Explain to me the sub-prime mess?

[Buccaneer]

I guess I play it straight on mortgages: fixed-rates, 30yr type of deals. Why are lenders having troubles right now and what is the sub-prime segment? Are there people getting slammed from adjustable rates and if so, why would anyone have ever taken those conditions? If it's not, why all of sudden are there more foreclosures when the job market has been holding steady?

[wade moore]

Originally Posted by Buccaneer

I guess I play it straight on mortgages: fixed-rates, 30yr type of deals. Why are lenders having troubles right now and what is the sub-prime segment? Are there people getting slammed from adjustable rates and if so, why would anyone have ever taken those conditions? If it's not, why all of sudden are there more foreclosures when the job market has been holding steady?

I'm somewhat educated on the general idea here, but not the specific issues that have caused my 401k to plummet over the last couple of weeks.

The issue here is that during the housing boom of the last 5-10 years everyone was looking to buy more house and then turn it around for profit. So they couldn't make the payments on a regular 30 yr fixed and would get some type of balloon loan. One of the main ones being "interest only" loans where for the first say 3-5 years you ONLY pay interest - nothing on the principal and then it would cause mortgage payments to be say 1/2 or 1/3 of what it would be. But once that 3-5 years passes the payments skyrocket as they have to start paying off the principal.

So, now that the bubble is bursting these people can't turn around and make a quick buck and they can't make the payments on their mortgage - boom, foreclosures.

In the end - it's a ton of people making stupid, stupid decisions. When you're making a huge purchase like a house you need to educate yourself on what you're doing and not set yourself up for failure like these people did. Not to insult anyone in this situation, but people were idiots for doing this if they did not have some sort of backup to be able to make the mortgage payments.

I'm sure there's more details to it than this, but I know this is a large part of it.

[Peregrine]

Another key factor here is in addition to the individual sub-prime mortgage companies like Countrywide that are having problems, these kind of loans were packaged up with a mix of other mortgages and securities and sold off, so that caused a lot of other companies to have exposure to the problems in the sub-prime segment. Also, companies and institutional investors that took a hit on this had to sell off other securities to raise cash to soak the sub-prime problems, causing stock values of other companies to drop from the mass selloffs.

[King of New York]

It was a perfect storm of greed. Borrowers decided to gamble that interest rates, because they had sunk to historic lows, were going to stay there for a long time: they went for Adjustable Rate Mortgages with very low initial rates and payments in order to buy as much house as possible, and then crossed their fingers that rates and their payments would not go up. Lenders also gambled that historically low interest rates would stay that way for years to come: they threw out traditional income-to-debt ratios and started lending money to people with little income and lots of debt, who could just barely make their initial payments.

Then the interest rates went up--not all that much, but enough to cause the most vulnerable borrowers, the subprime ones who represented the biggest credit risks, to go belly up.

For years I had to endure the taunts of acquaintances about their variable-rate mortgages and low payments, vs. my traditional 30-year fixed payment mortgage.

Of course, if the government decides to bail out all the folks who gambled and lost, then I really was a fool to play it safe.

[wade moore]

Originally Posted by King of New York

Then the interest rates went up--not all that much, but enough to cause the most vulnerable borrowers, the subprime ones who represented the biggest credit risks, to go belly up.

I don't think you were necessarily saying it wasn't a factor, but I don't think you can underestimate the perfect storm of the boom in housing costs stopping. I think many of these people were banking on dumping the house either when interest rates started climbing or just before the balloon payments started.

Of course, if the government decides to bail out all the folks who gambled and lost, then I really was a fool to play it safe.

This would potentially make me the maddest at the US Government that I have been in my adult life.

[Kodos]

Originally Posted by wade moore

This would potentially make the maddest at the US Government that I have been in my adult life.

Even madder than getting us into a pointless quagmire war?

[wade moore]

Originally Posted by Kodos

Even madder than getting us into a pointless quagmire war?

Not to derail this thread, but yes.

[Radii]

Originally Posted by wade moore

This would potentially make the maddest at the US Government that I have been in my adult life.

It'd be up there for me as well.

[Peregrine]

Originally Posted by wade moore

This would potentially make me the maddest at the US Government that I have been in my adult life.

For me I think this was when they ditched habeas corpus.

[JPhillips]

Wade: I think you're only partly right. Having just left the DC area after shopping for a house, I think some of the sub-prime mess comes from people who can't afford a traditional mortgage payment. When houses are costing 300K or more it's difficult for families making less than say 80K to make a full payment on a thirty year fixed.

Now I think greed, stupid decisions, etc. inflated the cost of homes, but the fact remains that a lot of families really didn't have another option.

[Masked]

Originally Posted by Peregrine

Another key factor here is in addition to the individual sub-prime mortgage companies like Countrywide that are having problems, these kind of loans were packaged up with a mix of other mortgages and securities and sold off, so that caused a lot of other companies to have exposure to the problems in the sub-prime segment. Also, companies and institutional investors that took a hit on this had to sell off other securities to raise cash to soak the sub-prime problems, causing stock values of other companies to drop from the mass selloffs.

Peregrine hit the real key as to why the sub-prime mess is becoming more and more critical - it has moved from being a problem faced by the guy who bought the house next door into one faced by the large, global financial companies.

One key example is the huge secondary market for mortgages that has essentially vanished over the past few weeks. Hedge funds and such hold enormous amounts of these "collaterlized debt obligations". As holders of the original mortgages default on their loans, these CDO's lose value (they become riskier for one thing and the asset, the house, backing the original mortgage has lost value). Without a market for these instruments, there is no way to know what there value is (do they even have value in the extreme case) - so they don't even know how much they have lost. Hedge funds by their very nature are highly leveraged entities. As the value of their assets drop, the banks (and investors) who have lent them vast amounts of money start getting nervous - they try to cash out or ask for more collateral. Now the hedge funds need to raise cash, but they can't sell their CDO's so they are forced to borrow more money at ever higher rates and/or sell whatever they can.

[rowech]

People, mostly 25-40 who live past their means and want as much as possible not realizing what a bad economy might look like is about what it boils down to. Everything else is just a derivative off of manipulating situations to fit under that.

[Buccaneer]

Originally Posted by Peregrine

For me I think this was when they ditched habeas corpus.

You call me old? At least I read it in the paper when Lincoln did this.

[wade moore]

Originally Posted by JPhillips

Wade: I think you're only partly right. Having just left the DC area after shopping for a house, I think some of the sub-prime mess comes from people who can't afford a traditional mortgage payment. When houses are costing 300K or more it's difficult for families making less than say 80K to make a full payment on a thirty year fixed.

Now I think greed, stupid decisions, etc. inflated the cost of homes, but the fact remains that a lot of families really didn't have another option.

I forgot you left the DC area..

Anyway... we'd probably disagree here on what "didn't have another option" means.. I understand what you're saying, I think I'd disagree with some of your definitions though.

[Buccaneer]

Thanks for all of the explainations, I understand now. Did anyone not see this coming, esp. when real estate prices in some parts of the country shot up unpredictably?

[wade moore]

Originally Posted by Buccaneer

Thanks for all of the explainations, I understand now. Did anyone not see this coming, esp. when real estate prices in some parts of the country shot up unpredictably?

I'd argue that a lot of people I know saw it coming.. I know my father and I talked about this before I bought a house and that was 3 years ago.

[Crapshoot]

Stupid people caught up in the rat race with the Joneses. If you make $3,000 a month, you are not going to be able to afford a house that costs $4,000 a month. This isn't rocket science.

[Chief Rum]

Remember, guys, financial institutions aren't in the business of owning property. And that's exactly what's happening now. Foreclosures are at an alltime high, but the buyer's market is pitiful, because people can't afford the houses at their current prices and at current rates. The result is, no one comes along to buy the foreclosed property, and the bank has to take on the property itself. Which is a liability for them. Not only are they not receiving payments for that property anymore, they are essentially paying interest on themselves. It's money leaking away. And that doesn't even mention that now they are responsible for the upkeep of those properties if they want them to hold their value until they can offload them.

These financial institutions have taken on huge costs with no apparent revenues coming in the near future.

I have to tell you, in the past three months, I have written tons--and I mean tons--of REO policies (that's the final actual step of foreclosure wherein the beneficiary of the mortgage loan receives the property as compensation for lack of payment) for financial lending institutions.

[st.cronin]

I think lots of people saw it coming, too. The question wasn't IF it would happen, but WHEN it would happen.

[rowech]

Originally Posted by Buccaneer

Thanks for all of the explainations, I understand now. Did anyone not see this coming, esp. when real estate prices in some parts of the country shot up unpredictably?

The economy's a balloon. It can't expand forever nor can it expand too fast.

[wade moore]

Originally Posted by st.cronin

I think lots of people saw it coming, too. The question wasn't IF it would happen, but WHEN it would happen.

*ding ding ding*

[Buccaneer]

There is a real estate web site that begins with "z" that I remembered looking at for a while. It showed, for each property, the appraised value over a 10-20+ period in a line graph. I was looking at properties all over the country to get an idea of comparative values and was surprised to see in some parts, the ridiculous spike in values that screamed correction. Fortunately, my property still has a nice steady climb to it.

[JPhillips]

A nice illustrative movie.

[Craptacular]

Zillow.com

[Maple Leafs]

They're both longtime posters here and have the respect of everyone. I think we're all aware of the almost unbearable sexual tension between them, but I'm not sure I'd call it a "mess".

[PilotMan]

On the one hand it makes me glad that we didn't buy a couple of years ago when we were looking and at the same time ticked off, that when we will finally be able to buy we are going to need 20% down again. And folks, that ain't happenin' for a looooong time. Third, if you are an investor, right now has to be a goldmine of opportunity, if you can get the right deal.

[Buccaneer]

Parts of the country have gone through this before in the past 30 years.

[sterlingice]

Glad I stopped in this thread. They had about a 5 minute blurb about this on NPR a few days ago but this fills in some of the gaps

SI

[Buccaneer]

Thanks, Crappy. Here's what I mean - the value of my house over the past 10 years.



I guess there was a small spike the middle of last year but it seems to be back on the predictive track (the house is a little over 10 years old). Or does all of this mess apply to new homes in the past few years?

[sterlingice]

Originally Posted by JPhillips

A nice illustrative movie.

It's not Schoolhouse Rock but a great idea, nonetheless.


SI

[knolysis]

I hope you don't mind a long time lurker joining the discussion as I find the current mess somewhat fascinating.

My guess is that Bucc posted because the subprime mess is dominating the headlines and he wants to know why. As he pointed out, the job market seems fine, and could be argued to be improving.

My take on the situation is that the growth of financial markets and resulting complexities of investment strategies (e.g., hedge funds) have caused underlying investments to become entertwined in ways that are not fully understood by economists and professional money managers. Losses in one area of the market unpredictably spill over into another area.

Right now, investors are finding it difficult to sell various types of investments as many markets have suddenly become illiquid (a basic economic tenet is that the price of a security is partially determined by how easy it is to sell it, refered to as its liquidity). Losses have caused buyers to pull back from the markets.

The other option is to borrow money rather than sell securities. Unfortnately, because banks have been taking losses or aren't sure if they will take losses, they haven't been lending money (which is why the Fed injected some funds into the banking system earlier in the week).

Thus, instead of being able to sell bad investments or get a loan to ride it out, investors start selling the good investments they own to raise cash. This means my 401(k) and Roth IRA have been taking it on the chin lately as there are now more sellers than buyers in the market.

[wade moore]

Blah, this site still has little to no data for my area... at least specifically where my house is.

[Buccaneer]

Thanks, knolysis, for posting and welcome to FOFC. Hope you can become a regular.

[Celeval]

You're thinking of zillow, I think.

We had some of the same questions, although not so far-seeing as we just bought at the start of this year. 30-year fixed for us - although we're pretty conservative financially anyway.

[JPhillips]

The underlying problem is how leveraged the market is. Here are a couple of data points I saw.

The cash positions in mutual funds stand at 3.8%, slightly below the 3.9% low established in 1972.

Margin debt as a percentage of the S&P market cap has climbed to 2.4%, an all-time high. The previous peak? Early 2000, at the height of the Internet bubble.

[Buccaneer]

Originally Posted by JPhillips

The underlying problem is how leveraged the market is. Here are a couple of data points I saw.

The cash positions in mutual funds stand at 3.8%, slightly below the 3.9% low established in 1972.

Margin debt as a percentage of the S&P market cap has climbed to 2.4%, an all-time high. The previous peak? Early 2000, at the height of the Internet bubble.

Highly leveraged due to real estate speculation or is there more?

[knolysis]

Originally Posted by JPhillips

The underlying problem is how leveraged the market is. Here are a couple of data points I saw.

The cash positions in mutual funds stand at 3.8%, slightly below the 3.9% low established in 1972.

Margin debt as a percentage of the S&P market cap has climbed to 2.4%, an all-time high. The previous peak? Early 2000, at the height of the Internet bubble.

I think the data points you have seen are just an indicator of the increasing spread of previously successful investment strategies. Everybody chases performance (even the professional money managers).

The current use of leverage isn't specific to any particular market or strategy. A decade or so ago, it became apparent hedge funds were successful using borrowed money to amplify their returns. Copy cats emerged and now many investors use this same strategy (which is what I think the data point illustrates as the average investor can now buy mutual fund shares that use leverage to amplify returns). Works great in a strong, rising market. Not so great in a weak, falling market as it tends to compound itself as the underlying investments the borrowed funds purchased lose value.

[Logan]

Being one who works for the agency that regulates the national banking system, I'll just say that it makes life a lot easier when national banks only hold 2-3% of the country's subprime mortgages and we force lenders to run an analysis of whether the borrower of an ARM could repay the loan when amortized on a 30-year schedule, and if they don't, we shove a boot up their ass .

[Crapshoot]

Originally Posted by knolysis

I think the data points you have seen are just an indicator of the increasing spread of previously successful investment strategies. Everybody chases performance (even the professional money managers).

The current use of leverage isn't specific to any particular market or strategy. A decade or so ago, it became apparent hedge funds were successful using borrowed money to amplify their returns. Copy cats emerged and now many investors use this same strategy (which is what I think the data point illustrates as the average investor can now buy mutual fund shares that use leverage to amplify returns). Works great in a strong, rising market. Not so great in a weak, falling market as it tends to compound itself as the underlying investments the borrowed funds purchased lose value.

Bingo. Another common strategy is the yen-carry trade, and that's been beaten to death as well. Arbitrages in today's world basically exist for infinitesimal periods of time - not longer.

[JPhillips]

Buc: From what I've read it goes much deeper than the subprime market. I'm not an investment banker, so everything I know comes second hand.

Second example: today any wealthy individual can take $1 million and go to a prime broker and leverage this amount three times; then the resulting $4 million ($1 equity and $3 debt) can be invested in a fund of funds that will in turn leverage these $4 millions three or four times and invest them in a hedge fund; then the hedge fund will take these funds and leverage them three or four times and buy some very junior tranche of a CDO that is itself levered nine or ten times. At the end of this credit chain, the initial $1 million of equity becomes a $100 million investment out of which $99 million is debt (leverage) and only $1 million is equity. So we got an overall leverage ratio of 100 to 1. Then, even a small 1% fall in the price of the final investment (CDO) wipes out the initial capital and creates a chain of margin calls that unravel this debt house of cards. This unraveling of a Minskian Ponzi credit scheme is exactly what is happening right now in financial markets.

[knolysis]

Originally Posted by Crapshoot

Bingo. Another common strategy is the yen-carry trade, and that's been beaten to death as well. Arbitrages in today's world basically exist for infinitesimal periods of time - not longer.

Very well stated. It never ceases to amaze me that people acknowledge this basic truth then proceed to ignore it when actually investing. Chasing performance is a fool's game yet new fools show up every day.

[Logan]

Originally Posted by wade moore

One of the main ones being "interest only" loans where for the first say 3-5 years you ONLY pay interest - nothing on the principal and then it would cause mortgage payments to be say 1/2 or 1/3 of what it would be. But once that 3-5 years passes the payments skyrocket as they have to start paying off the principal.

Not to nitpick, but this is a pretty big exaggeration. No matter what product you pick, the early years of your loan will be paid back almost entirely in interest. As anyone who has needed to sell their house shortly after buying it could tell you, you're automatically behind the 8-ball when you factor in closing costs and other fees because you haven't paid down any of the principal balance.

Take a $250k loan at 7%. Your monthly payments on a 30 year fixed will be $1,663. During the first year, you will pay an average of about $1,450 in interest each month, for a total of $17,419 over the course of the year. Meanwhile, you've only paid down $2,500 in principal. So you're saving a couple hundred a month and gambling that your house will appreciate to the point where that is how you're technically paying down the balance.

The huge payment changes arise more from the changes in rates when they reprice. An IO at 4.5% is much different than the fixed at 8%.

[wade moore]

Originally Posted by Logan

Not to nitpick, but this is a pretty big exaggeration. No matter what product you pick, the early years of your loan will be paid back almost entirely in interest. As anyone who has needed to sell their house shortly after buying it could tell you, you're automatically behind the 8-ball when you factor in closing costs and other fees because you haven't paid down any of the principal balance.

Take a $250k loan at 7%. Your monthly payments on a 30 year fixed will be $1,663. During the first year, you will pay an average of about $1,450 in interest each month, for a total of $17,419 over the course of the year. Meanwhile, you've only paid down $2,500 in principal. So you're saving a couple hundred a month and gambling that your house will appreciate to the point where that is how you're technically paying down the balance.

The huge payment changes arise more from the changes in rates when they reprice. An IO at 4.5% is much different than the fixed at 8%.

Right. I just wasn't explaining myself very well.

[Anthony]

Originally Posted by JPhillips

Now I think greed, stupid decisions, etc. inflated the cost of homes, but the fact remains that a lot of families really didn't have another option.

Renting. Co-ops. Condos. that's 3 options right there that don't involve the higher expenses of a house. houses aren't for everyone.

[Mizzou B-ball fan]

Had an amazing foreclosure in my neighborhood recently. Note that this is in the Kansas City area, where prices are relatively low compared to some of the coastal markets that you're discussing.

Home is a 6,000 square foot house (8,200 if you include unfinished basement space. 6 bedroom, 5 bath with a 4 car garage. Lot is one acre and is about 15-20 minute drive from downtown. It sold 1 1/2 years ago to the buyer for $1.2 million. Buyer had a bum loan like you all are discussing and it was foreclosed on. Last weekend, that house sold for $750,000. Quite a steal of a deal.

Another thing that should be mentioned. I've always make sure to take the 15 or 30 year fixed loans. If you take a 30 year loan and make one extra payment each year, you'll pay off that loan in 22 years rather than the 30 years it would take otherwise.

In regards to JPhillips comment that "there weren't any other options", I'd respond that there are plenty. In addition to renting, you can always move. There's a reason Kansas City is adding 25,000 residents a year right now. Lots of jobs available and housing that costs much less than an equivalent home on either coast. Our current home would easily cost 3X as much where we used to live in Baltimore.

[Flasch186]

if I wasnt sick I'd point you all to the thread where I predicted this mess....years ago.

[Draft Dodger]

Originally Posted by Maple Leafs

They're both longtime posters here and have the respect of everyone. I think we're all aware of the almost unbearable sexual tension between them, but I'm not sure I'd call it a "mess".

This.
Is.
An.
AWESOME.
Post.

[sachmo71]

What will the fallout be? More regulation of lending?

[Toddiec]

Let me chime in on this with my opinion as a Real Estate lender. Most people in the industry knew that this bubble would burst sometime in a 3-7 year windows, but everyone had different methods to "get out of it" when the time came (remember I am talking from a bank standpoint, not the borrower). When the boom began a bunch of fly-by-night mortgage companies popped up everywhere to take advantage of not only the new house craze but the massive increase in refinances. They would take the large closing costs and then sell the loan to the secondary market (the Fannie Mae's of the world). So, the loan is no longer on their books, they get their one time income shot from the closing fees and all is good with them.

From there it is a trickle effect. The banks and credit unions had to do something to avoid being undercut by the mortage companies (and I am generalizing, it was more than just mortgage companies...they are not the evil entity I make them out to be in this theory) so they lowered rates. But that wasn't enough because EVERYONE had low rates, so they started lowering their lending requirements such as credit score guidelines etc. They then went with 110% financing and that kind of thing. Now, the appraisers also felt the crunch because banks wanted to meet the customers demands of buying the houses at inflated prices (people selling property took advantage of this boom as well) so you saw appraisal values spike.

So in the end, super low interest rate loans with decreased lending requirements and artificially increased appraisal values let people who normally couldn't get into a $300,000 house, for example, now suddenly be able to do so. So a lot of people took advantage of it.

Now comes the kicker. The banks and credit unions and mortage companies aren't stupid. They knew the balloon would burst, so they put in the interest rate kickers at 3 and 5 years. The sweetest deals out there were the 3 and 5 year variable type notes because thats what the lenders wanted people to get so they (lenders) would be protected. If you locked yourself in at a 20-30 year fixed rate at super low interest rates you were golden, but if you got a variable one, you were setting yourself up for a fall.

So here we are. The bubble burst and the interest rates are ballooning on Joe Blows variable rate note and all of the sudden he can't afford the payments. Unfortunately, he borrowed money on an inflated appraisal rate, so more often than not the borrower is head over heels in his mortage. He now owes more on a house than it is worth (thus the difficulty selling it because he wants enough to get out at least even) and can't afford the payments. The only real option is to walk away in a lot of cases.

Now, this is all my opinion from being in the lending business. I really have no idea of how wide spread the problem with repo's are going to be. It could be just a small number of really vocal people, but we won't know that until we can look back on all of this in a decade or so. Really, overall it is an interesting example of opportunity cost and short term vs. long term economic benefits.

[NoMyths]

Interesting thread -- let this be the rebuttal to the "Why would you ask a serious question around here?" folks.