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Thursday, October 4, 2007

Mortgage Market Woes

Here is the very simplified formula for what happened:

Low interest rates* + a lot of available money + housing boom
= Harder to see risks
= Investors willing to buy collateralized debt for more than the lenders paid
= Lenders lowered their standards for making loans and a lot of people (sub-prime/alt-a borrowers**) get loans who cannot repay them. If they get to a point when they can no longer make the monthly payments, all the borrowers had to do was sell the house for more than they bought it. The way the market was at that time, that strategy worked!

Then home values started to decrease…
> Risks became more apparent
> Investors will not buy or will only pay less to the lenders for the collateralized debt
= Lenders stop making risky loans
= For some lenders, it is too late. They already made risky loans that they cannot sell for more money. They can’t cover their losses and go out of business

*an interesting side-note…. rates were dropped in 2000/2001 to soften the blow of the collapse of the dot-com bubble

Here are a few more things to know that will help you understand. Although some banks and mortgage companies do keep the loans that they make, many sell their loans to investors on the secondary mortgage market. The lenders will group many types of loans (prime, alt-a and subprime) together and sell as it as collateralized debt. This is supposed to reduce the risk of the individual loans. Unfortunately, it also explains how the collapse of the sub-prime market can affect the prime and alt-a markets. What affects one market gets all of them.

Prime borrowers get the best interest rates on their loans because they have a good credit history and can prove that their income will cover the monthly payments. If they add to that the ability to make a down payment of 20% the purchase price of the property, then they are considered the least risky of borrowers.

Alt-A borrowers have a good credit history but either have little documentation or no documentation to prove their income. For example, people who earn tips or commissions could be in this category.

Sub-prime borrowers are the most risky and as a result, get the highest interest rates. They generally have problems with their credit history and cannot prove their ability to make the monthly payments on the loan.

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