The life of a mortgage loan is not as simple as it once was. Up until about a decade ago, lenders made loans to homebuyers and held onto the loan until they were paid off, but things have changed. Now, soon after homeowners close on their properties, their mortgage loans are bought, sold and resold over and over as part of an elaborate financial web that affects many, many areas of our economy. Here is a glimpse at the typical mortgage loan “life cycle”:
Step 1: A lender originates a loan, enabling a homebuyer to obtain the financing they need to purchase a property.
Step 2: After closing, the lender attempts to sell the loan on the secondary market in order to generate the funds needed to be able to offer new loans to other customers. Loans are commonly bundled into packages called Mortgage Backed Securities (securities that yield payments of principal and/or interest from the underlying mortgage loans).
Step 3: A rating agency rates the securities according to how risky they are; e.g., how likely it is that they will hold their value or increase in value.
Step 4: Dealers and investors buy and sell these securities.
Step 5: The value of these investments is dependent upon homeowners who complete the cycle by making their scheduled monthly mortgage payments. Each step in the cycle is highly dependent on the other steps in order to maintain a consistent flow of mortgage money available for home financing.
What has Changed These Days?
In short, the mortgage life cycle has been disrupted because there has been a break in the chain and there is not enough money to go around. Beginning last year, an alarming number of homeowners were not able to make their payments and the percentage of defaults and foreclosures began rising rapidly, and continues to rise. There are reasons why this happened so suddenly.
Lending Practices Changed
In the late 1990s, overzealous lenders started bending the traditional “rules” by giving loans to customers who really didn’t have the resources to meet the monthly mortgage payments. These loans are known as “subprime” because the customers’ ability to pay did not meet the standards of the reliable (“prime”) loans. Many of these loans were adjustable rate mortgages (ARMs) with very low initial monthly payments that increase periodically. The assumption was that either the homebuyers’ income would rise later on, so they could afford the higher payments, or that the value of their home would increase, allowing them to refinance while still maintaining a minimum amount of equity.
Subprime lenders were not the only ones who helped cause today’s situation. Others include:
- Rating agencies. The rating agencies severely underestimated the number of defaults and foreclosures that could happen with subprime loans. In the last few months, these Rating Agencies have downgraded many of the Mortgage Backed Securities all at once, so investors are either forced to sell them at a loss – or worse, not sell at all, which constricts “liquidity” of credit and essentially brings the mortgage life cycle to a halt.
- Wall Street dealers and investors. Dealers “sliced and diced” the cash flows of the underlying mortgages to create mortgage securities which yielded high returns for investors. However, investors began paying less attention to the risks inherent in these securities and the underlying loans, encouraging inexperienced lenders to enter the industry. Many of these lenders were unaware of the dangers of irresponsible lending and some of them have recently gone out of business.