As 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.
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.
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