Debt Snowball – Who Is Holding How Much Bag

| March 12, 2007

Outstanding graphic from a report by Credit Suisse showing the break down of the size of the mortgage business by percentage and estimated absolute value. Of special note is that a majority of the money (51.4%) now comes from outside the Government Sponsored Entities (GSE), and through Wall Street and hedge funds. That means that pension plans, 401Ks, IRAs and Mutual Funds could possibly be holding on to some toxic debt. That makes it imperative that folks find out if the funds they are invested in, and counting on for long term, could be at risk because of the mortgage industry troubles.

Mortgage Market Percentages - Credit Suisse
(click on graphic for larger view)

Some Terms Behind The Chart:

ARM – Adjustable Rate Mortgage: This is a mortgage with a variable interest rate. Typically the mortgage has a fixed rate for 1-3 years, often at a low “teaser” rate. After the introductory time is over, the interest rate will adjust to a new rate based on some benchmark, such as LIBOR, plus some number. When the adjustment hits, the monthly payment adjusts as well. In this day and age, that means the payment goes up. Many of these loans were written with 1% or 2% teasers for 2 years, and are now adjusting into the 8% range (some higher). This results in a huge payment shock for some folks who took out these kinds of loans.

Interest Only – This is a loan where for the introductory period, you are not paying any principal on the loan, only the interest portion of the payment. That further lowers the initial payment during the “teaser” time period, but further increases the “Boost” once the intro period is over. Payments can more than double after the introductory period.

Option ARM – This is the most toxic sort of loan, the person with the mortgage does not even have to play the full interest during the introductory period, they have an “option” to pay whatever amount they choose. They could be paying off the principal as well as the interest, but it should come as no surprise that most choose to pay a minimum amount. After a certain period the loan converts to a fully amortized mortgage, and the amounts they should have been paying (but weren’t because they optioned to pay less) are added onto the loan balance. In essence the total value of the loan balloons over time.

Why does this matter? As Wall Street became the primary funder of these wacky mortgages, the risk that maybe they were not as good an investment as was assumed was injected into the funds that purchased them, and that created them. Of course Wall Street was most interested in selling as many of them as possible. They had little or no history on how to price this risk, or who should or should not be funded for such a large block of money.

How much of this is fraud? We should find out over the next year or so. This chart is an important key to remember.

Hit tip to Calculated Risk

Here is why this is all so dangerous (simplified money flow)

Step 1 – Mortgage company originated mortgages
Step 2 – Mortgage company borrows money from Wall Street via warehouse financing
Step 3 – Mortgage company provides borrower with cash and receives note payable (the mortgage)
Step 4 – Mortgage company bundles up mortgages and ships them back to Wall Street less processing fee and covers its original borrowing
Step 5 – Wall Street packages and then slices and dices and sells derivative securities (collateralized by the mortgages) to pension funds, insurance companies , money market funds, foreign investors, etc.
Step 6 – Home owners begin to default on these mortgages thus effecting the mark-to-market value of the derivative securities
Step 7 – Pension funds, insurance companies , money market funds, foreign investors, etc. go to Wall Street and demand that they take back these securities
Step 8 – Wall Street goes back to mortgage company and asks them to buy back the original mortgages
Step 9 – Mortgage company has no money to pay the “call” — they never did — it was Wall Street’s money

This is exactly how companies like New Century are unwinding so fast. They had very little actual money on hand, they were largely just taking orders and funneling the results into investment pools. When the time came to pay up on the bad paper, all they had left was the money they were supposed to be using for loans.

So will the bagholder be the investors or Wall Street? If Wall Street fails to make good on the securities sold to investors they’ll be done. Therefore, the FINAL BAGHOLDER IS WALL STREET.

Over the past 10 – 15 years, everyone who is saving for retirement, who is trying to make money has put money into Wall Street. That means the real final bag holder is all of us who have been investing.

When that payload of pain hits, most of us are going to feel it.

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Category: Credit Backlash, Economics, Main

About the Author ()

Bruce Henderson is a former Marine who focuses custom data mining and visualization technologies on the economy and other disasters.

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