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Mortgage trickle-down effect hurt Wall Street

September 29, 2008|By ERIN CUNNINGHAM

When someone wins the lottery, there is a choice to be made. The winner can take small payments spread over decades or can take a large sum of money upfront.

That large sum of money often is the one lottery winners take, and it is always less than the amount they would get if they chose to receive equal payments over a number of years.

This mentality has a lot to do with the current economic crisis, according to Associate Professor of Economics at Frostburg (Md.) State University Bill Anderson.

Mortgage giants like Fannie Mae and Freddie Mac bought mortgages at a discounted rate so banks could get a large sum of money upfront, he said. Accepting that discounted rate, known as "present value," will always be less than the accumulated dollar amount over time.

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Banks used that money to provide even more loans -- often to people who had questionable means of paying them back.

Companies like Fannie Mae and Freddie Mac bundled the mortgages they purchased and sold them to Wall Street investors, Anderson said. In a normal marketplace, investors know that some mortgages will be defaulted on.

However, housing prices had been inflated, interest rates had gone up and many attractive "teaser" rates had been eliminated, Anderson said. People could no longer afford their mortgage payments, and once the housing market cooled, some homes were worth less than the amount owed on the mortgages.

"The bank now has an interesting situation," he said. "It has a mortgage that is higher than the value of the house, but they have to list the asset value of the house in their portfolio."

When real estate prices fell, so did the value of the banks' assets. Foreclosures became more common, and investors and mortgage companies were not paid back for the loans they issued.

"This is happening on a really huge scale," Anderson said. "What happens when this debt goes bad? The pyramids have all been built on very shaky foundations."

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