I worked for years as outside counsel to the FDIC, the Resolution Trust Corporation, Fannie Mae, Freddie Mac, and several banks including Bank of America. From that experience, I gathered this knowledge which should help you understand the underlying problem in the loan industry.
First of all, in mortgage loans, there is A, B, C, and D paper.
"A paper" is a standard home loan of 80% LTV "loan to value". For example, if your cost of a new home is $300,000 and you are going to put 20% down, i.e. $60,000 and you have a high credit score, your loan is "A Paper". With "B paper" your credit score is lower or you are getting a 90% loan but it is close.
With "C Paper", the credit score is lower. We used to say that only an Italian named "Guido" will loan on "D Paper". That's a hard money loan.
"C Paper" can also be 2nd mortgages on a home. It is a "C" because if the borrower defaults on the 1st mortgage, the 2nd mortgage can only save it's security (that is the house) by paying the first mortgage off. The 2nd actually has to put money in to save a 2nd mortgage.
Bank Lending 101
In a small town at the turn of the 1900s, a small bank like Bailey S&L from "It's a Wonderful Life" would get in say $100,000 in deposits. If they had to keep a 20% reserve (to cash checks and cover regular withdrawals) they could lend up to $80,000 on a mortgage.
But once they lent that $80,000, they would have to turn down other fine citizens because they had no more money to loan.
So Fannie Mae and Freddie Mac were formed to buy those loans. Bailey would "sell" the loan to Freddie Mac for $80,000 (less some discount) and Bailey's would continue to service the loan.
Bailey's now had another $80,000 to lend a fine homeowner. But in our example, Freddie Mac doesn't have another $80,000 to buy a 2nd Bailey's loan and thus a 3rd fine citizen can not buy his home, and therefore Pottersville Construction Company doesn't need to hire workers, Pottersville's grocery store and auto dealer don't get the worker's wages they would have made, and so forth.
But Freddie Mac could sell the loan to a rich company who wanted the security of monthly payments at a set interest rate secured by a home. Once Freddie does that, it now has another $80,000 and can buy Bailey's 2nd loan, and Bailey S&L can now lend to another citizen.
This is how it works, or is supposed to work. The exception is that these loans are not sold individually but rather bundled in $100,000,000 groups and bonds secured by the loans are sold by Fannie Mae. Also there are certain rules that make the loans similar and safe. They can't be jumbo loans ($410,000 or above) and the home buyer has to put 20% down (or 10% with PMI insurance) so that the homeowner has some serious motivation to save his home if things go bad.
I believe that Fannie Mae and Freddie Mac loans are guaranteed to the buyer, but I'm not absolutely sure of that.
Meantime, the C and D paper loans also get bundled together and bonds are sold secured by these loans. These bonds pay higher interest than the Fannie Mae loans because they are riskier.
What Happened
People were getting A loans because they were putting 20% down. But then some people didn't have the 20%. So loan brokers (who get paid by the number of loans funded, not by how the loans perform) said: "No problem. We'll get you a 2nd mortgage on the same property for 20% so you can put 20% down."
Now this is even before loan brokers who lied about income and assets. That's a separate deal.
A Real Story
A man had worked hard all his life in the construction trades. His wife worked for the school system. He had always lived in an apartment but wanted to provide for his family. He was jealous because some of the guys he knew bought a house for $450,000 and the value went up to $600,000. They had made "$150,000" in addition to their salaries over the last several years. The man had been working 12 hour days for years and had no equity to show for it.
He wanted a home.
A friend of his became a real estate agent who "had a loan broker who could get anybody funded". Now before you get mad at this loan broker, remember that he only gets paid and only gets new business and referrals if he can get deals done. He gets paid nothing when they don't get done.
The man "bought" a $620,000 house. Even he admitted it was expensive, but he had had a good year the year before. He worked almost everyday except Christmas. He had to turn clients away.
He just didn't have the down payment.
But if he could work just as hard for a few years, maybe when his kids went to college he could sell the house for $150,000 profit.
There was no malice here at all!
The real estate agent said: My loan broker can get you a 1st and a 2nd loan. You'll get into the house without a down payment. And he did - with a $5,000 per month mortgage.
The economy slowed down. People were no longer buying houses.
The real estate agent went into another line of business. The loan broker quit and retired.
The man's construction business slowed down. Fewer people were hiring this man. Some who did hire him, welched on their contracts and didn't pay him. He couldn't keep paying the full $5,000. He tried to pay a partial payment of $4,500 but they returned the payment (partial payments are not allowed. It's all or nothing).
He went into default on the 2nd mortgage. They sent out a notice of default which put the 1st mortgage in default. The bank said if he paid them $12,000 immediately, it would come out of default. He said he now had $5,000 but he couldn't get $12,000.
The bank foreclosed. The man and his wife are angry with one another. They are both embarrassed because all they wanted was a piece of the American Dream.
Meanwhile
Somewhere some company (e.g. AIG) had bought a bond containing $100,000,000 of C paper loans. "How many of these loans are bad?" The president cried. The CFO said: "There is no way to tell." The CEO screamed "Well then don't buy any more until this crisis is over!".... and the market for home equity loans dried up.
But AIG's president's problems weren't over. His accountants and stockholders said "Your balance sheet lists a bond secured by $100,000,000 in home loans. How many of those loans are still good?" And AIG's president said "Nobody knows". So then stockholders sold his stock and other people wouldn't lend AIG any money. In fact, even though AIG had basically a good business, it might have to declare bankruptcy.
But it doesn't end there. But to keep it short, I'll make this part really simple.
1. There is a company, let's call it ABC who did a big deal with XYZ. XYZ was insured by AIG. When ABC heard that AIG might go under, they called XYZ and said: "We no longer feel secure in this deal. No matter what the contract says, we may pull out because we can't trust that AIG will be able to pay off any insurance claim." XYZ threatened to sue ABC but that would take years. In the meantime, they told their HR department to lay off most of the people working on the project with ABC. One of the workers laid off defaulted on his 2nd mortgage which put the first mortgage in default. See above for what happened to this man's loan.
2. There is a money market fund with a lot of retirement money in it. The money manager only invested in the most secure investments to guarantee that his retirees would have their retirement money. In fact, he bought a bond from Fannie Mae which is secured with $100,000,000 home loans. The man's home loan is in that package. The money manager wants to know if his investment is any good. "How many loans have gone bad?" he screams to Fannie Mae. "It's hard to tell" Fanie Mae says. If Fannie Mae can't sell their next $100,000,000 bond, because nobody wants to buy a bond secured by home loans, that will mean that the bond that the retirement fund has will be almost worthless too. The retirement fund won't have enough assets to pay off all the pensions. What then happens to the retirees?
That's why there needs to be a "bailout". It's for everybody, not just the rich. And while the CEO's may have taken too big of a bonus, their bonus was not the cause of the problem.
(My apologies to anyone who has a better knowledge of this. We accept your comments.)
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