See, the entire subprime market is based on securitization. Not on the lenders actually holding the loan on their own books through its entire life. They would not have the capital to do the volumes they do, for one thing. They wouldn't lend to half as many poorly qualified borrowers, on the other.
What they do instead is charge several percent of the loan value in "points", which means a few thousands on each loan rolled into the mortgage amount and kept by the issuer. Then they take a bundle of thousands of the loans and park them in an off balance sheet vehicle - typically a financial trust. Those pay full face value for the loans.
They get the fund to do so by selling mortgage backed securities (MBS) against the loan pool - but all this is in the off balance sheet trust, mind. The MBS are made palatable to banks and mutual funds by first carving them up into "tranches", based on seniority of claim against the loan pool.
For example, the largest tranch might have 60 to 80% of the principle value, and first claim to anything actually paid out by the loan pool - giving it an investment grade credit rating, sometimes AAA even. The next tier shoots for the lowest investment grade rating. The top 10% or so is "toxic waste" - junk credit leftovers. The last are sometimes retained by the trusts or sold back to the initial lenders as unsellable. The lenders themselves are financed by both bank borrowings and selling REIT stock to investors. Sometimes the waste is instead parked in junk bond mutual funds.
So the money flows from banks or mutual funds buying RBSs, to the off balance sheet trusts, to the mortgage lender, to the mortgage lendee, to the house construction company. And the beauty of it is, everyone in the chain except the mutual fund holders expects somebody else to take any resulting hit if the credits go bad. As long as house prices were rising 15% per year, there was little fear, because it was assumed if the loan did go bad the house could just be sold and would cover the loan amount, or all but the top, "toxic" tranch.
What has happened in the last 6-9 months is first, house prices stopped rising. Second, new activity dried up, reducing the cash coming from the loan process pipeline coming into the lenders (their points etc). The mortgage brokers themselves then became illiquid - they need cash to fund their recently issued loans, but their own profitability was dropping, making them poor credits for new rounds of bank loans. Simultaneously, their REIT stock prices began plummeting. (Look at the chart of NEW e.g.)
But the real difficulties began to appear as the upper tranches in the trusts starting getting "blown out". The MBS holders started aggressively using provisions in the MBS contracts allowing non-performing loans to be forced back into lenders hands for collection - particularly for in process stuff. (Typically the contracts specify that a loan that defaults within 6 or 9 months of being parked in the trust can be "unbought" - a "lemon law" in effect).
As these came back to the mortgage brokers, their credit ratings imploded. Illiquid to begin with, they then could not make payments on their existing bank loans and the smaller ones began declaring bankruptcy. Bankruptcy is a scramble to get paid ahead of other creditors, and banks exercise plenty of leverage trying to get paid first. They aggressively attached assets in the trusts and such, or grabbed in process MBS collateral and sold it for whatever it would fetch this instant, to get out.
In turn this has revealed that the modern "rocket science finance" of the securitizations are vastly less sound than Wall Street pretended, and could get people to believe as long as house prices were going straight up and money was gushing into the whole industry. You are now seeing a classic "repudiation" of the credit given, not to the end home buyers, but to asset backed securities (ABS).
Right now it is focused in the subprime mortgage ABS market, but the issue is general. ABS was the hot new financial product of the last 10 years. They are used for car loans, credit cards, etc - in addition to housing. They create the illusion that any credit, however dodgy, can be instantly made liquid, and the problem of tracking or collection or enforcement parked with "somebody else". What actually happens is nobody does that work, at all.
Most housing is not affected by any of this. Most people bought long before the run up of the last 5 years, have equity, notes they can afford, etc. But this is a typical Wall Street story of a new finance vehicle created under boom conditions being underpriced (for its risks I mean), that goosing demand and leading to overuse, and the cost only appearing later after the stuff has been around long enough for some to go sour naturally and for the whole market to face non-boom conditions.
That is a world class post JasonC. Thanks. You should pull it together, expand it and, then, publish it in some form or another. It is very hard for a non-professional or non-sophisticated investor to understand what is actually happening.
I think that's exactly what I said in less then 10 paragraphs. The S&L "crisis" was a pretty good example of what could/would happen.
That is the clearest explanation yet I have seen of the housing finance market.
Wow that was a great post JasonC. Do you have a ping list?
Very informative. Thanks for the wrinkles on the brain.