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Friday, October 3, 2008

Budget Bailout & Your Credit

It’s not Just about Wall Street How the Housing Slump Affected Your Credit

By Jim Maresca

Wall Street bail out? As usual, the mainstream media is over simplifying and distorting. This article is also a bit of an oversimplification, but I hope will increase understanding for those who are confused about what is happening in the credit markets.

Here’s how our system works. Banks borrow money from depositors and pay them an interest rate. The banks show these deposits on their financial statements as a LIABILITY.

Banks also lend money to borrowers at an interest rate higher than what they pay to depositors. (That is how they make their money.) Such loans show up on the banks’ financial statements as ASSETS.

To keep the banking system sound, banks are required by the agencies that regulate them to keep assets in appropriate proportion to liabilities and to have primary and secondary sources of repayment. In the case of a home mortgage, the primary source of repayment is the income of the homeowner and the secondary source of repayment is the sale of the mortgaged home, which is the underlying asset serving as collateral.

What has happened in the sub-prime mortgage market is that home buyers were allowed to qualify for mortgages without having to adequately document income. In many cases, these unqualified buyers were induced into their mortgages with initial payments that seemed affordable because they not only did not decrease the principal but did not even cover all the interest. So the total money owed thereby increased every month . The unspoken assumption in the market was that real estate price would only go up, so there was no real risk since the home could always be sold to pay off the loan.

As previously unqualified buyers entered the market and increased demand, the home building industry responded with increased supply.

Then two phenomena began to happen at the same, creating a kind of “financial perfect storm”. First, home prices, which had been rising at an obviously unsustainable rate, began to level and fall. At the same time, the initial rates on the mortgages began to re-set to rates that would pay full interest and fully amortize the principal. That meant monthly payments often doubled or even tripled. When homeowners went to refinance, they found that their loans, which had increased due to the negative amortization of the initial low rates, were now higher than the value of their homes. The disastrous result? They could no longer qualify for a loan, could not sell the home for enough to pay off their loans, and found themselves headed for foreclosure.

Now back to the banks. As long as payments are being made, the loans are carried on the banks’ books at their full value. However, when the loans becomes “non-performing”, they have to be revalued on the banks’ financial statements at the value of the underlying asset, the so-called “mark to market”. Since home prices had dropped the new valuations reduced the banks’ assets.

When the assets (loans) are no longer enough to support the liabilities (deposits) the banks have to increase their cash by either selling stock or borrowing money from other banks. If they are unable to do either, they have to begin calling in their least secured loans such as lines of credit they give to businesses. Those businesses, unable to secure financing, pull their cash out of banks to meet their expenses, thus aggravating the problem still further.

But it gets even more complicated than that. Investment banks developed something called Credit Default Swaps (CDS). They are a kind of insurance in which mortgages are bundled and, in return for regular “insurance” payments, a seller takes on the obligation to buy any defaulted mortgage in the bundle at its full value.

As foreclosed houses entered the market, prices continued to fall, banks continued to have to mark down their assets, meaning they can no longer continue lending. If they had sold CDS’s the problem was even worse as the banks had to buy defaulted mortgages and add those to their books. The books end up out of balance and the bank is not allowed to continue lending. If banks can’t lend, they can’t make money, so the banks become unable to meet their expenses. At that point the regulators come in and either take over the bank (as with Lehman Brothers) or find a solvent bank to buy the insolvent bank (as with Wachovia).

Here’s how this mess trickles down to hurt individuals. Assume you are a home buyer looking for a mortgage or a student looking for a student loan or a small manufacturer needing to buy materials to fill an order that will be paid for when you deliver you product. If no bank is able to lend to you, you’re adversely affected. Even though you did nothing wrong, it’s as if you had no credit at all. The ripple affects us all in the long run. If the unavailability of credit continues for a significant period of time, the whole economy begins to slow down and businesses begin to lay off employees. Then we go into deep recession or depression.

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