Bank of America makes a $100 million in loans to 1,000 homeowners
Bank of America wishes to make home loans to an additional 1,000 home owners but it does have the $100 million
Bank of American places all of its loans in a pool (package/portfolio) and offers this pool for sale to an investor-
Before selling toe pool, Bank of America has a credit agency rate the riskiness of the pool – A, B, C, junk- The rating is based upon many things, but simply and most basically, each loan in the pool is rated based up a combination of
Credit rating – is the borrower for each loan a good credit risk
Down payment – did the borrower put their own money down
Whether or not loan has full documentation – proof of income, job history etc.
Interest rate- is this a fixed rate loan, adjustable-
The higher the rating, the more an investor will pay for the pool -
Let’s assume that the average rate that Bank of America lent the money is 6% – Let’s also assume that an investor wishes to make 6.25% on their investment- the investor buying the pool from Bank of America, would be pay $925 million to purchase Bank of America’s $100 million Loan pool -
Bank of America can do this as they are only paying 3% on the $100 million that they lent to he 1,000 homeowners-
The only reason that the investor will buy the loan pool, is that they are able to borrow their money at an interest rate low enough that allows them to make a profit when all of the homeowners or borrowers in the loan pool make their payments-
Investor borrows $100 million at 5% / Annual payment is $5 million
Investor gets payments from borrowers in the loan pool at 6% / $6 million
But when 25% of the borrowers in loan pool stop making payments, income to the investor is now reduced to $4 ½ million, which is not enough to pay the bank that they borrowed the money from -
Investors
The biggest investor that purchased loan pools from Banks was Freddie Mac and Fannie Mae- Publicly traded companies, that ironically are insured by the government – Simply meaning, that Freddie Mac and Fannie Mae were created to buy loans that conformed to standard lending principles, from banks so that banks could go out and lend more money to more home borrowers -
In theory this was a great system, until the special interest groups started to insist that Freddie Mac and Fannie Mae be more relaxed the conforming lending standards (credit score, job history and most importantly, cash down payment) – Yes, before these politicians required lenders to start lending money to riskier borrowers, it was the law that borrowers of government insured loans had to have a down payment of at least 3% and the seller of the property could not assist with this down payment. The borrower had to show proof of where the down payment came from and that it was not borrowed-
So now Freddie Mac, with insurance from the US government, is pressuring banks that it buys loan pools from, to make loans to borrowers that are traditionally considered “non-conforming”- Borrowers who could not prove that their job history, could not prove their source of income- could not provide a decent credit score-
This subsequently increased the riskiness of the loan pools which would have traditionally driven down the price that any investor would have paid Bank of America – Meaning, that an investor will pay a higher price which offers a lower return on their investment for loans that are less risky- and will pay less money for the loan pool for loans that offer more risk-
Well, now comes Freddie Mac who is insured by the government and now required by the special interests to invest more in riskier home buyers – so Freddie Mac , using someone else’s money (the US tax payers) starts to compete with the private market who usually buys high risk loans and in an effort to compete for these loans, Freddie Mac starts to pay higher prices- becoming a machine that is an endless source for buying loan pools, regardless of their credit risk-
Taking a couple of steps backwards, all investors when purchasing loan pools, assume that a certain percentage of the loans will default. So the investor takes this into consideration in the price they will pay for a portfolio and the annual return they want
1,000 loans for $100 million paying $8 million per year
Assume 5% default $7.6 million
Investor wants an 8% return on their money which means they can pay $95 million
For a riskier loan portfolio with non conforming loans an investor may look at the investment in this way
1,000 loans for $100 million $8 million
Assume 10% default $800,000 in lost income
Net income $7.2 million
As this is a riskier loan poll, investor wants higher return of 11% which means he could pay $65 million for the loan pool
Now Freddie Mac comes riding in on their white horse and a blank check from the US Government and says we can now buy these risky non-conforming loans and do not have to assume that anyone will default- because the loan losses are insured by the US government (tax payers) and they do not need that 11% return, and can take a 6% return, which meant that they can pay a much higher price for the loan pool that private investors would only pay much less for.
Now Freddie Mac can do this because they buy money from the Feds at much lower rates, as low as 1.25% over the past six years -
Now what happens when additional capital comes into the market is that the cost of money (interest rates) come down- and as interest rates come down, prices will go up as the borrower can now afford more home for the same monthly payment- so builders start building a bigger more costly home- And as prices go up, even with cheap money, those lower income earners are priced out of the market and cannot afford to buy a home
Now remember, this all started in an effort to make loans more accessible to low income earners- borrowers who could not traditionally afford to buy a home – so now the dilemma, especially in light of the federal mandates to offer more loans to non conforming borrowers, was how to include these buyers in a rapidly appreciating market-
This is where creative financing came in and with the new lax lending standards to comply with the federal mandates, new loan programs were created to allow those who could not afford to buy a home, now afford to buy a home.. The mostly recognized program that was created to assist non conforming buyers was the graduated payment program, where the initial interest rate was very low and would increase over time to eventually a market or above market rate.
So a family who made $50,000 per year and could afford $1,500 per month for their mortgage payments, which would buy a $225,000 home, could capitalize on these new creative financing schemes to buy a $450,000 home with their monthly payments during the first three years being fixed at $1,500, but then increasing every 6 months until the interest rate caught up with the market rate- subsequently doubling their monthly payments.
Now the problems did not stop there- this creative financing program was then capitalized on by those who did not need help but simply wanted a bigger home. It was common for new home sales people, real estate agents and loan agents to ask, not how much can you afford to pay for a home, but how much monthly can you afford. They would then using the creative financing, back into the most expensive loan a borrower could afford and show them a home in that price range.
So, not only did the creative financing sucker poor people who could not afford a home in the first place to obligate themselves for more that they could afford, it allowed those who could otherwise afford a home loan with no special help, to abuse the process and borrow twice what they could afford.
Loan Defaults
Now, so long as every home borrower paid their monthly payments, everything would be okay. But as the first wave of those creative loans came time to adjust upwards, the default rate accelerated at a great pace and subsequently resulted in the homes being foreclosed upon.
As more homes were foreclosed upon, the availability of bank owned homes at reduced values drove down the values of exiting homes, so that when a homeowner went to sell their home, the appraised value of their home was now greatly affected by the sale or foreclosure of these many bank owned properties, subsequently, not allowing homeowners to sell their homes for what they owed against them-
Going backwards again, it is important to understand that as the availability of loans increased, and more and more people were able to buy homes, the demand pushed pries to historical highs. So it was not uncommon for a home purchased in January to increase by 25% by June. Now the lenders, flush with all of this very inexpensive money, were eager to make loans to these new home owners with their newly found wealth in the equity of their homes. So it was very common to have lenders send new home owners checks for $125,000 in the mail, saying, that this was an unconditional loan, all they had to do was sign the check and make the deposit and the bank would put a 2nd deed of trust against their property.
Great, free money! New Home owners now had $125,000 or more, to go buy new stuff, boats, cars, RV’s boob-jobs (yes plastic surgery is down 30% as most people were using refinance money against their homes to pay for it) – So in addition to the looming increase in their monthly payments for the adjustable first deed of trust, these homes owners now had a second and third deed of trust that also needed to be paid monthly-
As loan defaults began to accelerate, investors become nervous, and lowered
their willingness to buy loan pools, and much worse, began to lose their ability to debt service the money that they borrowed to buy the loan pools. As investors stopped buying pools, banks were left with increasing more and more risky debt that they could not sell to the private market, and now they began to have loan defaults affect their business models.
New accounting laws requires banks, including investment banks, to adjust the way the report how much in loans they have about and how much value the real estate that the loans are loaned against are valued- These new accounting laws said that even if a loan was not in default, but had gone down in value, the bank must place cash reserves in an account that would be used to pay for that loan if the loan was ever to go into default-
Now not only ore the lenders faced with not being able to sell their loan pools, they are now required to take what cash they have, and put it into an account to allow for possibility of loans going bad- So now the bank does not have any money to lend to car buyers, credit cards, home loans, business loans because the money is tied up in the holding account-
And worse yet, if the bank does not have enough free cash available to be placed into this reserve account, then the bank, even though it is paying it’s bills and most loans are not in default, can be considered illiquid by the FDIC and shut down-
Financial Crises
Historically, banks lend other banks money, however, with the growing crises, banks either do not have the money to lend, or do not have the confidence that they will get paid back. So what transpires is that banks stop lending to each other which prevent banks from lending to it’s customers-
Financial Recovery Plan
It is an incredibly misleading term to call this a Financial Bailout- A bailout would be if the US Government (taxpayers) went to Bank of America and said, “Hey, you lent $100 million out to risky borrowers, we are going toe buy those $100 million in loans for $100 million- You are now bailed out and have no loss”
What is happening instead is this: Remember that new accounting low I mentioned earlier the Oakley – ( developed in response primarily to he ENRON accounting scandal) well the banks value or latest value for the loans it has made is the current market value for the homes the loans are secured against- The Feds are going to buy the loans for current market value of the homes – which means the bank loses the difference -
So why would the banks do this and how does this help? First of all, it injects billions of dollars back into the bank, even at a loss, it is liquid capital. Secondly, now that he “bad loan” is removed from the books, the bank can take their free cash out of the reserves and use it for day to day lending -
The biggest concerns for the US Tax payers in the Financial recovery package should be
1: The assets purchased are truly at fair market value
2: That special interest groups do not receive any monies fro affordable housing programs
3: Any institution that accepts help, needs to assign any stock options, golden parachutes to the Federal Recovery Program as a condition of their acceptance of any financial help
Limiting CEO’s pay in unconstitutional and defies the principles of capitalism. Share holders need
to deal with that. If we are going to limit the pay of CEO’s why stop there? Why not pro athletes-
I am sure that many would agree that paying someone $3 million a year, let alone $26 million a
year in professional sports, in light of their contributions or lack thereof to society, is a gross waste
of money. How about actors and singers ?- Hell, what about former and existing public “servants( I despise that term) who earn millions writing books or giving speeches- My God, what gives them the right to limit the pay of a CEO when they made theirs on the backs of the US tax payers.
So as the media freely throws around the terms “Financial Bailout” and says that the government is buying $700 billion in worthless assets, a gross disservice is being done. The US government will buy over a Trillion dollars in loans, all secured by mortgages against homes across America. 75% of these loans are actually paying their monthly payments, while the other 25% are in default.
The media is not telling you that us the Treasury borrows the $700 billion , lets say from China paying a bond rate of 4%, the Treasury will collect income from 75% of the loans it acquires at 50 cents on the dollar
US Treasury buys $1.4 Trillion in loans averaging $300,000 paying on average $1,500 per month
Only 75% of borrowers are paying on time 4,667,000 loan payments coming in
Total annual income $63 billion , an 8 ½% annualize return, not to mention the added value when some of the loans are paid in full when the property owners sell their homes. Remember, many of these loans are not in default- they have only been designated as bad loan due the accounting rules.
I realize that I greatly simplify this process, however, it is necessary to take a simplified view to gain a clearer picture of what has and is happening-
The banks are not the bad guys, they did what they are supposed to do, lend money to willing borrowers, and further only id what they were told to do by the feds..
Wall street in general, are not the bad guys. Wall street simply reacted to a demand from the consumers and provided the capital to banks to lend to their customers.
It appears to me that real culprits are the politicians who mandate lending policy to cater to those who cannot afford to buy a home. There is a fundamental difference between low income housing assistance and low income subsidies. Assistance perhaps takes some of the barriers that preclude those in lower income brackets from buying a home, such as offering tax credits to developers who provide affordable housing. Subsidies simply state that those who cannot afford a home, deserve a home and someone else has to pay for it. Listen, FHA before all of this mess, required a cash down payment of 3% to qualify for a home loan. The down payment could not be from the seller, could not be borrowed and the borrower had to show where he got the money. By removing this incredibly low hurdle, the government enabled too many people with a burden that they were not only not ready for, but not capable of meeting.
The other culprits were the Hedge Funds and Insurance Companies who bundled these loan pools and made representations as to the credit and reliability of the loan pools, sold them to unsuspecting, yet terribly naïve investors, and collected billions in fees and profits- It is beyond me why the US does not pursue to collect against hose who underwrote the loan pools and assured others of their credit worthiness- That is where the real attention should be directed- If as a real estate agent I made a representation that was false, I would lose my license, possibly go to jail and be subject to civil restitution – The tax payers need to demand to know why the government is not seeking the recovery of damages against those who underwrote the investments and sold investors on their credit worthiness
One of the main issues keeping the Democrats from approving a Recovery Plan, is that of saving people from losing their homes. GO GOD DMAN FIGURE- THE SAME POLITICIANS WHO DAMN SAVING THE BANKS WHO ARE LOSING THE SHIRTS OFF THEIR BACKS, ARE DEMANDING THAT WE BAIL OUT THOSE GREEDY BORROWERS WHO BORROWED TOO MUCH TO SATISFY THEIR OWN LUST AND GREED – WHAT HYPOCRISY AND DOUBLE STANDARDS- BUT WHAT CAN YOU EXPECT FROM A POLITICIAN-
But, if the deal is hinged on saving homeowners from foreclosure, we need to apply a capitalistic strategy in doing so.
Most people do not want to lose their homes and would most definitely stay in heir home if the monthly payment became affordable.
So let the Treasury become an equity partner with these first time disenfranchised home owners by doing the following
1: The Treasury buys the home from the home owner fro the amount of the price it is able to acquire the note from the bank for
2: The Treasury enters into an exclusive option with the previous homeowner allowing them to buy the home back from the Treasury at any time in the next ten years at a price equal to note amount plus eight percent interest per annum to the Treasury on the Treasury’s capital invested in the property, including the 5% being paid for the monthly payments
Effectively, on a $300,000 bad loan, the Treasury would buy it from the bank at $150,000, re-write the loan to the borrower at 5%, and in five years, the borrower could refinance the loan and pay the Treasury $172,5000 to buy their home back
Treasury buys for $150,000
Borrower pays 5% per years $37,500
Five years interest at 8% $60,000
Borrower pays premium $22,500
To make return to Treasury 8%
Total paid by borrower $172,500
joe bideman
