As we continue to deal with a very complex Real Estate markets chopped full of short sales, foreclosures and under water properties one thing has stood out to me. Many people both in and obviousley out of our business really don’t understand the exact causes of the meltdown. I had a friend just the other day say “Brandon I still don’t really get how this all happened”. With that being said I’m going to try to explain the complexity of this situation in the most understandable way.
Back in the 70’s when you purchased a house it was pretty simple. You borrowed money from a bank and you paid back that bank. Just like if you loaned your best friend money. Your friend would be responsible to pay you back. So you would really be careful which friends you lent money to. Underwriters at this time wanted substantial down payments and did full documentation loans meaning they verified your assets and income. These entities were tightly regulated.
The 80’s began a new day in investment banking and financial sectors. The administration at that time began the economic policy of deregulation which has now been apart of our society in America for 30 plus years. New securities now allowed those same lenders who in the 70’s were liable and lost money if you didn’t pay your mortgage to now sell your loan to investments banks. Imagine this, you loan a friend (borrower) $100 dollars. You now sell your friends loan to another friend (Investment banker) for $150 dollars. You just made a 50 dollar profit just for selling your friend’s 100 dollar loan to another friend. Pretty cool huh. What’s even cooler is you made 50 bucks and if the first friend (borrower) doesn’t pay your second friend (Investment banker) your not at all responsible. You get to keep all of your money! Sweet right!
Here’s where it starts to get tricky. Follow me closely. Using that same example above the second friend (Investment Banker) who purchased your original 100 dollar loan for 150 now does the same thing that you did. He takes that 150 dollar loan and combines it with other similar loans. This is known as pooling. Pooling means lumping a large sum of loans together to make one big package. Ladies and gentlemen congratulations you have just learned how Investment Banks make Collateralized Debt Obligation (CDO’s) which is what they called the final package of all these loans pulled together. It’s very complex how they do this but now you at least have the basic understanding of the system.
I sure do know what your thinking now…What does the Investment Banks do with these CDO’s? I bet you will never guess!! Need another minute to think? If you said they sell them to overseas investors winner winner chicken dinner for you! Did you all pick up on my sarcasm because I was laying it on pretty thick lol! Back to business people let’s try to stay focused here. So once the Investment Banks sell these CDO’s to overseas investors guess what. They’re no longer responsible if they fail either. The poor sap overseas is the final entity left holding this toxic paper. Let’s bring this whole thing together.
So we have four entities here. Your original friend who you lent 100 dollar to is a home buyer. You lent him 100 bucks knowing that you could sell his loan to an Investment Bank, make a profit and not be responsible if he failed to make his or her mortgage payments. So now you really become relaxed and you lend all your friends money (home loans) knowing you will just keep selling them to Investment bankers. Investment Bankers will keep buying those loans from you because they know they can make money pooling the loans and selling them to other investors.
So now you lend all your friends money because hey… Why not you’re making a killing!!! You could care less if your friends have jobs to pay you back or have good credit because…you’re making a killing! So you need more and more friends to buy homes so you make it easier for them by requiring no down payments no income verification and even in some cases letting them pick their payments. And you don’t care why… you guessed it you’re making a killing!
Ladies in Gentlemen welcome to the Sub prime Mortgage era! If all this sounds crazy it’s simple, IT WAS! This is what started us down the path of no return and the financial collapse that now has agents trying to move properties ( REO’S and short sales) were some banks have no idea where the original loan is. So it’s important I think for us all to grasp exactly what were now dealing with. A wise old woman once told me we never know where we’re going unless we know where we’ve been. Thanks Grandma.