As a special feature for April, TheStreet.com offers a 20-part series on virtually everything to do with real estate. Today's installment is part one.These days, if we're not talking about the paternity of Anna Nicole Smith's baby, we're talking about the subprime mortgage market. That's probably why our
Everything checks out and Joe gets his loan. Yippee! Local Bank issues lot of loans to borrowers like Joe. But at some point, Local Bank runs out of money to loan. So Local Bank decides to clean up its balance sheet. It chooses to sell those mortgages to a government-sponsored institution, like Fannie Mae ( FNM) or Freddie Mac ( FRE), or to an investment bank. The Federal National Mortgage Association, a.k.a. Fannie Mae, was formed by the by the government back in 1938 to promote home ownership in the America. Fannie would purchase the mortgages from the banks to free up the banks' money so they could originate more mortgages. The Government National Mortgage Association, Ginnie Mae, and the Federal Home Loan Mortgage Corporation, Freddie Mac, were formed in 1968 and 1970, respectively. They play a similar role to Fannie Mae but target different segments of the mortgage market. More recently, a number of Wall Street firms have gotten in on the act. A lot of the mortgages they are buying and securitizing are made to less creditworthy borrowers -- stuff Fannie and Freddie won't buy. So Local Bank sells its mortgages to Fannie, Freddie or whomever, to free up its capital. Freddie, Fannie and the investment banks will now receive the principal and interest payments on those mortgages.
In most cases, our Local Bank will still service those loans, though. It will still collect payments, answer any questions and send out tax documents at the end of the year. It'll just keep a service fee, or percentage of the interest payment, for its work. So if the interest payment on the mortgage is, say, 5-3/4%, the bank will keep, say, 1/8% for its servicing. It will send the remaining interest payment on to Fannie or Freddie. So now Fannie and Freddie are holding all this debt. But after a while, they too realize they need to free up some cash so they can continue to relieve the debt of Local Banks. Fannie and Freddie also know that there's a whole market of bond investors out there looking to invest. But bond investors don't want to hold a single mortgage in their portfolio. That does nothing for their portfolio's fixed-income diversification. So a security is created. This security is basically a bunch of mortgages all under one umbrella, called a mortgage-backed security. The mortgages can be pooled in a number of different ways -- by different maturity, risk and return characteristics. They can also be pooled by mortgages for single-family home only, multifamily home, 30-year fixed, 15-year fixed, adjustable-rate mortgages, geographic location and, of course, subprime loans. But the permutations are endless.
The investors of these securities are typically very large and sophisticated money managers, like mutual funds and pension funds.
Well, what if he doesn't? What if he was a subprime borrower, turned deadbeat? The individual or fund who bought the security won't get its payment stream. So what does that investor do? Well, on one hand, that risk is part of the game. On the other hand, he could go back to Local Bank and request that it cover the loan. Now the bank does have some money set aside for defective loans that it could give to the investors. But the defaults are coming faster these days, and that reserve has run out. So now the bank's losses begin to mount, its stock price falls, and its profits are gone. "In addition, the bank now has no access to cash to fund new loans and sell them, so their business model no longer performs," says Keith Gumbinger, vice president of HSH Associates of Pompton Plains, N.J., which tracks a variety of loan products. So now both the banks and the MBS investors are suffering. But the banks get hit from both ends when they're in the subprime world. That's because many times the banks that offer subprime loans aren't able to sell those loans, notes Mark Grinis, a partner in Ernst & Young's real estate, hospitality and construction group. So our Local Bank bears all the risk of those loans. And these days, that's not such a good thing. OK. So that's a very simple run-through of the mortgage-backed security world. Whew! I'm sure you'd much rather go back to talking about Anna Nicole right about now.