A look at the subprime mortgage picture

Foreclosures are up as the subprime mortgage market bottoms out. Politicians are weighing in, expressing concern. President Bush issued a statement yesterday about the importance of housing. Here’s what’s going on, from my perspective as a journalist who covers the banking industry.

The subprime mortgage phenomenon was supply driven. Investment firms like Merrill Lynch figured out how to sell questionable credit from high risk borrowers to pension fund managers and other typical bond buyers. Investment bankers figured out they could create a bond out of very good, or “A,” credits, mixed with questionable, or “C,” credits, to produce a bond with an overall quality of a pretty good, or “B,” credit. Pension fund managers, who typically buy B-rated bonds, showed interest after independent rating agencies blessed the new recipe. This created a new market for C credits in the form of subprime mortgages.

The investment bankers went to the mortgage brokers with the new product and the brokers sold the product like mad. You remember hearing all those ads on the radio and on television, where mortgages were promised to anyone, regardless of credit history. People with marred credit, who otherwise could not get mortgages, responded and bought homes with the easy credit. In many cases, they didn’t even have to put money down.

In the third or fourth year of this game, those C credit borrowers are beginning to show why they were C credits in the first place. They aren’t keeping up with payments and the mortgage holders are foreclosing. That’s the phenomenon that is making so much news lately. But remember, a good number of people losing their homes weren’t in homes prior to the availability of subprime mortgages, and they also aren’t losing much, if any, equity.

The people who are losing money are the people who bought the bonds made up of these mortgages. They are not likely to get all of their investment back, let alone any kind of a market rate on their principal. I feel bad for these guys, but not too bad. Investments, especially those including C credit components, are risky.

Decades ago, when someone wanted to buy a house, they went to the bank or savings and loan to borrowed money for the house. The lender held onto the loan for the life of the mortgage. The lender and borrow stayed closed to one another. If the borrower got in trouble – lost a job or incurred substantial medical expenses – the lender was there to consider the situation. They usually tried to work something out. In the absolute worst cases, the lender might foreclose, but in most cases, the borrower and lender worked something out to keep everything on track.

Today, there are many more players between the borrower and the lender. An investment banker finds a funding source. They then work with a mortgage broker, who finds borrowers. Brokers also find mortgage servicers, who handle the paperwork. The mortgage ends up being a complicated legal document which binds the borrower to the servicer, who is tied to the funder. The broker, who initially works with the borrower, is out of the picture. Consider what incentive the broker has to get the right product for the borrower when they disappear the minute the final papers are signed. The servicer rarely knows the borrower and if the borrower falls behind, the servicer usually has no option than to initiate foreclosure as prescribed by the legal agreement it has with the funder. It’s a much tougher arrangement for the borrower than the mortgage arrangement of decades ago.

But there’s no going back. Access to equity markets for mortgages has a substantial upside as well. Many more people have access to mortgage credit than did under the old direct lending system. But the downside is that over-eager players come up with shaky ideas and sell them to others who don’t look close enough at the product. In the end, it’s the way the market has worked for centuries, and overall, the market always self corrects. That is what is happening now with the subprime mortgages. The politicians really don’t have much of a role in all this.