From Mortgage to Bailout: How Did The Problem Arise?

Published on September 23rd, 2008 | by

House of CardsAs the government begins to unleash a highly criticized bailout plan for Wall Street’s toxic mortgage backed assets, it is worth taking a step back to understand how the problem actually arose.

Investing In Real Estate

It all started with real estate investing which involves the purchase, ownership and sale of real estate for profit. Real estate is an asset form with limited liquidity relative to other investments, it is also capital intensive (although capital may be gained through mortgage leverage) and is highly cash flow dependent. The primary cause of investment failure for real estate is that the investor goes into negative cash flow for a period of time that is not sustainable, often forcing them to resell the property at a loss or go into insolvency.

Mortgages Are Converted to Mortgage Backed Securities

A layperson typically borrows money from a high street bank into order to invest in real estate, without extensive mortgage advice. The bank then often ‘sells’ these mortgage loans to investment banks that in turn bundle them into securities known as mortgage-backed securities. Redistributing mortgage backed securities to investors (often foreign investors), has allowed investment banks not only to distribute the risk of a mortgage, but it has given investment bank clients the opportunity to partake in the U.S. real estate market (through the purchase of mortgage back securities).

Mortgage Payment Failure Threatens Mortgage-Backed Securities

The trouble begins when the layperson fails to make regular mortgage payments. This causes the mortgage-backed securities to decline in value and the holder of these securities has a “paper loss”. If several borrowers default this leads to foreclosures and a steep decline in property values due to oversupply. So when the layperson ultimately renegs on his or her mortgage, the securities goes down in value. When these securities cant be resold because of a downward spiraling real estate market they are characterized as :toxic”

Investment banks have issues mortgage backed securities but have also invested in actual real estate themselves. The falling value of real estate has not helped their case.

Bailout Plan

The Fed and the Treasury now propose to spend up to $700 billion to purchase toxic mortgage backed securities from financial companies in an effort to ‘rescue them’ by taking them off their balance sheet. This way, financial companies can start over with a clean slate.

Related Posts:

To Bailout or Not to Bailout: Is Free Market Economics Sustainable?
Death of Wall Street, Rise of Main Street
Financial Crisis: What Will The Collapse of Investment Banking Mean for CSR?

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About the Author

Reenita Malhotra Hora is an Ayurveda clinician, entrepreneur, writer and mom. Her experience has ranged from running Ayoma, an Ayurveda business to running a natural health practice at San Francisco's California Pacific Medical Center. Reenita is a published author of two books books about health and wellness: ‘Ayurveda - the Natural Medicine of India’ and ‘Inner Beauty’. She is also the Editor for Green Options Media's business blogs and a freelance writer for a variety of print and web publications. In quieter moments, she likes to spend her time hiking, swimming the warm seas, cooking with the family or writing fantasy fiction adventure stories for kids from from 2 to 92. Check out her wisdom at www.reenita.com