posted by Chris | As the third quarter comes to a close, we find the market bouncing around like Congress voting on a bailout bill. The year-to-date numbers are sobering as we look squarely at the teeth of a bear market.
The Dow Jones Industrial Average is -16.6 % and the Standard & Poors 500 is down 19.3%. I have been asked many times about the bailout and the cause(s) of our current situation.
The easiest answer to this problem was for people to pay their mortgages; however, most of the subprime mortgagees should have never received a mortgage. Let’s start with some background.
In 1977, Congress passed the Community Reinvestment Act (CRA) which required banks to make real estate loans in areas they usually preferred to avoid. In 1995, Congress started to aggressively require that the banks live up to the CRA or the banking regulators would be called in.
In 1999, the focus shifted to home ownership for low and middle income earners; the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) loosened their loan requirements, which was the genesis for no-documentation loans, lower down payments, more adjustable rate mortgages, etc. (These riskier loans are now referred to as ‘sub-prime’).
Banks and mortgage companies make their money by “originating” loans, which means they write the loan, receive the fees, sell the loan, and start all over. Because Fannie & Freddie lowered their standards for buying the loans, mortgage lenders could pay less attention to the borrower’s qualifications.
Wall Street saw these mortgages as an opportunity to invest in something that paid a higher interest rate than many bonds.
Investment banks bought these mortgages and comingled them into "investments" called Collateralized Mortgage Obligations (CMOs) and Collateralized Debt Obligations (CDOs).
The next step was to get mortgage insurance to insure an AAA rating and sell them to investors. Investors -- in this case -- could be individuals, banks, insurance companies and countries. These CMOs and CDOs allowed banks another option to sell the mortgages (other than Fannie & Freddie), which meant the banks' process started all over again.
For a while, everything was great. People owned homes, banks made money, Wall Street made money; as long as real estate prices kept rising.
When the real estate bubble burst, it started a tsunami that has taken the economy, bond markets (credit markets), and the stock market with it. Remember, while all of this was happening, real estate speculation was running hot, builders were pushing out inventory, mortgage brokers & real estate agents were all making money as well.
As people lost their jobs, homeowners stopped making their payments as they realized that their houses were worth less than their mortgage. It ultimately became a supply and demand problem for real estate: much more supply than demand. Then as foreclosures started to hit the market – the problem started to grow exponentially.
Those investors that held subprime mortgages started to have difficulty understanding the true value of the mortgages. An accounting change required firms to "mark to market," which means: let’s guess what it is worth today – not guess at what you will receive at the end of the term!
My favorite analogy was the “Mark to Myth,” because it was extremely difficult to know the underlying value of the mortgages. Ultimately, no one wanted to buy subprime loans and everyone wanted out.
Unfortunately, large companies had bought these subprime mortgages, borrowed money, bought more subprime mortgages -- and the cycle continued sometimes 30 times the original purchase.
This type of leveraging basically caused companies like Bear Sterns and Lehman Brothers to go out of business, as well as pushing many companies to the edge of a cliff!
Now that you have a sense of the issue, we need to go back to the fundamental value of the collateral of the loan. What is the home worth? How do we manage the real estate that we own as a result of the numerous foreclosures? Once the real estate markets find equilibrium, then we can start to wade out of this morass.
As for the bailout, getting cash (liquidity) into the banking system is a good first step -- but more action will be needed by the government and, as always, time will be required to work through this complex situation.
I will write an investment outlook piece as we approach the end of the fourth quarter, but for now I am watching, because inaction may be a better route than forced action: discipline over conviction as we view this global market fallout.
Global economic conditions are slowing – not stopping. We will survive.
Christopher J. Conner
Certified Financial Planner TM
Certified Fund Specialist
5200 W. Newberry Road E-7
Gainesville, Florida 32607
352-225-3132 (Fax) 352-225-3784
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