The System of the World (Part Two)

Our house is a very, very, very fine house...

But what is it worth?

Back in part one we mentioned that Fred sold his house to Ernie. Fred had an asking price, but Ernie offered him a little less. The went back and forth a couple times, but eventually agreed on $35,000. (Remember, this was the 1970's). It's a small house in a nice neighborhood. It was Fred's first house, but he's had it for several years and his family is growing and he's making more money now and he's ready for something bigger. But it's just right for Ernie.

So anyhow, there's the simplest explanation for what anything is worth - it's worth what the buyer is willing to pay the seller. In the real estate market if the buyers outnumber the sellers it's a "seller's market" - he can get a higher price than when the sellers outnumber the buyers (a "buyer's market"). But here in Yortown supply pretty much equals demand, and Bob the Builder keeps it that way.

Now Ernie doesn't have $35,000 in his pocket - or even in the bank. So he asked for a loan from the bank. After they determined he was likely to pay the loan back (he had a good job working at Joe's Widget Mill and a history of paying his debts) the bankers wanted to know what the house was worth. So they had an appraiser check it out. She looked at the house inside and outside and measured the rooms and looked at the type and quality of construction and material and compared it to other houses that had sold in the area and determined it was worth the agreed upon price. Since Joe was also using some of his savings as a down payment this meant the bank was fairly safe in making the loan - so they did.

After the deal was complete, Fred paid off his loan to another bank and used most of his profit (he only owed $16,000) as a down payment on a bigger $50,000 house Bob was building over in the nice new Avon Park subdivision.

So everyone was happy.

Now, we already know from part one that the bank is going to send that mortgage off to Fannie Mae and get money to offer more mortgage loans. Fannie Mae, in turn, is going to offer that mortgage on the "secondary market".

But that begs a question: "What is the mortgage worth? And if you think about it for a minute, you'll know that's a very different question than "what is the house worth?" Here are a few reasons why:

Ernie's mortgage is designed to be paid off over 30 years. If he makes the scheduled payments on time whoever gets those payments will get a large sum of money - their profit will be the interest Ernie pays. (However, those payments will look pretty small in 20 years time compared to new mortgages if housing values keep going up...)

But if Ernie makes larger payments he might pay the loan off sooner with less interest accrued.

But he might also do what Fred did and sell the house to someone else and pay off the entire loan after only a few years.

Or he might fall on hard times and not be able to make his payments at all. If his loan was guaranteed or insured then once again the principal would be covered, but there would be no more interest received and whoever guaranteed or insured it gets the house. If not, whoever Ernie owed the money to gets a house. And what is that house worth? How long has it been since Ernie bought it? How much did he still owe? What will it cost the company to sell the house? How long will that take?

So the best answer to "what is the mortgage worth" is "something". That uncertainty means there's quite a bit of risk involved in buying a mortgage, making it more difficult for buyer and seller to agree on a price . If you deal in a high volume of mortgages to qualified borrowers you reduce that risk, but frankly anyone willing to assume that risk is probably better off originating mortgages (what the bank did for Ernie) in the first place.

But we already explained in part one why a secondary market for mortgages is desirable. So how do you go about creating one?

Here's a simplified explanation of how it was done in America. The Emergency Home Finance Act of 1970 established new standards for mortgages, and reduced or eliminated regional and local variations. This allowed Fannie Mae (and other Government Sponsored Enterprises) to "pool" several similar mortgages. Then, instead of trying to sell one mortgage worth "something" they had a large block of mortgages that had a more definable value.

While you can't predict with great certainty what one mortgage will be worth over time, you can statistically predict what a thousand will (especially if they were generated using the same applied standards). Some percentage will be paid off on time, another percentage will default, another will be paid off early, etc. etc. This doesn't eliminate uncertainty (risk), but it does reduce it.

And to further lower risk, instead of trying to sell that large pool to one investor, Fannie Mae (or anyone else in the business) could get multiple investors to purchase a portion of the pool. Those "portions" are called "mortgage backed securities". There are numerous complex variations, but the bottom line is that these securities facilitated the growth of the secondary mortgage market - and a way for investment firms that weren't in the industry to cycle money through it, keep mortgage generation possible, and make a profit. With the system "backed" by property (collateral), insurance, guarantees, (and in many cases the United States government); along with a widely accepted premise that real estate would gradually increase in value over time (albeit with fluctuations), an assumption of generally accepted "safe" lending practices in loan origination, and assumed fiscal responsibility throughout all levels of the process it seemed like a safe bet. Lots of pension funds, insurance companies, and other financial institutions "bought in".

In fact, it was a safe bet. "The system" even facilitated that gradual increase in property values that it needed to thrive.

But the key word, as we all know now, is "was".

More to follow...