Tuesday, September 9, 2008

The Mortgage Debacle -- Part I

To understand the mortgage mess, one needs to have a rudimentary understanding of the economics and accounting of any business and of the mortgage business in particular. So this series of postings will begin with the following simplified outline of the essentials of that subject. (Those who already understand these basics can skip this post and pick up the more advanced aspects of the subject with the postings that will be forthcoming.)

To begin, let's assume that Ernie Entrepreneur want to go into the mortgage lending business. Let's further assume that Ernie and his investors put $200,000 into the business. That $200,000 is the capital of TTMCB (Teeny Tiny Mortagage Company or Bank). TTMCB then borrows another $800,000, giving it $1 million in cash and now it's ready to do business.

Along comes a Joe Consumer, who wants to buy a house for $1 million or more and needs to borrow $1 million to do so. TTMCB is eager to loan out its $1 million because it is paying interest on the $800,000 borrowed portion of that amount. So it loans the $1 million to Joe Consumer at a rate of interest higher than the interest rate on its $800,000 debt.

That's great so long as Joe Consumer can make the mortgage payments. These payments are enough to meet TTMCB's operating costs (including its debt payment obligations) and give it a little extra as an operating profit. And if Joe Consumer fails to pay, TTMCB always can foreclose on its mortgage, take the house, sell it, and thus come out whole.

That's fine if the house is worth enough more than $1 million to yield that amount to TTMCB after it pays the expenses incurred in and while it is going through the foreclosure and resale process. Remember, TTMCB has to service its obligations -- meaning meet its interest and principal payment -- on its borrowed $800,000 while all this is going on. And TTMCB's other operating costs (such as salary, rent, utilities, office supplies, legal and accounting fees, etc) also have to be met.

Now suppose Joe Consumer isn't the responsible borrower he or the mortgage broker who brought him to TTMCB claimed he was. He's really Joe Deadbeat, and he or his lawyer knows lots of ways to delay the foreclosure process. Meanwhile, it also turns out that the house isn't really worth $1 million. Also, Joe Deadbeat hasn't been taking care of it so it and its value have been deteriorating. And now that good old Joe knows he's going to lose the house anyway, he's not just letting it deteriorate. He's trashing it while he lives there debt free.

In an ideal world, the house would yield enough more than $800,000 to pay off TTMCB's debt, the interest accrued on it and TTMCB's operating costs. However, in the real world, the house yields substantially less than that, and in order to pay off its loan and meet its operating costs TTMCB has to dip into its own capital.

If at the end of the process the house yields less than $600,000, TTMCB will be wiped out and unable even to pay off the $800,000 it borrowed, let alone its interest and operating costs obligations.

The whole thing works only if (i) the borrower is an honest and responsible one, and (ii) the house is worth enough more than $1 million loan it secures to ensure that TTMCB will get back all of the funds it loaned together with all interest accrued on that loan plus its associated costs and expenses.

The current mortgage mess is due to the fact that millions of loans were made by thousands of huge and big time TTCMBs without regard to the template necessary to allow the system to work. Why and how this occurred and why and how the government not only allowed but also promoted the deviation from the template, and the consequences of those failures will be covered in future postings. Such postings also will explain why the government bailout only delays and will exacerbate the resulting pain.

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