For the past year, the "mortgage crisis" has earned differing levels of attention from the media. During the past two months, the coverage has been constant, to the point where Congress is actually taking action to address the problem. As we all know, if Congress is actually doing something, then things must be bad.
This crisis affects the entire US economy, even those of us who are not struggling with our mortgage payments or facing bankruptcy. This month, we'll take a break from personal finances and look at why the Mortgage Meltdown is a crisis. If you understand it better, you can form a more educated opinion on whether to support Congress' effort to fix the issue.
Issuing and Selling Mortgages
A mortgage, quite simply, is a loan to buy property. The most common mortgage is the personal mortgage used to buy a primary residence - your home. Banks collect deposits from people in return for promising interest. The bank earns interest by issuing loans, including mortgages, and charging the borrower a higher interest rate than the bank pays on savings. The difference in what they charge versus what they pay is how banks pay their expenses and make a profit.
Mortgages are secured by a specific property, meaning that if the loan is not repaid, the property can be seized as payment. Mortgages also are very long-term loans, normally 15 to 30 years in length. Stretching out the payment time lowers the monthly cost, making it easier to buy a more expensive home. However, the longer timeframe raises the total cost paid over the life of the loan.
The long life of a mortgage is a blessing and a curse. The lower monthly costs are a blessing to the borrower; the 30-year term is a curse to the bank. If the bank lends $200,000 to each of five people, the bank has $1 million tied up in the mortgages. That is $1 million that is will not collect in full for 30 years, which restricts how much money the bank can lend to car buyers, small business and the like.
Therefore, many banks sell their mortgages. This gives the banks more money to lend. It also gives money market funds, mutual funds and investment banks something to buy. Mortgages are historically stable investments, and these funds appreciate the long-term income associated with mortgages. The buying and selling of mortgages keeps the lending industry healthy, keeping capital (that is, money) moving through the system to those who need to borrow. A few years ago, the industry started packaging mortgages together and selling them like bonds or stocks. Everyone figured that with home prices rising and interest rates low, investing in mortgage-backed securities was a no-brainer - until now.
Housing Bubble Bursts
When the economy was roaring at the turn of the century, house prices were climbing in many areas. This created the false impression that home prices always rise, so people were willing to go into more debt than usual, since they believed they would make money just by buying the house. This tended to drive up home prices even more. This buying frenzy was fed by a flood of new mortgage programs. Gone were the standard 15- or 30-year mortgages. People could now get interest-only mortgages, flexible principal mortgages, adjustable rate mortgages, no-down-payment loans and more. Homeowners took on more debt to buy houses, often taking on mortgages that had the potential to adjust after a few years. In short, people could buy more house than they could comfortably afford. And millions of people did buy more house than they could afford.
Then, interest rates started going up. Unemployment started creeping up. Gas prices and food prices skyrocketed. People started missing mortgage payments. Missing payments led to threats of foreclosure, and sometimes actual foreclosure. Desperate to sell, homeowners and banks accepted less than the original price, trying to get something rather than nothing from the home. Suddenly, people started realizing that the house they bought for $500,000 was probably worth only $300,000. Remember, the value of the mortgage is tied to the value of the house. This is a problem for the owner of the mortgage when someone owes $500,000 on a house that is only worth $300,000.
Panic followed.
Why the Meltdown?
Investors, including money market funds, mutual funds and investment banks, suddenly found that the mortgages they purchased from the regular banks were not worth what they thought. Investment banks that held onto the mortgage-backed securities suddenly found them worth almost nothing. With the mortgages worth less than assumed, suddenly the owners realize they have a capital crisis; they don't have enough money to pay for stuff.
Since the housing prices are unstable, and mortgages cannot be trusted, the people who normally buy mortgages don't want to buy them anymore. The risk is too great. So, the normal banks have trouble finding people to buy mortgages. Since the banks cannot sell mortgages, they cannot get back the front money to lend to Bob's Bakery or Joe Carbuyer. The credit market starts to bog down.
It gets worse, though. Remember, the investment banks have a capital crisis. They don't have money to buy mortgages; their money is tied up in the mortgage-backed securities that are quickly becoming worthless. That means they don't have money to lend to big companies. Many corporations, such as General Motors, Xerox and Coca-Cola, borrow money. They borrow money to fund short-term projects, balance cash flow, or invest in major construction projects. They issue bonds, just like your city or state government. Corporate bonds, though, are normally bought by money market funds, mutual funds and investment banks.
Remember who has a capital crisis and can't buy anything?
Since the investment banks cannot buy corporate bonds, the corporations have to turn to regular banks to borrow money. GM comes to the bank and says, "Hey, we need to borrow $400 million to retool a production line." The bank probably has an agreement with GM to lend them money at a specific rate (called a credit line). But now the bank has $400 million tied up with GM and it cannot lend money to Bob's Bakery or Joe Carbuyer. Double-whammy! The banks have less to loan and what little they do have to loan is going to corporate credit lines.
The credit market seizes up. Too few people can borrow money to start new companies or invest in old ones; too few people can qualify for a mortgage. The economy shuts down.
What do we do?
Economics is an imperfect science. In fact, my Economics 101 professor actually told us on the first day, "Everything you learn in this class is the basis for economics. When you apply economics, you will have to forget it all because none of it works in real life." The catch is that economic theory assumes that people have full knowledge and that they act rationally. As cops, we know neither of these is true.
Whether you call it a bailout or a rescue plan, most people believe Congress has to do something. If the credit market locks up, we will undoubtedly have a recession; maybe even a depression. The real issue is how much does government come to the rescue? Eventually, even without government intervention, the economy will recover. It might be painful, it might take months or years, but the credit and housing markets will eventually realign with reality. That part of economic theory holds true. The question is how much pain are we willing to endure? Shortening the pain means spending billions of dollars; shortening the pain means saving people and companies from their own poor decisions.
So, as you look at the bailout/rescue plan, recognize that the whole issue is a balance between economic pain, rescuing people and companies from bad decisions, and spending billions of tax-payer dollars. It's not as simple as saving homeowners or funding Wall Street fat-cats. It's really about how long we are willing to wait for the credit markets to fix themselves. The longer we wait, the less it costs the government (that is, the taxpayers), but the more it hurts the economy.
I hope this helps you understand the Mortgage Meltdown so that you can align your support or opposition to Congress from an educated stance. Next month, we'll get back to keeping your financial house in order.
