who knew

1. that i love riding in small planes?

2. waking up to my cat staring at the snowfall would make my day?

3. that coffee really prevents one from sleeping?

4. fear of judgment is a very hard feeling to shake?

5. reading novels and poems is ceaselessly wonderful and amazing?

6. b-school is all sorts of hellish (maybe i should have known that)?

what happened to bear stearns?

picture of bird friend and the oc suburban sprawl

alright, so back to those “undiscovered gems” aka mortgage-backed securities.

fast forward to 2007, when housing prices fell due to increased supply and lower demand, especially in places like nevada. this, coupled with the fact that many of the adjustable rate mortgages given the early 00’s had just adjusted their rates, led to the foreclosure rates hitting a disastrous high. fyi, foreclosure is the process in which the bank repossesses your house after you fail to pay your mortgage. in nevada, the foreclosure rate was up 224% from 2007, which is completely insane when you think about it.

and all those mortgages that went bad meant that all those mortgage-backed securities were worthless, and all the banks that bought them up had to take huge losses in the form of write-downs, which meant *publicly* devaluing the assets they were holding. without going into all the ins and outs of investment banking, let’s just remember that two of the most important “assets” any investment bank can have are consumer confidence and credit strength, which go hand in hand. If you hear that your bank doesn’t have as much money as you thought it did, then you might take your money out, because you're worried about insolvency. which means it WILL have less money, and someone else might follow in your lead. this cycle of declining confidence leading to declining capital and vice versa is called a “bank run” and is disaster for an individual bank and a very bad omen for the rest of the industry. the federal reserve system is set up partially to address these types of banking panics.

in retrospect, we see that bear stearns was particularly vulnerable to a bank run because it was one of the smaller investment banks and it had built up most of its core assets by manipulating the mortgage-derivatives market, so it was not as diversified as many of its peers. the week of March 10th, rumors were floating around rival firms that bear stearns was out of cash and could not even cover day-to-day expenses, which prompted shares to plummet (in this way, finance is like fashion, all about perceptions). the week before, its stock was trading at $70 per share. as these rumors spread, the value dropped to $45 per share and a bank run was imminent, if not already beginning.

as we know now , jp morgan and the federal reserve bank of ny swooped in and brokered a deal to bail out bear stearns. but there were a few other options for how things could have gone.

ps. obviously this issue is infinitely more complex than my basic outline here, but if you want a list of articles to read for deeper analysis, i've saved my own list of research. email me and i'll send it to you.

huh? mortgage-backed securities explained

image courtesy of here

okay, this gets a little more complicated, so hang on.

when housing prices were rising in the late 90’s, many people purchased homes with sub-prime loans due to a confluence of factors: 1. they believed housing prices would continue to rise and they would be able to re-finance at a more favorable rate in the future 2. banks realized they could charge much higher origination fees for sub-prime loans and so encouraged people without adequate education to apply for a sub-prime loan 3. everyone got a little greedy.

the goal of homeownership is basically the bedrock of the american dream, so it’s hard to really blame anyone for allowing more americans that experience. regardless, when the percent of sub-prime loans skyrocketed, financial institutions realized they could spread the risk of defaulting around by packaging the sub-prime loans into mortgage backed securities.

let's break it up to explain. a security is an instrument of financial value; stocks and bonds are securities. a mortgage backed security is where a bunch of mortgage loans are grouped together to create a large pool of debt. this debt is then sold to investors the same way a bond is; you buy it at a discount and rely on the mortgage payments for the payout. it was supposed to be a relatively safe investment, partly thought so because of these odd rating rules for bond insurers (i’m sure you’ve heard about this), and because some of these mortgages were structured so that people ended up paying MORE than they were borrowing, it sounded like a great deal.

the primary holders of these mortgage-backed securities (and there are also these other very complicated things called collateralized debt obligations , or CDO’s, which are made up of various types of mortgage related securities) were corporate and institutional investors and investment banks like Bear Stearns, who bought them in droves during the height of the real estate boom, often touting them as “undiscovered gems”.

tomorrow we'll look at the fallout and how the government is getting involved.

a very good place to start: interpreting financial news

there’s big news in the markets this week. to understand what is happening to bear stearns, and the implications of the federal reserve’s actions, let’s start at the very beginning.
(in my head i hear maria’s voice from "the sound of music"- anyone else?)
sub-prime mortgages/sub-prime loans
these buzzwords have been at the root of much of this financial turmoil; but do we really know what they mean? here’s the straight story.

if you are interested in buying a house, you usually need a couple of things: 1. a good credit score (usually above 650 FICO score) and 2. a down payment that is usually between 10%-20% of the purchase price of the home. if you don’t have either of these things, you can still buy a home, but since you don’t qualify for a prime mortgage rate (this rate fluctuates, but has been around 5% for the past 5 years), you have to get a sub-prime loan. a sub-prime loan will have higher origination costs and a higher interest rate than the 5% you would get as a prime borrower, because you are more of a risk to the bank to lend to.

this is a really important lesson for us twenty-something’s who don’t really understand the importance of a credit score. in the financial world, your credit score is the single most important factor people look at when making financial decisions about you. take care of it! (i’ll post about credit soon)

many of these sub-prime mortgages take the form of adjustable rate mortgages, which is probably another term you’ve heard a lot about. an adjustable rate mortgage adjusts its rate (duh!) over time, so you may start out with a 5% mortgage that shoots up to 10% after 4 years. These can mean the difference between paying a $750 monthly mortgage payment for a couple of years and one day opening your mail to find out your monthly mortgage payment has shot up to $3,500. there is obviously great risk that the borrower will default in this situation, which the banks soon realized and created the derivative product of mortgage backed securities to spread the risk around.

this brings us to mortgage-backed securities, which i will unpack tomorrow. hopefully, by the end of the week we will all have a much better understanding of what is going on and more importantly, how this is going to affect us.