Some Financial World Basics
I’m certainly not an economist, but I did stay at a Holiday Inn Express last night! (Just kidding!) Actually, I had a couple of economics courses in college, but that doesn’t exactly qualify me to be Federal Reserve Chairman. Then again, if living next door to Russia qualifies Sarah Palin to be vice president, hey... Federal Reserve, here I come! Just to give something of a basic explanation as to what is going on in the economy and financial world, here’s a little info, but it is only very basic and should not be construed to be all encompassing. The overall financial world is VERY, VERY complex, and even people who are involved in Wall Street don’t understand all of the various aspects of finance.
Years ago when a person got just about any kind of credit, that business held the note or agreement until it was paid. Back then, individual store accounts were common. If you shopped at such and such a department store, chances were you had a credit account there, too. The store (or the department store chain) carried their own credit accounts. If you got a mortgage from such and such a mortgage company (usually they had a bank affiliate that actually loaned the money), they sometimes held the note you signed giving the repayment terms, but with mortgages, they did often sell them to companies like Freddie Mac or Fannie Mae, the two companies that recently collapsed. They sell the mortgages to free up money to make more loans.
In more recent times, mortgages are written and then often times immediately sold. The basic idea and procedure being that “Mortgage Company XYZ” got you to take out the loan, they checked you out for credit worthiness for the amount you needed, they took care of all the paperwork, and then, after you signed on the dotted line, they sold the mortgage to someone else. A mortgage is just another word for a loan, but it is typically secured by the property that is being bought. In even more recent times, mortgages have been “bundled” into packages to be sold, or used as collateral. With the ongoing financial difficulty lately, you may have heard or read the term, “CDO.“ That is what these “bundles” of mortgages are, “Collateralized Debt Obligations.”
Example for mortgages and just about any kind of loan today:
I come to you to with hat in hand... I mean to borrow money; say $10,000. You do some kind of check on me, and either say “yes,” or “no.” If you give me the loan, I sign on the dotted line saying that I‘ll repay the $10,000, and so much more in interest over some specified term. Then you more than likely put my loan together with other loans, perhaps as many as thousands, and you sell the “bundle” to some investor, or more likely, some form of group of investors (banks around the world have bought or loaned money against these). They pay you a specified amount, freeing up money for you to loan out to someone else. They may turn around and sell this bundle to someone else, or they may use it as collateral to borrow money for whatever purpose. I hope you’re with me, so far.
So, now you’re saying, “Well, so what’s all the fuss about, then?”
First, there’s no easy answer to that question, because there are undoubtedly many reasons for what has happened, but I’d say there are “probably” two main things that have taken place with mortgages (forget about other types of credit, for right now). First, some mortgages were given without the originating company having done much to limit risk; that is, they didn’t check out thoroughly whether the person was a good credit risk. Now, when you loan money, there’s always risk, because lots of things can happen over a given period of time, especially for mortgages, which typically are written for thirty years. Anyway, as some kind of jokingly say, “They gave mortgages to anyone capable of writing their name, and got witnesses for those who could only make a big 'X.' " Often times, too, these mortgages carried very high interest rates, or had provisions that allowed the lender to raise rates after such and such a time.
Second, some areas of the country have been especially hard hit by jobs losses in more recent years, often times, but not always, in manufacturing. When these folks signed for a mortgage, they were very credit worthy. When they lost their jobs, that was it. Ohio, Michigan, Indiana are some of the states that fall into this category. Often times too, when interest rates were extremely low (post 9/11), many people who had existing mortgages refinanced them at lower rates, often times taking some cash out for some purpose, or they took out home equity loans. Again, once they lost their jobs, that was it.
So now we’ve got all kinds of “bundles” of mortgages that have been sold or used as collateral. Gradually, more and more people couldn’t pay their mortgages, resulting in defaults on many loans. Banks began to foreclose on these properties. The number of these cases escalated so much, that with so many foreclosed properties put on the market, that new or existing homes sales fell, and many folks had to lower the price of their property in order to sell it. (Now, in more recent months, IF they can even sell it!)
Guess what happened to the value of those “bundles” of mortgages? They lost value. As matters in the housing market deteriorated and foreclosures increased, they lost even more value. That brings us to very recent times, when no one even wanted to buy them at all, or take them as collateral. Thus you hear the term “toxic” used. Banks have had to write down losses in the billions as the housing market has collapsed, in my opinion, into a depression for that industry. As losses mounted, banks have often been pressed for money to cover all sorts of things, including reserves held to cover many deposits in their institutions. As financial information became available on how bad a condition some banks were in, their stock prices plunged, depositors have pulled their money out, and some have been taken over by the government or forced into mergers with what are thought to be stronger banks.
Further, the “bundles” of mortgages became a problem, too, because often times they contained thousands of loans and the banks having them didn’t have the personnel to check into the situation with each mortgage to see who was paying, and who wasn’t, and who might not be able to pay next month. That’s why you have heard that they don’t know the value of these bundles. No one will buy them, because they don't want to be stuck with a bunch of bad mortgages. In order to sell ANYTHING, you have to have a BUYER, and preferably many potential buyers to bid the price up. With no buyers, these mortgages are worthless, at the moment, until they can somehow get investors bidding on them, and thus setting a price for each.
This whole series of events shows no sign of getting better, either, as foreclosures have skyrocketed, putting more houses on the market at cheap prices, and thus preventing other folks from being able to sell their homes. If you lose your job and now make far less money, you may say, “Well, I’m going to have to sell the house and live more cheaply.” The problem is, there’s a good chance you CAN’T sell your house at a price that you need. It may well be worth less money than you owe on it! Eventually, in such situations, some people have given up, mailed in the keys to the mortgage company and left. Others have just plain abandoned their homes. It is just UGLY!!!
Part Two in a day or so.
Years ago when a person got just about any kind of credit, that business held the note or agreement until it was paid. Back then, individual store accounts were common. If you shopped at such and such a department store, chances were you had a credit account there, too. The store (or the department store chain) carried their own credit accounts. If you got a mortgage from such and such a mortgage company (usually they had a bank affiliate that actually loaned the money), they sometimes held the note you signed giving the repayment terms, but with mortgages, they did often sell them to companies like Freddie Mac or Fannie Mae, the two companies that recently collapsed. They sell the mortgages to free up money to make more loans.
In more recent times, mortgages are written and then often times immediately sold. The basic idea and procedure being that “Mortgage Company XYZ” got you to take out the loan, they checked you out for credit worthiness for the amount you needed, they took care of all the paperwork, and then, after you signed on the dotted line, they sold the mortgage to someone else. A mortgage is just another word for a loan, but it is typically secured by the property that is being bought. In even more recent times, mortgages have been “bundled” into packages to be sold, or used as collateral. With the ongoing financial difficulty lately, you may have heard or read the term, “CDO.“ That is what these “bundles” of mortgages are, “Collateralized Debt Obligations.”
Example for mortgages and just about any kind of loan today:
I come to you to with hat in hand... I mean to borrow money; say $10,000. You do some kind of check on me, and either say “yes,” or “no.” If you give me the loan, I sign on the dotted line saying that I‘ll repay the $10,000, and so much more in interest over some specified term. Then you more than likely put my loan together with other loans, perhaps as many as thousands, and you sell the “bundle” to some investor, or more likely, some form of group of investors (banks around the world have bought or loaned money against these). They pay you a specified amount, freeing up money for you to loan out to someone else. They may turn around and sell this bundle to someone else, or they may use it as collateral to borrow money for whatever purpose. I hope you’re with me, so far.
So, now you’re saying, “Well, so what’s all the fuss about, then?”
First, there’s no easy answer to that question, because there are undoubtedly many reasons for what has happened, but I’d say there are “probably” two main things that have taken place with mortgages (forget about other types of credit, for right now). First, some mortgages were given without the originating company having done much to limit risk; that is, they didn’t check out thoroughly whether the person was a good credit risk. Now, when you loan money, there’s always risk, because lots of things can happen over a given period of time, especially for mortgages, which typically are written for thirty years. Anyway, as some kind of jokingly say, “They gave mortgages to anyone capable of writing their name, and got witnesses for those who could only make a big 'X.' " Often times, too, these mortgages carried very high interest rates, or had provisions that allowed the lender to raise rates after such and such a time.
Second, some areas of the country have been especially hard hit by jobs losses in more recent years, often times, but not always, in manufacturing. When these folks signed for a mortgage, they were very credit worthy. When they lost their jobs, that was it. Ohio, Michigan, Indiana are some of the states that fall into this category. Often times too, when interest rates were extremely low (post 9/11), many people who had existing mortgages refinanced them at lower rates, often times taking some cash out for some purpose, or they took out home equity loans. Again, once they lost their jobs, that was it.
So now we’ve got all kinds of “bundles” of mortgages that have been sold or used as collateral. Gradually, more and more people couldn’t pay their mortgages, resulting in defaults on many loans. Banks began to foreclose on these properties. The number of these cases escalated so much, that with so many foreclosed properties put on the market, that new or existing homes sales fell, and many folks had to lower the price of their property in order to sell it. (Now, in more recent months, IF they can even sell it!)
Guess what happened to the value of those “bundles” of mortgages? They lost value. As matters in the housing market deteriorated and foreclosures increased, they lost even more value. That brings us to very recent times, when no one even wanted to buy them at all, or take them as collateral. Thus you hear the term “toxic” used. Banks have had to write down losses in the billions as the housing market has collapsed, in my opinion, into a depression for that industry. As losses mounted, banks have often been pressed for money to cover all sorts of things, including reserves held to cover many deposits in their institutions. As financial information became available on how bad a condition some banks were in, their stock prices plunged, depositors have pulled their money out, and some have been taken over by the government or forced into mergers with what are thought to be stronger banks.
Further, the “bundles” of mortgages became a problem, too, because often times they contained thousands of loans and the banks having them didn’t have the personnel to check into the situation with each mortgage to see who was paying, and who wasn’t, and who might not be able to pay next month. That’s why you have heard that they don’t know the value of these bundles. No one will buy them, because they don't want to be stuck with a bunch of bad mortgages. In order to sell ANYTHING, you have to have a BUYER, and preferably many potential buyers to bid the price up. With no buyers, these mortgages are worthless, at the moment, until they can somehow get investors bidding on them, and thus setting a price for each.
This whole series of events shows no sign of getting better, either, as foreclosures have skyrocketed, putting more houses on the market at cheap prices, and thus preventing other folks from being able to sell their homes. If you lose your job and now make far less money, you may say, “Well, I’m going to have to sell the house and live more cheaply.” The problem is, there’s a good chance you CAN’T sell your house at a price that you need. It may well be worth less money than you owe on it! Eventually, in such situations, some people have given up, mailed in the keys to the mortgage company and left. Others have just plain abandoned their homes. It is just UGLY!!!
Part Two in a day or so.
Labels: CDO, finance, financial crisis, foreclosures
posted by Randy at 11:52 AM
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