A Primer on Sub-Prime Mortgages

The sub-prime mortgage infection has already spread to affect most areas of the U.S. economy and the world. What started as one of the after-effects of the "Great Greenspan Depression of the Millennium", it has recently threatened to destabilize the very financial system of the most powerful economy in the world.

This presentation called "A primer on Sub-Prime Mortgages" is entertaining while at the same time very educational. It describes in simple terms some of the reasons that got us into this mess.

Many AAA mortgage bonds are actually extremely high risk because of little-considered nuances in the hundreds of pages of trust indentures and servicing agreements. In addition to the widely understood mortgage default risks and other concerns, these contracts actually permit the loan servicers to advance payments on behalf of defaulted homeowners for years and years at interest rates of 12% and more. These advances put funds back into the trust to be paid to junior security holders and are subsequently repaid first from foreclosed home sales. The net effect is that foreclosed home sales may result in little or no proceeds, or even a liability to the AAA bonds which are supposed to be the senior securities. This is not widely understood even now.

The large amount of "First Mortgage Syndicated Bank Loans" issued since 2004 are, for the most part, garbage. Most of these loans permit the borrowers to sell the collateral, keep the money, and reinvest in almost anything they want to, including stocks junk bonds, defaulted loans, or even Al Gore's ventures.

Roger Lowenstein in his recent New York Times article Triple-A Failure puts it most succincly:

Mortgage volume surged; in 2006, it topped $2.5 trillion. Also, many more mortgages were issued to risky subprime borrowers. Almost all of those subprime loans ended up in securitized pools; indeed, the reason banks were willing to issue so many risky loans is that they could fob them off on Wall Street.

But who was evaluating these securities? Who was passing judgment on the quality of the mortgages, on the equity behind them and on myriad other investment considerations? Certainly not the investors. They relied on a credit rating.

Thus the agencies became the de facto watchdog over the mortgage industry. In a practical sense, it was Moody’s and Standard & Poor’s that set the credit standards that determined which loans Wall Street could repackage and, ultimately, which borrowers would qualify. Effectively, they did the job that was expected of banks and government regulators. And today, they are a central culprit in the mortgage bust, in which the total loss has been projected at $250 billion and possibly much more.

The Fed is now stepping up to guarantee these loans which is effectively shifting them into the Federal Reserve's Balance Sheet. And, you may ask, who "balances" the Balance Sheet?...

The taxpayers - You, me, and our kids...