Saturday, April 19, 2008

US Housing Market Crises caused by Mortgage Backed Securities

Some believe that 100% financing led to the current real estate crisis. That wasn't the cause of the bust. It did set the stage, however.

Yes, it would have been bad if the banks were lending 100% and the housing market turned down but that wasn't the actual cause of the crises. If fact, while we might have had a bit of a bumpy road, we would have been able to ride the high prices for another few years before a relatively minor correction happened.

The problem is that the 100% loans were able to satisfy the US demand for Mortgage Backed Securities (MBS). The MBS were generally bought in people's IRAs. Supply of MBS generally equaled demand.

The problem arose when foreign investors saw how well the MBS were doing and started investing in them. Suddenly, the demand was much higher than the supply. The investment houses were almost begging for more loans. However, the loan market was saturated by then (from a big refi boom). They needed another loan product that would create another refi boom. So they created one: the minimum payment loan (sometimes called an option pay).

The minimum payment loan was just another version of a negatively amortized loan (Neg-Am Loan). In general, if the interest only rate was 6%, the minimum payment was 1-3% (with the rest of the interest being tacked on to the principle). All in all, this type of loan isn't a bad loan. It also wasn't anything new and it didn't offer anything that would cause people to jump on it.

The problem came from the broker's being pressured to make more product available for the MBS. They started qualifying people, not on the real payment based on 6% interest but on the 1-3% interest payment.

This did a number of things. It created a new refi boom, it provided enough product to satisfy the foreign investment in the MBS, it fed the real estate boom and it set us up for a crash.

The real estate boom happened because more people could afford houses and people could afford bigger houses than they already had. Since house building lags so far behind demand, this created a surge in house prices. People were then refiing their houses at the new higher prices and facing lower loan payments than they had before the refi.

Then the shoe dropped. Most of the minimum payment loans were set to recast in 3 or 5 years. That means that 3 or 5 years after they were created, the loans jump to the current interest rate. If a person could, according to the brokers, afford a house at 2% interest and the rate jumps to 6%, they are now expected to pay 3x what they were paying before.

THAT is what caused the bust.