How Mortgage Backed Securities and Forclosures Led to the Housing Bust
Everyone knows about the housing bubble and the economic slowdown of 2008. The term, “mortgage backed security” has become the proverbial villain in this dramatic time for the U.S. Markets. However, in my many conversations with people, they know all to well about the term “mortgage backed security”. Upon further questioning, many individuals know the cause of many of these financial institutions troubles, but do not really understand how mortgage backed securities work, and how they have caused this massive slowdown in the economy.
So let me tell you the details about what has transpired this year, starting with the housing bubble and the history of the "Mortgage Backed Security".
History
In 1938, a governmental agency named the National Mortgage Association of Washington was formed and soon was renamed Federal National Mortgage Association (FNMA or Fannie Mae). It was chartered by the US government as a corporation which buys Federal Housing Administration(FHA) and Veterans Administration (VA) mortgages on the secondary market, pools them, and sells them as "mortgage-backed securities" to investors on the open market. FNMA was privatized in 1968 as a "government sponsored enterprise" listed on the stock exchange. Additionally, the 1970 Emergency Home Finance Act created a new secondary mortgage market participant, the Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac) to support conventional mortgages originated by thrift institutions. The Act also allowed FNMA to buy conventional mortgages in addition to FHA & VA. Freddie Mac competed in the secondary market, where Fannie Mae had enjoyed a monopoly.
It started with the Housing Bubble
The United States housing bubble is an economic bubble in many parts of the United States housing market including areas of California, Florida, Colorado, Michigan, the Northeast Corridor, and the Southwest markets. On a national level, housing prices peaked in early 2005, began declining in 2006 and may not yet have hit bottom. Increased foreclosure rates in 2006–2007 by U.S. homeowners led to a crisis in August 2008 for the subprime, Alt-A, Collateralized debt obligation (CDO), mortgage, credit, hedge fund, and foreign bank markets. In October 2007 the U.S. Treasury Secretary called the bursting housing bubble "the most significant risk to our economy.
A mortgage-backed security (MBS) is an asset-backed security whose cash flows are backed by the principal and interest payments of a set of mortgage loans. Payments are typically made monthly over the lifetime of the underlying loans. Residential mortgages in the United States have the option to pay more than the required monthly payment (curtailment) or to pay off the loan in its entirety (prepayment). Because curtailment and prepayment affect the remaining loan principal, the monthly cash flow of an MBS is not known in advance, and therefore presents an additional risk to MBS investors.
The Resulting Fallout, and Meltdown
It is convenient to levy all blame for our country's current economic condition on our nation's president for the last eight years. However, many of the fiscal woes now plaguing both Wall Street and Main Street originated well before the current administration ever set foot in the White House. In fact, it was in 1999 that the Clinton Administration openly urged the Federal National Mortgage Association (aka "Fannie Mae") to reduce down payment and credit requirements for sub-prime or "at risk" borrowers in an attempt to increase home ownership rates among minorities and low-income consumers.
With so much attention directed at slumping housing and stock values, it is easy to forget that this fiscal contraction began with the sub-prime mortgage crisis that has since turned Wall Street into a house of cards that seems to shed portions of its structure each week.
By 2008, both of the government sponsored enterprises ("GSE") known as Fannie Mae and Freddie Mac ultimately failed and were eventually rescued by the Federal Government as predicted. Even enormous public investment houses and banks such as Bear Stearns, Lehman Brothers, A.I.G., Washington Mutual and Wachovia have all required government intervention that has cost tax payers hundreds of billions of dollars to date.
Despite continuous public outcries condemning the "Wall Street Fat Cats," it is difficult to blame these failed public corporations that either originated these sub-prime mortgages that conformed to GSE requirements or purchased or insured supposedly sound mortgage-backed securities from the GSEs. Specifically, banks such as Washington Mutual and Wachovia originated loans to sub-prime borrowers according to GSE conforming loan requirements before selling these mortgages on the secondary loan market to Fannie Mae and Freddie Mac. Investment banks such as Bear Stearns and Lehman Brothers then assisted the GSEs by pooling these mortgages together to attempt to diversify risk, thereby creating collateralized debt obligations called mortgage-backed securities that were sold to institutional investors. Companies like A.I.G. provided credit-default swaps ("CDS") that acted like insurance for institutional investors that purchased the mortgage-backed securities to protect them from defaults by the original borrowers.
It is critical to remember that before the sub-prime loan defaults escalated far beyond generally anticipated levels that caused the house of cards to start falling, the companies originating, purchasing and insuring these loans and securities were operating under the assumption that they were working with relatively safe loans that conformed to the requirements of government sponsored entities. It is unfortunate that it was these very requirements that had been relaxed in 1999 under the Clinton Administration, which in turn formed the unstable foundation upon which all of the cards ultimately fell.
