Underwater Mortgage vs Highly Leveraged Financial Institution

Many people are looking for someone to blame for the turmoil in the financial markets. I've read and heard a lot of different opinions on various sites, articles and in news reports. One thing I see quite a bit is blaming these problems on "greedy home buyers". The opinion is that if these people didn't try to make out like bandits, buying a home they couldn't afford or refinacing to take expensive vacations, buy flat screen tv's, remodel kitchens with granite counters and stainless steel appliances. I'm not going to go into all the details as I've discussed this in previous posts and am sure to talk about it again. Right now I just want to concentrate on buyers vs lenders.

I don't argue that there was a good bit of that going around. Many people were using their homes as ATM machines to live lavish lifestyles. I ran accross a couple of bankruptcy filings for NJ couples that did just that. In both cases the households had 6-figure incomes and good jobs. Unfortunately they had a lot of debt. Much more than they could handle. Expensive cars, and very little savings. In one case the amount of debt secured by the family home was around 10 times their income.

But there were still others that tried to use the money a little more wisely, pulling out equity in their homes to start businesses, invest in other real estate or pay for education. As well as others that just got in trouble because the economic downturn caused them to lose their jobs or in some cases they had medical problems. The problem was many individuals had paid too much for their home or taken out too much equity. Even if you tried to be sensible during the bubble, and buy a home you could afford, which in most cases meant a lower priced home, you were still in trouble, as prices of lower priced homes grew faster than those of middle and higher priced homes.

Now, home buyers are an important part of the equation but they did not cause the problem. If home buyers all got together to look at was going on they may have decided to stop buying. But to my knowledge, there is no national organization representing home buyers. A group of analysts and economists to determine what is in their collective best interest and lobby government on their behalf.

The finance and realty industries however do. They can get together and push for what's in their best interests. In fact the banking industry had spent $100's of millions for decades to fight for deregulation. Over the past decade, the phrase "predatory lending" has been used many times. When states tried to do something about it, the Treasury Department stepped in to quash state anti predatory legislationt. This 2004 story from USA Today gives some examples of predatory loans. There were also brokers flipping mortgages to generate new fees as well as putting people into subprime loans when they could qualify for a prime loan, just because it made the broker more money.

There are so many bad actors in this whole mess and many profited from it, but it all comes down to two things. Responsibility and control. In my opinion, it was the financial industry (Wall Street) that created a giant wave. Everyone else was necessary to keep it going or just hopped along for the ride.

That doesn't absolve home buyers that made poor decisions. They were under considerable pressure from government, the media, realtors to buy, but nobody put a gun to their heads. They made poor choices and have to deal with the consequences of those decisions. But they have no responsibility past themselves. They abided by their contracts and if they get foreclosed on, well that was a risk both parties, borrowers and lenders, had to anticipate. They also had no control. One person buying one house does not move a market. Many people decided to stay away from the tsunami, including local community banks and credit unions which stuck to more traditional lending practices.

Lenders on the other hand had responsibility and control. Lenders ultimately make the final decision if a house gets purchased. You may make 35k/yr and want to buy a 500k house but if the lender doesn't lend it to you, you don't get the house. When you're a home buyer you're responsibile for your own financial situation, you're not responsible to the bank, their investors or other interested parties. The lender however is. They have to make sure they make sound lending descisions so that they do not jeapordize their business. There are many details to that story but for now lets just say lending money to people who couldn't pay it back wasn't a great idea.

So why is it we hear about troubled homeowners being "underwater" but troubled banks are "highly leveraged"? They mean the same thing, your in debt up to your eyeballs.. Underwater sounds a bit more negative.

Underwater is when your mortgage balance is greater than the value of your home. Being highly leveraged, according to investopedia, when you have significantly higher debt than equity.

Part of the equity these financial institutions used to secure debt was based on residential and commercial mortgages. But why would these banks and other financial institutions take out so much debt? The deregulation in the banking industry, including the repeal of the Glass-Steagall Act, made some of this possible as well as the secondary mortgage market. Where commercial banks were required to make better risk decisions, investment banks were not. And when they were allowed to merge they were able to work in concert and have an ability to manipulate the housing market by creating a larger pool of buyers that drove up the price of houses. If you can manipulate the market this much then you want to beg, borrow and steal to take advantage of it, just like you would if you could rig a sports game.

Think about it. If you had $10,000 to invest and you had a sure thing that would make you a 10% annual return on your investment, you'd do what you could to get more money to invest in it. Lets say you own a home with $100,000 in home equity and you borrowed that at 5%. So instead of making $1,000 per year with just $10,000 invested you'd make $10,000 per year but will be making loan payments of $6,41.84 so you'd be ahead $3,558.16 which is over 3.5 times if you didn't borrow.  If next year your equity goes up another $100,000 you can borrow against it again for another $3.558.16 and again and again as long as your equity keeps increasing.

The problem comes if value of your investment falls you put yourself at great risk. If the investment you purchased loses value and the return falls, your stuck in a position where you still have to repay the $100,000 but you are no longer making money from your investment to cover the payments and you can't sell the investment for enough to pay off the remaining principle.

When I first started learning about investing, one thing I saw a lot is that you should not borrow to invest in the market. It's just too risky for most people. But Wall Street thought they came up with a way to mitigate these risks. It turns out they were wrong.

The risk is increased but that also increases the potential for profit. So in our example, after 30 years of making 5% on the money invested, you still hold on to the assets. At that point you have paid off the debt and still hold the assets which are hopefully worth more than what you paid for them.

This is basically what the banks and other financial institutions did. To them, your mortgage or a security based on your mortgage is an asset to them that they can leverage. If your ability to repay and the value of the home secured by the mortgage the value of their assets decline and leaves them in a position where they do not have the equity necessary to continue borrowing. And banks and other financial institutions need to borrow to keep making money. In this market, they can't sell these assets to raise capital, even at  a loss, because investors don't want them because they're not sure if they're priced correctly.

Previously, banks wouldn't take these kinds of risks until there was deregulation. Many banks didn't leverage themselves this much and are in much better shape but the ones that did were big and borrowed big.

This is a simplification and banks do more than this, but with what is being said, residential mortgages are a big part of the problem. The reason for this is the housing sector was the biggest growing segment after the tech bubble and that growth was used to finance other parts of the economy. But now that the housing market has stalled, so has the rest. The banks took a big gamble that caused a lot of problems for not just themselves, but the rest of the economy. They should have known better than to put themselves in this position.

I'm not sure if they thought they finally invented a perpetual motion like time machine, where the mortgage market was fuled by easy loans that powered high paying risky mortgage related securities, or if they thought there would be and end to the party and just tried to scoop up as much as they can. In either case, it looks like they got caught with their pants down and are having a hard time doing business as usual now that they have to deal with real estate activity returning to normal and they are forced to go back to more traditional lending underwriting.

I'm not alone in thinking this. I'm paraphrasing (didn't get a chance to type it all up as he was saying it) James Glassman, CEO of JP Morgan Chase who I heard yesterday say 'I don't blame rating agencies, brokers, builders, homeowners that thought they were going to be bazillionaires, it's our responsibility.' That was very refreshing to hear.