So What Do Sub-Prime Loans Have To Do With Me? . . . . a layperson’s primer
Not much! At first blush, this is the clear answer to this question. That is, unless your credit is not so good and you stretched hard to get a mortgage that you really could not easily afford through a Mortgage Broker who sold your mortgage as part of a pool of mortgages. Not you, then, still…..not much. However, like many things in the financial world, and in particular, the capital markets, perception may be more important than reality. So you better keep reading. Let me start with a simplified explanation of exactly what the sub-prime crisis is about. In the old days, when most loans were made by local banks and savings and loans, they were made with money secured from local depositors. However, in recent years as the need for mortgages outstripped the ability to fund them with deposits, many institutions (but not all, for example, Hudson City Savings Bank is an extremely successful institution that does only residential mortgages, and keeps all of the loans within the bank) “sold” their mortgage loans, that were then often “securitized” and sold in pools of say, 200 loans. Along the way, the Mortgage Broker made a fee, and the local bank that still appears to be the lender gets paid a modest fee each month for servicing the loan. The investors that buy the securities the interest that is paid on the mortgages each month. Everything works well, unless, of course, the mortgages start to default. If they do, there are plenty of people that get hurt…….most particularly, the “investors,” and in many cases, the banks or Mortgage Brokers that made the loans, and of course, the borrower, if there is a foreclosure.
Historically, poor credit borrowers have had to pay a higher interest rate. These additional monies were used as a “hedge” against the defaults. In recent years, spurred by lots of competitive loans, loans made to “sub-prime” and “alt-A” borrowers (those with credit problems or low income relative to the amount they wish to borrow) at fairly low interest rates. Some would say that the risk of taking credit challenged mortgages was not properly priced into the securities in which they were pooled. The policy has now changed radically. A problem creditor with a low credit score today will be offered an approximately 12% adjustable mortgage on a loan to equity rate not to exceed 55%. Let me stay “technical” for just one more moment. In addition to home mortgages, other types of loans are also “securitized” in loan pooling devices called tructured investment vehicles or SIVs.
Fear Is The Problem
The real question then becomes, what do the defaults on a very small percentage of all mortgages, those made to borrowers who had questionable credit or in these complex SIVs, have to do with all of the rest of us. Likewise, why is the Federal Reserve lowering the discount rate and large banks putting together pools to buy up these questionable investments. The answer is mostly the psychological side of the whole thing. Remember when FDR tried to help Americans get out of the depression by saying “The only thing we have to fear……is fear itself”? It is fear that the risk factor of questionable credit may not have been properly factored into securitized loans, that has now spread into other capital markets.
Capitalism, our economic system, works best with large amounts of capital. The capital comes mostly from all us little guys….savings and stock ownership (which has become much more prevalent in the United States, with almost fifty percent of Americans now owning stock, usually frequently in 401Ks, mutual funds, pension plans, etc.). Lots and lots of little guys put their money into capital markets. A good chunk of that capital has found its way into securitized debt instruments like those groups of 200 sub-prime loans, but also many other debt instruments which are far more secure. When the sub-prime loans started to go bad, it created a level of panic throughout the capital markets and this is what has now become the concern. Just like World War I which started from one Austrian diplomat being shot, troublesome economic news can sometimes have a snowball effect. The goal of the Fed, and now the Treasury Department, and certainly the large banks, is to keep this particular snowball up at the top of the hill and not let it create an avalanche that could create problems for all of us.
Who Is the Victim
The crisis does raise a perplexing fairness issue. Let us start by looking at who the victims are. There are three types of victims directly being hurt in the root cause of this crisis, bad sub-prime loans. The first of these are folks who probably should not have been purchasing a home with very little money down and no real prospects to be able to pay a mortgage, especially if they took a “teaser” rate where their payments were inevitably going up. Should the government, or the rest of us, be bailing them out? Keep in mind that many of these folks were not very sophisticated, and may have been enticed into these mortgages by businesses who were trying to make quick fees, and pass the mortgages on to investors.
How about those Mortgage Brokers? These folks are going out of business left and right. Should we be bailing them out? Last, how about the investors…..in most cases very sophisticated folks or very large institutions like Merrill Lynch and Citibank, who were buying and selling the debt instruments, looking to get a good return for what they thought, would be very little risk. Are they worthy of a bail out? Whether you have sympathy for any of these three categories of victims, action by both the government and others concerned about the problem, does seem appropriate. If not sympathy for any of direct victims, then to try to keep this snowball from rolling down hill and creating a problem throughout our economy.
There are pundits announcing that there is no real problem here and never has been; that there was a problem and now it has been resolved; that there is a problem and it needs continuing government action to fix it; that there is a problem, but the government should stay out of it and the private market should fix it; and finally, that the market should just do what it must to punish those who have made risky loans or risky investments.
The answer, as almost always, probably lies somewhere in the middle. Some degree of reasonable regulation to impose the same kind of lending standards on that largely unregulated mortgage brokerage industry, as is typically in place for our banks, seems in order. Also, reasonable efforts by the government, or at the government’s prodding of large institutions to try to protect the overall capital markets, also seems like a good idea. If we are very lucky, this “crisis” will pass without causing a recession and this article will have told you much more than you ever wanted to know about sub-prime lending and its effect on the capital markets.
Thomas M. Wells is the Senior Partner of WJ&L, and divides his time between our New Jersey and Vermont offices. He practices in the areas of Land Use, Real Estate, and Business & Corporate, and also enjoys working with Non-Profits.
Author: Thomas M. Wells