Professor Elam

Okay now that we have covered margin calls, here is where the supposedly safe idea of mortgage trading went awry.

Here is how it is supposed to work. We all deposit $1 M in the local savings and loan. The S & L makes ten $100,000 loans and ten houses are built in the community.  Then the ten loans are packaged and sold as a one million dollar round lot’ to Fannie Mae or Freddie Mac, the govt created mortgage buyers and sellers. FNM and Freddie re sell the mortgage packages to insurance companies or other individuals or institutions who collect the mortgage interest on their investments. While there are many thirty year mortgages, the average life of a mortgage is about 12 years.  Folks move and sell their homes.When that happens the mortgage is paid off in that group or tranche.  These mortgage pools can have different speeds, the length of time it takes for the mortgage to pay off.   In some communities houses turn over quickly and in others more slowly. And since the government insures such mortgages, the buyer can be assured of getting paid, that is if the mortgage package meets all the specifications.

As you can imagine everyone along the way that re packages or sells these things takes a cut of the action so to speak. 

At least two things happened that changed the relatively conservative nature of this process. Make that three things.

The first change is that the banks putting these mortgage packages together started mixing up the contents.  We learned in Chapter 6 that a bond consists of s stream of interest payments and a principal re payment.  Well some of these things might contain only the interest payments or only the principal payment or some other combination.

Next, the sellers started becoming participants, a big change. Not content with re selling the package for a fee, CITI and MER became principals by actually owning the package themselves.  They would sell commercial paper which is sort term money. This would finance buying mortgages at a higher yield  Then MER or CITI or Bear would make the difference.  Of course this meant that the seller of the commercial paper has to continue to make short term interest payments from their long term mortgage pool.  Hmmm things are getting more complicated here.

Now the third change, still not content with a simple idea, why settle for a mere 6% mortgage when there is 7 or 8% to be made. That could be done by selling homes to folks that do not qualify  for a normal mortgage. Perhaps they don’t meet the take home pay requirement that the mortgage payment be no more than say 30% of take home pay. Perhaps they have no down payment. Perhaps they have had a house foreclosed.  Perhaps one of the two is out of a job, what they heck, let’s loan them the money anyway.  And interest rates are cheap they can probably pay. This would be a sub prime mortgage.

Okay, guess what….interest rates were often adjustable. So when rates start up the payments start up. With no down payment at stake, the buyer simply walks away from the house unable to make the payment.  Now the mortgage is not worth any more than the re sale value of the house. If multiple homes are foreclosed, it is not a stretch to imagine that they cannot be re sold for the same price in fire sale conditions, particularly now that interest rates are up. So, now MER et all cannot make their payments on the short term paper they sold in the commercial paper market.

And so the commercial paper market came to a halt because the buyers were not sure what they were buying. And this is when Secy  Treasury Paulson started proposing some sort of super SIV that would buy mortgages, but are they going to buy the bad ones, that is the question, well er ah no,well then who will.

And that is when things started being written down as impaired values.

Are we having fun on Wall Street yet?

Now how many ethical failures of fiduciary oversight can you spot here, gee more than I can count.

Now the companies that sold this paper to the public cannot re sell it to anyone and are stuck with the losses.  So how many more failures are out there, we don’t know and that is why the Broker and Banking Indices are falling through the floor.