Our Mortgage Crisis

So, these past few years, I have seen friends all around me buying up houses, with little down and huge monthly payments.  I stood by and said, no to a new house.  I stuck with my $80,000 house which is only 936 square feet.  Why did I do that?  Because, I believe growing up in Silicon Valley, that we have definitely lost our business sense.  My uncles and grandfather, grew their business as farmers, the old school way, by borrowing money from people you knew.  That way, if you were to ever try to screw people out of their money, they would be there to haunt you.  I'll leave the discovery of how to do business in the internet age for later.

Anyways, there are time tested hard and fast rules for buying a house.  Put 20% down and don't pay more than 3 times your annual salary.  I bought my house with 4 kids during graduate school, putting $20,000 down.  I always worked through school, but not many people I know bought a house during school.

So, as the years past, and I looked at my friends buying the houses, unfortunately many of them lost their houses.  Sometimes multiple.  Now lets dig in a little deeper as to what is happening.

A bank, offers a loan to a poor person, who can't afford the payments.  The loan is tricky, with hidden fees and variables.  The bank is almost positive the person will default, but still takes the risk.  If you ever noticed, banks are funny this way.  They don't want to deal only with people with great credit.  They need people to default.  No one defaulting, means no one paying the expensive penalties.  Everyone defaulting means they have no cash flow.

Anyways, so the bank gives out a loan to a poor person.  In the event of default, that poor person's money is taken.  The bank gets the cash flow and turns around and sells the loan (through bonds, etc) to a middle class investor.  The middle class investor has no clue about investing, but walks into the bank one day, to see people all dressed nicely in business attire and believes the broker, when the broker talks the middle class person out of buying a CD and buying this bond which involves higher interest mortgages backed by real estate.  Wow, the bank just eliminated their risk of default.  In the case of a default, the investor loses all their money too.  The bank has the cash flow (from the investor's initial purchase and the poor person's monthly payments).  The whole scheme blows up one year, all these funds get placed to the side, CEO walks out with 4 million dollars and the poor person and bank file bankruptcy.  Whew, good thing the middle class investor didn't put all the chips in one basket.

The big short gives many details of the sub prime mortgage crisis.
Next time the bank offers you a great no down offer, just think about the guy on the other end, cause I can guarantee its not the bank taking the risk.  Speaking of which, who's fault is this?  I would say all three parties.

Take this interesting example.  Three guys live in a village.  One guy has a house, another wants to buy it and the third has $100,000.  The third provides interest and is trusted to hold money.  He loans the money to the guy wanting to buy the house, who trades if for the house.  The guy who sold the house, then gives back the money, to make interest.  The third guy was very smart.  He still has the $100,000, and now has extra since he is making profit on the loan he just gave as well as the up front fee to handle the transaction that just occurred.

This post was reposted from http://sizuservices.blogspot.com/2010/08/our-mortgage-crisis.html, originally written on August 6th, 2010.