The Great Collapse Part 6: Living on a Prayer...

Everybody have a good weekend? Good. Me too. Everybody forget where we were in the story of the Great Collapse? Good. Me too. So perhaps a recap...

In Part 1, we gave the thumbnail version that the collapse was primarily predicated by the Housing Bubble. We talked a bit about what a bubble is and what the characteristics of that bubble were. We only just mentioned that the Federal government was interested in more people buying houses but didn't go into great detail about the various players and reasons for the decade-long run-up in housing. Perhaps we'll discuss that in Part 6.

In Part 2, we took a stroll down memory lane and talked a bit about what a mortgage is and how they traditionally worked. That led us to...

Part 3, where we looked at the dawn of Fannie Mae and Freddie Mac and the government getting into the mortgage market in a huge way. But that was only the prelude to the real fun which was...

Part 4 where we look at the development of mortgage securitization and the enormous new pools of money that opened to the mortgage market. But to sell to those new investors you'd need someone to sign off on the quality of your mortgage backed products which got us to the first of the serious problems which was discussed in...

Part 5, where we looked at the conflict of interest driving the ratings agencies to rate these sub-prime-backed mortgage securities perhaps more highly than an objective rater might.

So. Now we're all caught up. So how on Earth did we get to the point where there were so many sub-prime mortgages getting balled up to sell? Well, this is kind of back to the housing bubble story but now that we know how things flow, we can kind of get into details.

There are a lot of groups involved and interested in increasing home ownership. Or maybe not even home-ownership, but just mortgage buying.

First, you've got the government. The rate of home-ownership in the United States had been stuck for years at about 64% or so. This was considered awful. So the Clinton and Bush administrations took it upon themselves to increase this. And they did. All the way up to about 68% or so. Of course, unless human nature is changing or the nature of the economy is changing, all you are doing there is letting people who are increasingly less capable of exhibiting the financial restraint and intelligence that dealing with a mortgage and home-ownership requires, have to deal with it.

Second, you've got ordinary people who watch home-prices go up and up and want in. Perhaps you also have people who watch rents (especially on the low end) go up and up and want out. Of course, people who are having to deal with the low-end of the rental market are prob. not ideal candidates for the trials and tribulations of home-ownership, but we'll ignore that for the moment. (Lord knows everybody ignored it during the bubble...)

Third, you've got people who sell mortgages for a living. They like nothing better than selling more and more of them.

Higher-up on the food chain, you've got the guys packaging and selling mortgage backed securities. More mortgages equals more securities equals more money. Yay!

So how does this play out in the real world? This is going to sound mean, but not everybody is cut-out for home-ownership. Certainly not everybody is cut out for it at any time. It takes a level of financial responsibility and, yes, intelligence that not everybody possesses and maybe even not everybody can possess.

So what this means is that you have some people who are solid locks. Rich, organized, smart, whatever, they are good to go with buying houses. As you head away from these rock-solid people, you go through people who are increasingly less solid purchasers and eventually you get to the 64% level that we've been at historically. At this level, not everyone is a rock-solid purchaser. There were defaults, there were foreclosures, just not a huge, huge amount. In fact, there were a pretty steady and stable amount.

As you push beyond that threshold, you are asking people who are less and less ready for the enormous responsibilities of home-ownership to step up. Ordinarily, the institutions that put up the money for these mortgages would balk at selling to them. But with the government breathing down your neck to increase your rate of mortgages to "disadvantaged" or other groups, maybe you're willing to chance it. When you can easily sell those mortgages off, you're much more likely to chance it. When it seems like a safe bet because house prices are going up, it becomes a lock! Best case scenario, these marginal people manage to keep the mortgage current. Worst case, they refinance with a new mortgage after their house goes up in value or you foreclose and sell the house for more than the loan. No problem.

So as the mortgage sellers dip further and further into the group of people that are prob. not in the position to responsibly handle a mortgage and as housing prices go up and up, you need to start throwing your lending standards out the window.

Traditionally, you needed 20% down to get a mortgage. And it had to be your money. This serves as a kind of test right there, because it takes a fair amount of financial planning and responsibility to get 20% of the value of a house saved up. Second, traditionally all of your financials had to be verified and documented. You had to prove that you actually made enough money to make the loan payments. And what's more, those loan payments couldn't be more than 30-36% of your pay. You couldn't, for example, have a mortgage payment that would eat up 50% or more of your pay.

All of these fairly sensible qualifications became more and more ignored as the bubble grew. People started taking out loans for the 20%, in effect borrowing the full value of their house. Thus they had no equity and even a slight price decline would mean their mortgage was more than the house it bought. Banks stopped verifying incomes and other financial documentation with anything like the diligence they should have.

Even still, you probably couldn't get enough people to take these loans. They would still be too expensive. So you start coming up with different structures. Interest only, wherein you pay only interest for the first so many years, thus lowering the payments. Or even, negative amortizations. Under these loans, you are actually increasing the amount you are borrowing for the first several years. You are, in effect, slowly going more and more in debt to the bank.

Or the famous Adjustable Rate Mortgages (ARM), these start off with a very low rate for a few years but then "adjust" to the market, which means the rate skyrockets. So unless the person's income skyrockets with it (unlikely, again we're dealing with the more marginal housing market participants here) they will have to refinance or sell the house. And there is often a penalty for refinancing or selling under these more "exotic" (read: "shady") loans.

So that's how people who prob. shouldn't have been taking mortgages were able to take out mortgages. And why they would take out mortgages that were structured in ways that made them riskier than traditional 30-year fixed rate mortgages.

Then these "sub-prime" mortgages would get balled together and taken to the rating agencies to get the stamp of approval and then sold off into the market.

And here's where it gets really, really fun...