As a bankruptcy attorney routinely filing Chapter 7 and Chapter 13 bankruptcies in an economically hard-pressed state, Michigan, I am daily confronted with the real-world consequences of what the news media talking-heads have come to refer to as “The Mortgage Meltdown” or “The Housing Bubble Burst.”
Everyone is familiar with the long and short of this economic crisis—namely, that property values were quite high for some period of time, during which many folks purchased homes at high prices thinking that they were investing in their future, and then, suddenly, those homes were not worth nearly as much, leaving homeowners with negative equity, massively high monthly mortgage payments relative to the value of their homes, and no real way to sell or move away from the home in the case of job-loss in their geographic areas.
This last problem has been particularly acute in a “deficiency state” like Michigan, in which mortgage lenders can pursue homeowners for collection of the difference between what they owe on the terms of their mortgage note contracts and the auction price of the house at a foreclosure sheriff’s sale or short sale.
This is the reality that is plain to see driving down any street in any neighborhood, urban or suburban, in the Metro Detroit area.
But the actual cause of the meltdown, although much discussed, has not been adequately and understandably made clear by the national or local media. Persons near and dear to me personally, for instance, still believe that the primary cause of the meltdown is that gullible homeowners foolishly borrowed more money to buy larger homes than they either could afford or really needed at all.
Well, to some extent, that may be true. But, as a prospective purchaser of a home, it’s very difficult to make a good decision if you are putting your faith in a mortgage broker or salesperson who is telling you one thing but giving you a volume of documents to sign that would confound even well-educated real estate attorneys and may be doing something quite different.
In any case, as a nation, we have not by and large adopted a legal system that “blames the victim.” At least not ideally. A rapist, to use the most pointed and ugly example possible, are not exonerated for their crimes because a female victim wore a short skirt. Elderly people conned out of their pensions and life-savings by con artists calling them on the telephone pretending to be long-lost relatives in dire need of cash assistance are not blamed for the crimes of the con artists. Neither should homeowners believing honestly that they were making an investment in real estate in purchasing their homes be blamed for what actually occurred, in my opinion.
So what happened? Really?
Once upon a time, banks loan money to prospective homeowners for mortgage purchases of real estate based upon the funds actually held by the banks. The banks lent the money from their own coffers, and the banks serviced the loans, collecting the monthly mortgage payments from their customers.
That model worked well for many decades, until, at some point, it became clear to the banks that they were not able to lend enough money to enough prospective homeowners because they had only a finite amount of money in their vaults. They couldn’t do as much business as they wanted to, or thought that they wanted to, in other words.
Thus was born the concept of “high-volume lending.” Banks wanted to lend more without, at the same time, having that increased volume of lending on their books as a liability.
In order to have that cake and eat it, too, the idea of securitized mortgage trusts was developed. These “trusts” were separate legal entities from the banks themselves, created to ultimately own the mortgages in “bundles” or securities, for which investment bonds were sold to investors to the trusts. The actual servicing of the mortgages would be handled by “servicing” companies that did not hold or own the mortgage notes but worked for the trust or other owner and holder of the mortgage note.
In short, the funding of the loans to new customers by the banks was provided by the pre-arranged sale of the mortgages and mortgage notes to securitized trusts which sold bonds to investors to earn profits themselves.
In doing this, the banks were creating what North Carolina bankruptcy attorney O. Max Gardner, III has called “a mirage of a true sale.” The banks offloaded these liabilities to other entities that then created the trusts so that the banks did not have to list the liabilities on their own books. When, eventually, hedge funds became increasingly interested in the trusts’ bonds as investments, as well as Saudi and Chinese oil money investors, the demand for more and more of these trust structures grew and grew.
The race was on to create these investment opportunities, then, and the United States governments’ and the banks’ own lending rules eventually, as pressure and financial influence came to bear, crumbled away in the face of this tremendous demand. All affiliated parties made money from foreign investment money in this market: banks, investors, even the ratings agencies whose job it allegedly was to rate the bonds highly or poorly based upon their quality.
From this market investment demand came mortgage products too strange for the average consumer to wrap their heads around: 2 years fixed at teaser-rates followed by 28 years at adjustable rates, option ARMs with multiple options each month for the repayment of the loans, and so on. Confusing purchase options resulted in a confusing array of decision for would-be homeowners.
But that is not the end of the tale: all of these things were really being pushed to find product for the market.
The further story lies with the bonds being sold to investors themselves.
Most bonds are structured as “investment-grade” to “non-investment-grade” (and worse) values. The investment-grade bonds are the AAA, AA, A, or even BBB-rated bonds; the non-investment-grade bonds are the BB and lower-rated bonds. When a pay-out is made on the investment in these bonds, the AAA bonds are paid first, then the AA bonds, and so on down the line. The losses, on the other hand, are taken from the non-investment-grade bonds at the bottom of the ratings scale and then move upward.
Ultimately, the bonds at the lower rating may be total losses and thus not viable. At that point, they become so-called “junk bonds,” and investors/owners simply may try to sell them for whatever they can get for them (which, ideally, would be nothing).
What happened in the mortgage market was that, given the intense demand for product, the banks and trusts would take the non-investment-grade bonds—say, all of the C-rated bonds in a bundled mortgage sale deal, and they would buy all of them in 5 or 6 securitized trusts, then securitize all of those in a new trust—and then a ratings agency such as Moody’s or Fitch’s or Standard & Poor’s would come in and re-rate it as a AAA or AA or A investment-grade bond, regardless of the fact that, essentially, the trust contained nothing but junk.
The bonds issued for these resulting structures were called Collateral Debt Obligations (CDO) Squared because they were assets not of the Notes for the origination mortgages but, rather, of the non-investment-grade bonds of the trusts those mortgages were actually in.
Eventually, this repackaging occurred with the same instruments again and again and again, until there were Collateral Debt Obligations x5 or x7 and so on rather than simply Squared.
What eventually really caused the crisis, then, was that investors in the CDO Squared deals realized that these might not actually be great investments, so they sought to insure themselves from potential losses. This is where insurance companies such as AIG became involved. AIG and other companies in its various lines of business invented a transaction known as a Credit Default Swap.
A Credit Default Swap is a transaction between investors to a CDO Squared (or beyond) deal and an investment insurance company such as AIG in which an investment in the bond is, for a premium paid to the insurer, guaranteed or insured for the full extent of the investor’s original investment. For example, for a $4 million premium paid to the insurer, a $20 million investment in CDO Squared bonds could be fully protected under the terms of this sort of deal.
This looked to companies like AIG like free money since the real estate market was allegedly booming with no end in sight. The media and moneyed backers of the industry trumpeted real estate investment as a “no-lose” proposition and a surefire way to invest in your future, and consumers borrowed more and more as a result, providing more and more fuel to the securitized mortgage trust fires. Loans were re-financed and re-written every two years on top of that, a massive gravy-train—or so it seemed.
AIG and, along with it, Lehman Brothers themselves did not realize that these things that they were protecting in their Credit Default Swaps were D-grade bonds that had been repeatedly re-securitized over and over again.
Ultimately, though, the gravy train did grind to a halt. The economy worsened, unemployment boomed (and continues to do so), and consumers could not afford their ARM mortgage payments and could not afford to re-finance before balloon payments came due. The mortgage bubble burst, and the nature of the investments insured by AIG and Lehman became apparent. These giant companies buckled and threatened to crack in half under the strain.
This was what inspired the Federal Government to step in bail out AIG: to cover their swap liability on all of these bonds. The government reasoned that 700 or 800 banks would have failed if AIG failed and rescued the company with $180 billion of US taxpayer funds—but then failed to recognized that Lehman Brothers was, in fact, even more heavily involved and, accordingly, failed to rescue it.
After Lehman collapsed, the entire credit system in the US froze, and we remain where we are today, with the real victims of this mad rush for easy money by banks and foreign money investors sitting in homes that they cannot now afford if they are lucky—and losing them if they are not.
The essential substance of this article is based upon a talk given by North Carolina bankruptcy attorney O. Max Gardner, III.
If you are a southeast Michigan resident considering filing for bankruptcy, please feel free to contact me at firstname.lastname@example.org or (866) 674-2317 to schedule a free, initial consultation.