7/23/2007

How does this subprime mess affect you?

Living under a rock might be the best place for pretty much anyone right now.

What’s currently happening in the subprime market is that many home-owners are defaulting and foreclosing on their mortgages. Simple enough, but add up the amount of delinquencies, defaults and foreclosures, that spears right into everyone’s finances.

From the bottom up, during the big real estate boom, buyer’s market, banks wildest dreams come true – people were taking out mortgages that added up to billions of dollars for companies. Great news, huh? People are living in their dream homes, real estate agents are dancing off to the banks, and mortgage companies are collecting fees and interest till they turn green themselves.

Which leads to the question – where does the money come from, to finance these mortgages to want-to-be home-owners? Mega lenders and servicers, like Bank of America and Countrywide Financial, essentially raise money through debt, for example, collateralized debt obligations (CDO) or residential mortgage-backed securities (MBS), to fund the loans. No problem there. These banks also can choose to fund with their own capital, rather than raising more.

In scrutinizing the process, lenders were eager during the housing boom to lend. People who shouldn’t have qualified for such a big undertaking did anyways. This is because of poor underwriting on the part of the lenders or brokers. It seemed like pretty much anyone could come in with low or no income documentation, low credit score (FICO), needing 100% of the value of the home and still walk out, mortgage in their hands and a decent rate to pay. This is where problems come in. What most buyers didn’t anticipate was that the rate they qualified for only lasted for two or three years and then would reset itself to the LIBOR rate + 5-7% margin. Interest rates for borrowers essentially doubled, along with their mortgage payment.

Troubled and worried, there certainly were a number of people who either went to sell their home or refinance their mortgage. The issue with wanting to sell their home is that the housing boom busted, and their home depreciated in value. So in selling, these struggling home-owners wouldn’t get the full value of what they paid for, leading to huge differences in what they have in their hands to what they owe. A credit loss for the lenders. If the home-owners decided to go the other route and refinance, stricter underwriting policies prevented the same borrowers to borrow again, leading them to be stuck between a rock and a hard place.

Another aspect to look at is the type of borrowers with these subprime loans don’t necessarily live comfortably. Sure enough, with a huge mortgage hanging over their heads, they have credit card debt as well. And which do you choose to pay when you have the money to? These borrowers live day-to-day on their credit card, so they can not let that be seized by the banks. This leads them to stiff the mortgage lenders, becoming delinquent. It’s a choice anyone in this position would make. Credit card companies will be more apt to cut the consumer off than the mortgage bank.

It looks like all in all, these mortgage lenders are pulling the short straw consistently. Despite stricter underwriting policies, they still have responsibility to the investors to cover losses of defaults and foreclosures. But they only can to a certain point.

This is where it’s bad news for more than just the banks. It’s bad news for you.

These lenders allot only a certain amount to cover these losses before it’s passed on to the investors, hence the Bear Stearns crisis. Two of Bear Stearns’ hedge funds quickly tanked because of the increased foreclosures due to the interest rate resetting on these borrowers. You might not think that it could affect you unless you were one of the three parties involved: the borrower, the lender or the investor. Well, you could be the investor without knowing.

These investors in the hedge funds with CDOs and MBSs are not only people with money or big companies like Merrill Lynch. They’re working for you. They are the investors playing with your 401ks, your personal mutual funds, your life insurance. That’s where you pull the short straw. I’d take a look at your next statement of capital gains from your investments.

Luckily this is a cyclical business, so in a year or two green will be more apt to roll in than roll out.