The Mortgage Mess 101
by L. Arthalia Cravin
For anyone who has been on Mars over the past several months, there is a problem with what folks are calling “sub prime” mortgages. No one has bothered to explain some of the details of the problem so I will explain the basics of mortgages. The word mortgage has been around since the 1300 and is rooted in Old English and Latin. The root word “mort” means “dead” in Latin, and the word “gage” means a security or pledge. (The word probably means that if you buy a house you will owe on it until you die.) Nowadays the term mortgage refers to the legal document that evidences a pledge of a house or other real estate as security for the repayment of a loan. When a persons buys a car, there is no mortgage given, instead if the car is financed the car is pledged as collateral until it is paid. The person or company that finances the car evidences the collateral by placing a lien on the car title. When a person buys a house, he or she signs a “deed of trust” which means that the deed is placed in trust with a “public trustee” who can foreclose on the house if the monthly payments are not paid. What is often misleading about the phrase, “I bought a house,” is that unless the person paid the entire purchase price in cash, they have not bought anything. Instead, they have signed mortgage papers that allow them to make monthly payments on the house and to enjoy the full and exclusive use of the house, including the right to any monetary increase in the value of the house—called equity.
A mortgage is a debt. The person who buys the house is the mortgagor and the company financing the house is the mortgagee. Buying a house starts with an application that qualifies a person for a certain price range. The person buying the house must show credit worthiness, meaning financial stability, the ability to make the monthly payments, as well as a history of credit that reflects that the person has handled other credit accounts responsibly. Years ago a house was bought by making a down payment, usually 10 percent or higher and the mortgagee, usually a bank, examined the person’s loan application and made a decision to either make or deny the loan. The loans were typically called conventional loans, meaning a loan with a 30-year fixed interest rate. With such a loan, each month the person buying the house paid a fix dollar amount, a portion of which was applied to interest and the rest to pay down the principal. The initials, “PITI” mean “principal, interest, taxes and insurance.” These are the “four biggies” for anyone buying a house. Interest it the cost of borrowing money and during the first years of a mortgage a large chunk goes to pay the interest on the loan and a much smaller portion goes to actually paying off the principal. (The situation reverses as the loan is paid down with more money going toward the principal and less going toward interest.) Some loan payments have the taxes and interest factored in, other loan payments are just principal and interest and the borrower must pay property taxes and homeowners insurance separately.
The mortgage mess is about another type of loan that has crept in over the past 10 years, and it is called a “sub prime” loan. These loans are offered to applicants with “less than top quality credit.” These loans could be at a fixed rate, but also could be one of a variety of “tailored” financing called adjustable rate mortgages, referred to as ARMs. These “ARMs” could be for a period of time, either 3, 5, or 7 years, which subjected the monthly payment to recalculation (upward) depending on an external trigger. The external trigger allowed the company lending the money to add points to the original interest rate in 2-point increments based on things going on with general interest rates.
Over the past 10-15 years or so, the value of houses has increased tremendously, the so-called housing boom. During this boom, folks were buying houses that, in some parts of the country, were increasing in excess of 20 percent a year. The historical average should be between 5 to 8 percent increase. With the housing boom came more folks wanting to get in the market, including home buyers and home builders. So, builders kept building houses and folks kept buying-hoping to make a fast buck when they resold, or at least have a nice little nest egg in the house because of the increasing value. Folks who did not have the best of credit also wanted to get in the market so lenders devised a way—sub prime loans. These loans, now called, “ninja” loans, (no income, no job, no assets”) were a way of getting folks into mostly newly built housing with little or no money down, at higher interest rates, but with the adjustable rate feature that allowed the loan to “re-set” every couple of years. The end result was the mortgage mess we now have–the so-call “bust” of the real estate bubble.
This bursting of speculative bubbles is not new. In the mid 1660s, the Dutch went on a frenzy buying Tulip bulbs—it was called Tulipmania. The boom started with someone paying a lot for a “rare” tulip, then someone paid even more to acquire that same tulip. Soon folks all over Holland were buying tulips with hopes of reselling and making a fortune. Some folks traded all sorts of other precious valuables for rare tulips—that is, until one day a man failed to show up to pay for his bulbs. A panic soon set in and the bubble burst, leaving folks holding a bag of worthless tulips that they had paid a small fortune to get. A variation of this happened with sub-prime loans. After everybody got in on the booming real estate market, and after many of these loans began to re-set, the buyers realized that they couldn’t pay the much higher monthly payments so they defaulted. Just like overpriced tulips, soon defaults were taking places everywhere. The lenders were left holding defaulted mortgages and foreclosed homes. Many of the lenders had already bundled and sold the mortgages to another company or mortgaged back securities sold to global investors. As the foreclosures increased, the value of the glut of houses decreased—so did the value of the houses down the street that were not involved in any way with the sub-prime loans. What happened is called a “knock-on” effect, where the glut of foreclosed housing spread to builders who couldn’t sell new houses and realtors who now have hundreds of listings and no buyers. So now there is a mess—lots of foreclosed houses, lots of folks who bought houses who lost them because they couldn’t pay the monthly note, lots of layoffs in the building support industry, home prices going down, and lots of lenders holding loans that no one can pay. But, people who knew the industry started warning of a melt-down several years ago. No one listened. This is the essence of the current mortgage mess—but behind the scenes lots of people made lots of money engaging in questionable mortgage lending. And, lots of other people were pulled into the “madness” of another frenzy-driven bubble that burst.