As of this writing, the financial markets are in turmoil due to extremely high delinquencies on so-called sub-prime mortgages. These are the mortgages made in the last few years by aggressive mortgage banking companies that were able to “bundle” the risky debts into packages and then sell them to mutual funds and other institutional investors.
The obvious reason why so many of these mortgages have gone sour is that they had adjustable interest rates that are now being reset higher than when the mortgages were granted. There are also several not-so-obvious reasons.
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What Caused This Meltdown?
In August of 2005, I wrote an article for the E-Commerce Times entitled “Is The Real Estate Bubble About to Burst?” In that article, I talk about borrowing being too easy. Here’s a quote from the article:
“A good percentage of first-time buyers were able to purchase a house with no down payment and with all of their financing costs added to their mortgage.
“In addition, there is a new mortgage instrument out that permits the buyer to borrow money and make no principal payments for a certain number of years: interest-only mortgages. This new type of mortgage grants credit to people who heretofore would not have qualified for a mortgage. And, this mortgage has been labeled the ‘smart mortgage.’ I’m sure that you can readily see how this type of easy credit puts tremendous steam into real estate values.
“Lending institutions are relying on the sustainability of real estate values to assure them that their loans will ultimately be collected. The question is, can these high real estate values be sustained in the long run?”
Forgive the long quote, but it seems that my concerns back in 2005 were well-founded. Because of easy lending policies by mortgage bankers, made possible by both low interest rates and flush lenders who always seemed to find institutional buyers for their packages of sub-par mortgages, both the real estate markets and the mortgage markets boomed.
As I see it, these are the real reasons why we find ourselves in the mess we’re in today — mortgage bankers flush with money and anxious to lend it out no matter how unsound the terms may be.
Where Is the Bottom to This Financial Shock?
It’s hard to say when the financial markets, the lending markets and the real estate markets will reach bottom. There are still some quite unsettling factors on the horizon.
For example, Credit Suisse estimates that there is US$1 trillion worth of adjustable rate mortgages that will be reset sometime in early fall. Obviously, these mortgages will be reset at a higher rate. So, in my opinion, we are yet to hit the bottom of this financial bloodletting.
Additionally, based upon personal experience of owning mortgage-banking companies, I think that it is quite difficult for economists to rate the overall quality of the currently outstanding mortgage portfolios. To do so would be a Herculean task. Economists would have to perform a massive analysis of thousands of mortgage portfolios. It just isn’t going to happen.
The best that they can do is determine who were the major institutional investors in these sub-prime, mortgage-backed securities and then perform some sort of economic extrapolation to try to get a handle on the magnitude of this crisis. One can readily see the difficulty in performing this onerous task.
Will Lending Policies Change?
On Sept. 18, the Federal Reserve lowered its benchmark interest rate to 4.75 percent from 5.25 percent. But this strong action came with a caveat: “The committee’s predominant policy concern remains the risk that inflation will fail to moderate as expected.” In my mind this means that the Fed is ready to assist in solving this problem, but we shouldn’t expect a wholesale bailout of lenders and borrowers who made unwise decisions.
There is no doubt that our government does not want to see a repetition of the current situation. In the past, banking institutions using strict underwriting guidelines did most of the mortgage lending. Later, institutional investors such as hedge funds and pension funds got into the financing of mortgage debt.
The problem presently facing the government is that many of the institutional investors are not under the same strict control as federally insured banks. Consequently, the government has lost a good amount of control over this type of lending and, therefore, there is not much that the government can do to the major investors who aided the growth of this mortgage bubble.
What drove those investors to get into the mortgage business was their need to put to work the vast amount of funds that were flooding into their coffers. Such an influx of funds to the institutional investors made many of them relax their investing standards and encouraged them to purchase poorly underwritten mortgage-backed securities, hoping that the real estate market was unlikely to suffer a massive realignment.
One way to avoid a future meltdown of mortgage markets is to put mortgage lending back under the purview of federally insured banks, thus giving the government more control over this type of lending. Another alternative is to put tight controls on institutional investors that buy mortgage backed securities.
Unfortunately, things didn’t go as planned and now we must learn from our mistakes. Mortgage markets, like all markets, will fluctuate. This is a simple economic reality. The trick for the government is to keep these fluctuations to a minimum.
Theodore F. di Stefano is a founder and managing partner at Capital Source Partners, which provides a wide range of investment banking services to the small and medium-sized business. He is also a frequent speaker to business groups on financial and corporate governance matters. He can be contacted at Ted@capitalsourcepartners.com.