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So we’re in this terrible economy, banks are shutting down or being taken-over all over the country, and it’s because people aren’t paying their mortgages, right?

Wrong.  Only about 5-7 percent of mortgage holders right now have stopped paying.

While about three times as many homes are going into foreclosure these days than is the historic norm, such levels aren’t themselves capable of sending the banking sector into such a tizzy.  No, it required the double whammy of a change in accounting standards (called mark-to-market) followed almost instantly by the brutal application of those new standards, after which the standards were then relaxed again after some firms died as a result. Think of it as a financial neutron bomb killing only the banks but not their deposits. It sounds like yet another scam to me.

Here’s how it works.  Under Generally Accepted Accounting Procedures (GAAP) the issue is how lenders (mainly banks) value the loans on their books. Apparently there was an accounting rules change not long ago that forced them to value the loans moe conservatively, valuing them at what they could be sold for that day in the current market (marking to market).  This change forced writedowns of subprime and alt-a loans resulting in big paper losses for the banks which put them in positions of having inadequate liquidity (not enough deposits backing the loans).  The banks were then insolvent, had to raise capital, couldn’t raise capital and failed or were taken over.

Now here’s the key point that I think is being missed.  The accounting rule change forced loan values to be marked-down severely while at the same time MOST MORTGAGE HOLDERS WERE CONTINUING TO MAKE THEIR PAYMENTS ON TIME.  Right now only 5-7 percent of subprime borrowers are in arrears yet the value of their loans have been marked down 60-70 percent.  There’s a disconnect here.  The write-downs are far in excess of what is justified on the basis of loan performance.

Was this crisis precipitated, then, by an accounting change?  Sure there’s a lot of bad lending going on, but most borrowers are still paying their bills.  IndyMac, CountryWide, WAMU and others failed for precisely this reason, yet now that they are gone the rules has been eased.

I think the rule was bad in the first place and while those banks might have failed anyway, they shouldn’t have failed for this specific reason.

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Given that this current financial crisis supposedly started with problem mortgages, how do you tell if you have one of those?  I have this gut feeling that there are more people out there who have sub-prime and alt-a mortgages and don’t even know it.  After all, I’ve never heard a mortgage broker try to sell something with a name like sub-prime or alt-a, but I know that at least one of my mortgages (I have two — on two different houses) definitely IS from one of the despised categories.

So what does it even mean to have a so-called “sub-prime” mortgage?  Here is the technical definition of sub-prime according to Wikipedia:

“Subprime borrowers have a heightened perceived risk of default, such as those who have a history of loan delinquency or default, those with a recorded bankruptcy, or those with limited debt experience. Although there is no standardized definition, in the US subprime loans are usually classified as those where the borrower has a credit score below a particular level, e.g. a FICO score below 660. Subprime lending encompasses a variety of credit types, including mortgages, auto loans, and credit cards.  Subprime could also refer to a security for which a return above the “prime” rate is received, also known as C-paper. In the United States, mortgage lending specifically, the term “subprime” can be applied to “non conforming” loans, those that do not meet Fannie Mae or Freddie Mac guidelines, generally due to one of an array of factors including the size of the loan, income to mortgage payment ratio or the quality of the documentation provided with the loan.”

So if that’s the definition of sub-prime, how does that vary from “alt-a?”

Again, from Wikipedia:

“An Alt-A mortgage, short for Alternative A-paper, is a type of U.S. mortgage that, for various reasons, is considered riskier than A-paper, or “prime”, and less risky than “subprime,” the riskiest category. Alt-A interest rates, which are determined by credit risk, therefore tend to be between those of prime and subprime home loans. Within the U.S. mortgage industry, different mortgage products are generally defined by how they differ from the types of “conforming” or “agency” mortgages, ones guaranteed by the Government-Sponsored Enterprises (GSEs) Fannie Mae and Freddie Mac.

“There are numerous factors that might cause a mortgage not to qualify under the GSEs’ lending guidelines even though the borrower’s creditworthiness is generally strong. A few of the more important factors are:

• Reduced borrower income and asset documentation (for example, “stated income”, “stated assets”, “no income verification”)
• Borrower debt-to-income ratios above what Fannie or Freddie will allow for the borrower credit, assets and type of property being financed
• Credit history with too many problems to qualify for an “agency” loan, but not so many as to require a subprime loan (for example, low scores or serious delinquencies, but no recent charge-offs or bankruptcy)
• Loan to value ratios (percentage of the property price being borrowed) above agency limits for the property, occupancy or borrower characteristics involved

“In this way, Alt-A loans are “alternatives” to the gold standard of conforming, GSE-backed mortgages.”

Okay, so an alt-a is a type of sub-prime mortgage but generally not as bad as a pure sub-prime, whatever that is.  I think the key distinction in these things is the FICO or credit score.  Alt-A borrowers tend to have scores above 660.

So do you have a sub-prime mortgage?  If you have a non-conforming loan like a jumbo you are some form of sub-prime no matter how high your credit score of how low your loan-to value ratio.  If you have a low-doc or a no-doc loan it is non-conforming and also sub-prime even if you aren’t.  You have a sub-prime loan if your mortgage is interest-only or some funky variety like an Option ARM.

As a result there are probably a lot more sub-prime mortgages and mortgage holders than you’d expect.  I’m one because I have a jumbo.  Are you?

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