Understanding The Financial Crisis, Part One

While most Americans are certainly aware of the financial crisis that is rocking the nation, I doubt that very many understand what has brought us to this crisis; a crisis that is not only ravaging our own country, but has now spread abroad, too. When Americans watch television, listen to the radio, or read newspapers or magazines, they encounter words and terms involved in this crisis that are not easily understood, unless you happen to be a Wall Streeter, mortgage executive, or banking official. I’m going to try to go through the basic process that has brought us to this devastating economic collapse, and put things into simple, every day language that all should be able to understand. This will by no means be a comprehensive history of the subject, as details are still emerging as to things that took place, and, to be quite honest, the consequences of the breakdown of the financial system are still ongoing, with no end in sight, so we don’t know the outcome, as yet. Further, the subject has some VERY complex aspects to it, and I’ll try to keep it as simple as possible.

Since home mortgages are at the center of this crisis, we need to understand the basic system of mortgages. So, you’ve found a house that you like and you’ve made an offer to the seller, who has accepted that offer. The mortgage company (usually with an affiliated bank) gives you a loan, you sign on the dotted line and you get the keys to the property, in a process referred to as a “closing;” that is, the deal has been completed; you have signed for the loan, any fees owed by the buyer or seller to whomever have been paid, the seller gets their money, and you get the property. How you got the loan is the important part. In times past, two “government sponsored enterprises,” (just for the record, also known as a “GSE,” for short) Fannie Mae and Freddie Mac, two names I’m sure you’ve heard before, were at the center of how you qualified to get your mortgage loan.

Fannie Mae started in the late 1930s as part of the effort to spur home buying during the Depression. It was government owned at that time. In the late 1960s, Fannie Mae was made private. Freddie Mac was established as a private corporation in 1970 to provide the now private Fannie Mae with competition. They buy mortgages from APPROVED loan originators. They then receive the mortgage payments and interest from these mortgages, which they then form into “pools.” Then they sell securities backed by these mortgage money pools to investors, guaranteeing the investments, even if people do not make their mortgage payments. The securities are called “Mortgage Backed Securities, or MBS, for short. Originally, Fannie Mae was government owned, and therefore, these securities were backed BY the United States Government, which made them highly desirable for investors, since they were safe (the Government can print money to cover costs, but private companies or individuals can't; legally, that is). The Great Depression had been so traumatizing, that loans of any type were hard to come by, as people were afraid. With Uncle Sam willing to buy mortgages from loan originators, this took the originators off the hook for the loan, placing the risk on the U.S. Government. Further, by guaranteeing the securities that were then issued, investors loved them, as they carried essentially no risk. When Fannie Mae was made private in 1968, and then Freddie was formed in 1970, the U.S. Government no longer actually guaranteed these securities, but investors felt that the guarantee would still apply, if for no other reason than that the government would NEVER let either or both companies fail. Both Fannie and Freddie charge a fee for these guarantees, which is one of the ways they make money. Fannie Mae and Freddie Mac are important, but I don’t want to get too bogged down in the details of their operations, as they are complex. So, we’re going to stick with the very basic info here.

These two giant companies bought mortgages from APPROVED loan originators; that is, the companies (or banks) that made the initial loans to home buyers. Between the two companies, they bought a very large proportion of American mortgages and I‘ve seen various percentages, but certainly at least 50% of all home mortgages, and perhaps higher. As such, they were able to have a big influence on how mortgage loans were made to Americans; that is, they were able to set “the guidelines.” Fannie Mae and Freddie Mac maintained strict guidelines for mortgage loans; that is, how consumers qualified for loans, including detailed proof of income, credit history, etc.

What does all of this mean? Well, let’s bring this down to a personal level that‘s easier to understand. This is only for the purpose of example: You have $200,000 and you want to make some money from it by loaning it out. Aunt Mary asks to borrow $100,000 to buy a house. Cousin Bob asks to borrow $100,000 for the same purpose. So you make those two loans at some set of interest rates and terms. Now, Uncle Henry asks to borrow some money to buy a house. Well, you don’t have any money to loan to him, because you’ve got all of your money out in other loans. Hmm, what to do? That’s where Fannie Mae and Freddie Mac come into the picture. One or the other buys the two mortgages from you (remember, this is an example only, and you’d have to be on their list of approved loan providers), which gives you back your original $200,000, plus some fee that is your profit. Further, you no longer have to worry if Aunt Mary or Cousin Bob pay their mortgages. You’re out of it. Now you can loan money to Uncle Henry and the whole process starts over again.