What a difference a year can make. There are many challenges facing the US economy, which media experts attribute to mortgage fallout. But in order to understand how these challenges developed, we have to go back 15 years to investigate the root cause.

In the late 1990’s, the goal was “Home ownership for all Americans.” Fannie Mae and Freddie Mac, the government-sponsored corporations that insure the bulk of conforming loans, eased their guidelines to expand their portfolios. After the terrorist attacks of 9/11, the Federal Reserve lowered the Federal Funds rate in order to avoid any serious economic fallout. By cutting this rate, the Fed made it cheaper for banks to borrow money. In turn, the Fed hoped that when the banks lent this money, it would stimulate the economy. As a result of these rate cuts, the Prime rate dropped to 4.00%. This prompted banks to launch creative financing ventures offering loans to “high risk” borrowers with challenging credit histories.

The securitization of these subprime mortgages spread the risk throughout the industry. In packaging and selling these loans, a particular mortgage was not solely owned by one investor. Rather, it was broken up and sold off in many parts. In the past few years, with real estate prices rising, borrowers were always able to refinance these loans, giving the appearance that they were performing well, yielding a high rate of return. Once real estate prices began to level off or decline, the borrowers were unable to refinance these loans and had to deal with rising rates. At this point, defaults began to increase.

From a trading mindset, once there’s an indication of bad news, the first course of action is to dump the position (in this case, mortgage backed securities) and move money elsewhere. If the trend continues in this direction, the market will follow, regardless of the fundamentals. Hence, there was a huge selloff and panic in the mortgage industry.

In terms of liquidity for these Wall Street firms holding these securities, once there’s a perception on the trading floor backed by defaults on loans that even though they’re risky and should expect these defaults, you have our current situation: a credit crunch carrying a panic on anything regarding mortgages.

Since the market “is always right,” there are two things to take away from this situation: 1) home ownership for all Americans is not a reality, and 2) these Wall Street firms did not properly price the risk associated with these loans. In their zeal to buy risky loans at higher returns, they ignored the obvious: risk always brings a downside. If the risk was properly assessed, the returns on well-performing risky loans would be enough to offset the defaults on the other loans. In other words, the rates on these subprime loans should have been much higher to offset the risk of the defaults.

It remains to be seen how, in the long term, the Fed, US government, and market will deal with this long term problem.

For Region: Chicago

• Dean Vlamis
• Mortgage Lender Perl Mortgage