Back in March I commented on the growing issues with the subprime mortgage sector and how it may affect quarterlifers.  Well, we are seeing “round two” of the meltdown hitting Wall Street as we speak.  Major market indices have shed some serious ground over the last week or two.  Why?

In order to understand what is happening in the market, it helps to understand the mortgage process.  Here is a very brief, somewhat simplified overview:

You decide to buy a home, and you need to finance a large portion of the purchase.  So you obtain a loan from a mortgage broker, who places your loan with a wholesale lender.  On the day of closing, that wholesale lender wires money to the title company on your behalf.  The wholesaler doesn’t have massive cash reserves sitting around to lend.  Rather, they in turn borrow those funds from larger institutional lenders by using what is known as a “warehouse line of credit”. 

The wholesale lender then packages your loan into a billion dollar bundle (literally) and sells it to investors worldwide as a mortgage-backed security.  The original lender may still retain servicing rights (you keep making your payment to Bank of America, for example) but the investors own the income from your loan.

Earlier this spring, we saw the beginnings of the meltdown happen when, all of the sudden, subprime wholesale lenders could not longer profitably sell loan packages to investors. (Which directly resulted from increasing late payments and defaults on similar loans.)   Instead, lenders had to discount loan packages by 2-7% in order to get investors to bite.  The warehouse lenders saw this and promptly shut down warehouse lines for many subprime lenders…precipitating the meltdown. 

Fast forward six months.  The subprime lenders who survived February 2007 have “cleaned up” their act by eliminating some riskier loan products (like 2/28 ARMS), increasing interest rates to better reflect the default risk on subprime loans. 

However, brokers were originating these loans until February of this year and investors were still purchasing the loan packages (albeit heavily discounted).  The discounted price only helps if the borrowers repay the loans; now more and more defaults in the subprime sector (which still holds a tremendous amount of debt that is mostly adjustable rates set to adjust between now and Feb 2009) have continued to cause losses for the ultimate investors.

Which brings us to the recent upheavals.  Folks are still losing money on subprime loans, and may continue to do so for two more years.  As I’ve said before - this will create hardship for a lot of subprime borrowers, but also create opportunities for individuals with good credit who are looking to buy homes, as well as for landlords who can benefit from higher barriers to entry in the housing market.

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This entry was posted on Friday, August 10th, 2007 at 12:00 pm and is filed under Mortgages. You may e-mail this post to a friend. You may print this page. Responses are currently closed.