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Tuesday, March 21, 2006

Musical Mortgages

Funny money, explained. You really ought to read the article, but here's a short summary. Normally the mortgage chain goes broker > bank > FHLMC or FNMA > investor. What investors actually buy are pools of loans with an expected yield based on the stated interest rates. Higher yield = higher price.

Now brokers get paid bonuses for providing high-rate mortgages, because the investors will pay a premium. At least one broker in CA got the bright idea of paying his customers to refinance at a high rate out of the bonus. He got some, and they got some, and the rest was used to pay any costs. So to keep the cash flow going, these customers were encouraged to refinance every 4 months, and were paid for doing so - as much as 1% of the loan value. Nice deal!

One day, the big bad investor wolf came along and blew and blew until the little piggies' houses nearly fell down. It seemed he had noticed that his nice expensive and-oh-so-safe investment was a dud, because the high-rate loans were evaporating at an astonishing speed.

National City Mortgage was one of the major players. It seems extremely unlikely that National City didn't know what was going on. After all, the same people were refinancing all the time. But, of course, any bank involved in such a practice would be getting their profit up front and handing off the risk. The same is true for the broker. The same is true for the mortgage securitizer. And perhaps that explains this:
In the last five years, lenders have become increasingly ingenious in their effort to get people whose finances may have seemed dubious into homes.

At the height of the boom, borrowers got loans for 100%, or more, of the value of their property. They got loans without having to prove their income. They got loans with no requirement to pay the minimum interest due each month.

Park Place, by refashioning another part of the mortgage business, stoked demand for its exotic "structured refinancings" from both the loan suppliers and borrowers.
There is so much funny money out there that it's incredible. Inflated appraisals are one of the major offenders, but there is, practically speaking, no limit to people's fraudulent inventiveness.

Anyway, this is an example of why I am not a libertarian. I believe that some government regulation is necessary, because it is human nature to game the system. If you want efficient markets, you need regulation and independent checks. Capitalism only works well in a system that enforces transparency and honesty.

Because who gets stuck here? The investor and possibly the homeowner, who may or may not have understood what he or she was doing. After all, most times you pay to refinance. These transactions (refis at higher interest rates) only pay off if you keep refinancing every few months, so if the game of Musical Mortgages stops, the homeowner will have to pay to refinance or get stuck with a higher mortgage payment over a long period.

Certainly the investor gets the short end of the stick. Silly games like this, and the comparable sales comp game, and the inflated appraisal game, and the no-money-down, no-need-to-pay-interest game all will make mortgage securitizations less attractive to investors in the future, which means that homebuyers in the future will pay higher mortgage rates.

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