Are you one of the many out there that cannot grasp the credit crisis? Join the club as it has taken me months to unravel this mess and understand it.
This is not pretty since I give financial advice for a living, but it gives you an idea of how complex this problem really is. For most of you out there, the part about the housing crash seems simple enough. People bought homes they could not afford and used exotic mortgage products to qualify for loans. Now they are falling behind on their payments and defaulting on the loans. No surprise that this would happen.
The fact that the overwhelming majority of Americans are just fine, paying their conventional mortgages on time leaves us with only one part of the mortgage business causing such a problem. Subprime loans have frozen the credit markets, sent stock markets gyrating, caused the collapse of Bear Stearns and the federal takeover of Fannie Mae and Freddie Mac. The economy is on the brink of recession and the Federal Reserve is taking bold action to provide liquidity to the markets.
How could such a small part of the mortgage market do all that? I know that I have been asking lots of folks connected with Wall Street to explain it all and for the most part, they could not. So is all this panic and uncertainty unfounded?
Let's go back to the beginning of the boom. In 1998, large numbers of people decided to invest in real estate. They saw a bargain as many areas had not yet recovered from the early 1990s slump and real estate seemed like a bargain.
At the same time the banks and Wall Street were making it easier to get loans. The mortgage business was transforming from a local one centered around the bank that processed your loan to a global one in which investors from anywhere could pool money to lend. This also brought about innovation in loans with more exotic forms available to suit the borrower. This turned out to be too much of a good thing with global investors, flush with cash from commodities wanting good returns on their money.
The answer, subprime mortgages. These loans were risky since they were stretching people's ability to afford a house. The interest rates were higher or they were adjustable.
Here comes the real scary part. The loans were then sliced into pieces and bundled into investments called CDOs or collateralized debt obligations. These synthesized products were then bundled and sold to different groups of investors.
Those investors then supercharged their returns by using leverage. They would make $100 million bets using only $1million of their own money and $99 million in debt. If the value of the investment rose a mere $1 million, they had doubled their money. Homebuyers were doing the same thing. They were putting little or no money down on these homes with the expectation that the value of the property would rise and they could cash out or refi, again taking the profits.
All of this strategy was highly risky. The whole principal here was that home prices had to continue to rise. After all, they had never really fallen before, so even ratings agencies like Moody's were buying into this strategy and rating all these synthetic financial products higher that they should.
You can now see that when prices started to fall, this had a ripple effect , not only here in America, but globally. There was no real way for folks who are underwater on their loans and values to refinance since there are so many different entities owning a piece of their loan. Defaults and foreclosures started to rise. Now we can see how deep into the global economy the problems really go and that it may take some time to unwind this mess.
I also smell a lot of new regulatory rules will apply in the future to the synthetic markets and the use of leverage. It appears that the rules go out the window sometimes when it comes to making money, but in the end , the results are always the same.
Just as with Fannie and Freddie, before this all shakes out, much of these subprime derivatives will be charge off and applied to the national debt , be it ours or that of other countries. Everybody pays. Don't you just love it.
The opinion expressed here is that of Carol Perry and may not reflect those of AWA Wealth Management or LPL.