady return.
How the Mortgage System Failed
This system failed at the consumer and banking end of the equation. Bank were simply too aggressive and lax in their lending practice. Consumers, who should not have been able to qualify for loans, were approved, but not able to make monthly payments. This caused a spike in the default rates on loans.
Unfortunately this default spike coincided with a dip in the real estate market. Once real estate values decreased below some loan values, banks begin to take loss on these loans. Remember, however, that these loans have been sold to investment banks and investors. The ultimate losers were the holders of the bonds linked to the subprime loans. Investors quickly lost their appetite for these types of financial products, leaving banks no way to take the risk off their books.
The lenders that continued to lend despite this quickly found themselves bankrupt. At least 86 mortgage companies have gone out of business since the subprime market faltered. Most lenders decided to simply tighten their credit standards and no longer carry subprime products.
New Borrowers and Borrowers Who Refinance Face an Uphill Battle
Expect rates to continue to rise and tougher standards. Loans consumers were able to qualify for six months ago may now be off limits to them. Home sellers should also expect a ripple effect into the real estate market. With fewer buyers being able to qualify for loans, real estate prices should come down significantly. Consumers’ best course of action now will be to wait out this storm. If obtaining a new mortgage or refinancing cannot be delayed, shop around. Sadly, consumers must go into this process with the understanding that it will be tougher than ever before.
