Anomalies

An anomaly is defined as:

"a deviation from the common rule, type, arrangement, or form."

The anomaly in question is the risk premium that the market assigned to the yield on junk mortgages.  Frankly, this wasn't just a problem with the junk mortgage market. It applied all across the spectrum of securities. The world has been awash with money seeking higher yields and the market just assigned the wrong numbers to risk.

Back when junk corporate bonds were all the rage – remember Michael Milkin? – low rated bonds might have had a yield of 13% when the best corporations paid 7% for their money.  The difference was the premium that the market assigned to the higher potential of defaults on the low rated securities.

Mr. Milkin sold those bonds because he said that the real risk was less than the market said it would be.  Although there were some defaults and losses, if an investor bought enough different issues to spread the risk, he would have made out handsomely compared with his more conservative counterparts.

Theoretically, this should have happened with junk mortgages too.  If the best borrowers were paying 6% for their loans, the risky borrowers should have been paying, say, 10% or maybe even higher. That extra 4% was all risk premium. 

But what happened was that the junk lenders were putting people into loans that might eventually yield 8%. You can see that the market was saying that the risk premium didn't have to be 4%. A 2% premium was OK.  That departure from reality was the anomaly I’m discussing.

What was even worse for investors is that the loans carried a lower rate – I prefer the term sucker rate over teaser rate – one substantially less than the final rate, maybe even less than the 6% rate being paid by the best borrowers.  They had to do this because they would have had a tough time selling that 8% yields to borrowers without disguising them in some way.  Note that the investor got a lower initial yield too. The higher return didn't kick in until the loans reset at the end of 2 or 3 years.  That reset issue is one cause of the current problems.

I will tell you bluntly that the lenders or mortgage brokers told the borrowers not to worry, they would just refinance into a new loan just before the loans reset. They wanted to make another commission so they really did plan on doing it, that is until the melt-down.

So if you are following this, it turns out the junk lenders created loan programs that promised the ultimate investor with higher yield, but the structure was such that the investor wasn't ever going to get the promised higher return. They'd get refinanced and paid off before that happened.  The investor would get to keep the loan during the higher yield period only if conditions were such that the borrowers couldn't refinance them, what we're seeing now. This is a Catch 22 involving billions and billions of dollars.

Of course, we know today that the effective yield should have been substantially higher than the yield that was actually being created by the junk lenders.  That's the opposite of what happened in the junk bond market.

And another strange part is that a lot of the investors' early yield was "eaten up" by paying the loan officers high commissions that were largely paid by the investor in the form of Yield Spread Premiums.

You have to admire the cunning salesmanship of the lenders and Wall Street to pull off a scam like this.

Randy Johnson – Author of How to Save Thousands of Dollars on your Home Mortgage and Savvy Borrower articles. Randy is a mortgage broker who has financed over $1 billion in properties. He writes about home buying and real estate finance topics for CreditBloggers.com.