Mortgage Lending For Dummies - How This All Works And Why You Should Care

I'm driven to post this because of the insane amount of misunderstanding or just plain willful blindness I'm seeing on some message boards regarding how the "sausage making" of loans actually works in the real world.

This is something that you simply have to understand if you're going to "get it" about why this entire "Subprime" mess is not contained, can't be contained, and will blow up the balance sheets of many of these lenders - and thus, kill their businesses.

Let's say you want to be a mortgage lender. Ok, to make loans you need money, right? So you go out to the big money center banks - Citibank, Chase, JP Morgan, Credit Suisse - and negotiate what is called a "warehouse line."

Think of that as a short-term loan - sort of like a credit card. The interest rate is usually very low because the money is only out there for 1 year at most (these facilities typically are renewed annually) and require only interest payments as the principle is not really intended to be "held" by you - its just a way to "park" assets (mortgages) you intend to "buy" (by issuing them to consumers.)

Ok, so you go get a million dollars in this warehouse line from these banks. We'll keep the numbers nice and round so they're easy to understand, and small as well (helps with the math); for the sake of argument we'll assume all houses cost $10,000 (again, makes the math easy.)

Now you start writing loans and funding them. The cash comes out of that warehouse line. With each house costing $10,000, you can write a maximum of 100 loans. When you've written the 100th loan your credit facility is "full"; there's no more money to fund loans with.

Well, this is bad, because you're in business to write LOTS of loans! So when you get to, say, 50 loans you package them all up and sell them.

On the bond markets there are a number of rate indices; the most common series is known as the "LIBOR", or London Interbank Offered Rate index. Most adjustable mortgages are pegged to this with a "margin" - that is, you might get "LIBOR + 2". The "+2" is there because nothing in life is free, including writing loans - you, Mr. Lender, have people, buildings and computers and all of that has to be paid for somehow. Guess who pays? Yep.

Ok, so you have your stack of mortgages. To get them off your warehouse line you must sell them. You put them out for what amounts to auction, asking for bids on the package. The free market determines what they're worth.

Of course, its not quite that simple. These loans are sliced, diced, and packaged in many different ways (e.g. you may have one "slice", or tranche, that contains only principle payments, another that carries only interest, etc)

The important part is that all of this has a "par value" - that is, its "face" value. 100% of par, however, leaves you, the issuer, with a loss, because you have costs associated with issuing the loans.

Typically, you need about 200 basis points - or 2% - to cover those costs. So if you can get someone to buy these mortgages at 103% of par value, then you make 1% - which, if you turn enough of these mortgages, is a very nice amount of money indeed!

But what happens to you if, between the time you issue the mortgage and attempt to sell it into the market, the market comes to believe that the risk of default is higher than they thought?

Well, then when you go to sell those loans you find that you can't get as much as they cost you to issue! You've now got a very serious problem - if you don't sell the loans you will run out of money to make more loans with (since your warehouse line will run out of credit, just like your credit card does if you don't pay it down) and what's worse, if you do sell the loans at the offered price you lose money on every single one!

That's a great position to be in - the more business you do, the more money you lose!

The obvious reaction to that event is to raise the interest rates you charge to borrowers.

But there is a problem with that too. Let's say you start getting bids of 100% of Par instead of 103%. You can compensate for this by raising your interest rates 3%.

But - will anyone take those loans? If you can have a 30 year fixed mortgage at 7% with full documentation, will you pay 10% to have one with lower or no documentation - that ALT-A product?

Historically, those ALT-A products were seen as having about a half-percent higher risk of default, and thus had about a half-percent higher interest rate. But now, the rate of defaults for no-documentation or low-documentation loans appears to be some four to five times as high as was originally assumed!

So if I, as a borrower, can prove my income, why wouldn't I? For a half-percent, if I'm a small business owner, I might not want to go to the trouble - and it can be considerable - to have a bank go over my financials with a fine-tooth comb.

But for three percent? You betcha I'm gonna pull out the balance sheets!

Who won't? Those who really don't have the income they're claiming, those who are dodging the IRS, and those who are engaged in some sort of illegal enterprise.

Now, having made this business adjustment, what do you think the default risk is of your remaining customers for those "ALT-A" products once all the reasonably-good customers no longer have a reason to buy?

See where this is going folks?

This, at the end of the day, is why the ALT-A space is dead and buried. Lenders, money-center banks and ultimately the bond market, hungry for better returns in a market that had a near-zero interest rate for a number of years (after the tech crash) kept demanding these securities and the lenders and banks provided them. This, in turn, drove asset appreciation in homes through simple supply and demand - with extremely low "teaser rates" people who could never qualify under traditional underwriting guidelines could suddenly buy homes. And buy they did.

Asset inflation in the housing sector has pushed homes to five times median income in many areas. This is almost double the recommended price-to-income ratio.

So long as home prices were going up at 10-20% yearly, this was somewhat sustainable. When your teaser rate expired you just refinanced and got a new one! Start over with a bigger balance, but the house is worth more - all is ok, right?

Until the asset appreciation stops, because even with the teaser rates people start to run into the wall as their equity goes below zero and they're unable to make the payments.

As a consequence, today fully half of borrowers who took mortgages in the last two years can't qualify under traditional underwriting rules.

The ALT-A market has accommodated them by, essentially, lying to the markets about the risk in these loans through the "assumption" that "this time its different - home prices will always go up at 10% or more a year."

But now the truth about that risk is becoming known, home prices are actually going down, and you can no longer sell those loans with an artificially low risk assessment!

There is no way out of this box except for the asset prices on which loans are being written to come back down to realistic levels.

This, fundamentally, is why I believe there is no "painless" or "slightly painful" way out of this mess. It is also why I believe there will be a number of lenders who do not survive and why I believe there is no escape from the impact of the mortgage tsunami on the American Economy.

I believe we are now reduced to arguing about the depth, breadth and length of the recession which is inevitably going to strike the United States economy, rather than about whether it will happen at all.

PS: Yes, I realize this is oversimplified. But it captures the essence of what was - and is - going on......