Sub Prime Real Estate – I have spoken to a lot of my current clients about the economy. Many of them care what is going on. Some don’t care as long as they are ok. I’ve been asked by a few to write about the mess we are in and how the sub-prime mess contributed. I wont say that greed exclusively got us to where we are today, but Id say that 80% of the problem was in fact that.
With the mortgage bailout bill playing center stage on all of the national news stations, I thought it was the perfect time to release the second post in my basic mortgage education series. The first post of this series covered the history of mortgages and mentioned that the second post would explain what the secondary market is, and who the major players in the secondary market happen to be.
Subprime Real Estate
To start with, we will cover some definitions. Since I always like to have examples to help me wrap my head around concepts, I decided to provide an example for each lender class.
- Commercial bank Nongovernmental financial institutions. Sometimes called full-service banks because they provide a wide range of services including checking and savings accounts, credit and loan arrangements, consumer and business loans (generally short-term with full recourse to the Borrower), and safety deposit box rentals. Commercial banks also sell and redeem US savings bonds. A good example of a commercial bank is Bank of America.
- Savings and loan A federally or state chartered financial institution that takes deposits from individuals, funds mortgages, and pays dividends. These institutions are required by law to provide home mortgages as a certain percentage of their loans. An example of a savings and loan would be the previous World Savings that was swallowed by Wachovia. Not many of these banking entities exist as most of them failed during the early 90 in what has been called the savings and loan crisis.
- Thrifts A depository financial institution intended to encourage personal savings and home buying. Washington Mutual is a good example of a thrift.
- Mortgage Brokerage An organization that is hired by large institutional lenders, such as pension funds of large unions or commercial banks. Most mortgage brokerages are small independent organizations such as Lone Star Funding.
If, after reading these definitions, it is not clear to you what the difference is between these institutions, it is not an absolute must in order to understand the secondary market, and you are not alone. In the end the differences are really in the legal regulations that govern them.
Whether someone applies for a mortgage through a commercial bank, a savings and loan, a thrift or a mortgage brokerage, the institution is known as the primary originator of the mortgage. Companies that later purchase loans from primary originators are referred to as secondary originators, because they sell the loans in the secondary market.
Primary originators package a large number of loans together and then sell them off to one of the three main purchasers of mortgage loans: Ginnie Mae (GNMA), Freddie Mac (FHLMC) or Fannie Mae (FNMA). Once one of these groups purchases the loans, they are split up into smaller pools, and the principal and interest payments made by individual home buyers are then combined to create mortgage-backed securities. These securities are subsequently sold on Wall Street to individual or institutional investors as bond class investments. By selling off these bonds FNMA, GNMA and FHLMC refill their coffers, which allows them to purchase more loans from primary originators, thereby allowing the primary lenders to make more loans to consumers.
The breaking of this chain is what has caused the subprime crisis, sending a shivering shock through the entire credit market. In my next post in this series, we will cover the rolls of secondary originators such as Fannie Mae and Freddie Mac.
In 2004 to 2006, I was National Sales Director to one of the largest construction lenders in the country. The secondary market accepted unrealistic guidelines. Recent appreciation and higher fees justified the loan to many lenders. I saw school teachers on a fixed $35k annual income being approved for 4 preconstruction loans at 100% financing!! I noticed this error back then and was ignored on my recommendation to scale back to limiting mortgages based on back-end debt to income (DTI) ratios. The virtual game of hot potato ended in the last couple of years and these uneducated and vulnerable middle income investors were now stuck in terrible investments.
What the secondary market was is nearly criminal and rooted to the greedy aspect of the business. Real estate across the globe will be forever changed and the old school method of being old fashionedwill be reborn again.