The mainstream media coverage of the US subprime mortgage meltdown has mostly been about all the folk who have lost their homes, and various plans the government has come up with to try and ease the problem. Thinking about it more carefully, though, doesn’t it seem a little odd for the US government to interfere in the sacred free market merely in order to save a bunch of poor people from ruin?

Well, the SF Chronicle has an interesting article that explains this curious situation. It’s not about saving people from losing their houses, it’s about saving the banks.

During the housing bubble which was fueled by the subprime lending, banks sold mortgage-backed securities. For those who don’t know, mortgage-backed securities are basically in-place mortgage agreements, packaged for resell between financial organizations, or between financial organizations and investors.

The key is to view a mortgage in the abstract, as a promise by person A to pay an amount X for N years. That promise has a value, and can be sold.

For example, we arranged our mortgage through a small financial firm in the Austin area. Once all the paperwork was done, they packaged us up as an asset and sold us to GMAC. GMAC took on the business of extracting money from us over the course of years, and paid the small financial firm a lesser amount in compensation for the value of us as a customer.

This is generally a good thing. Because GMAC does administration for millions of mortgages, they can provide convenient billing and payment services, and reduce per-customer overheads. For the small firm, the benefit was immediate cashflow and no ongoing overheads.

A similar process can be used to package a mortgage and sell it to investors as a bond. The bank gets to remove the liability from their balance sheet; they can then use the cash to provide mortgage funds to more homebuyers. Hence, allowing the transfer of mortgages as mortgage-backed bonds should allow more people to buy their own houses.

For example, suppose John Smith owes the bank $1000 a month for the next 20 years. That’s a total of $1,040,000. The bank could sell that mortgage to an investor as a bond for (say) $750,000. The bank would get the $750,000 immediately, reducing their liabilities. They could use the money to finance some new homebuyer’s mortgage. Meanwhile, the investor would get $1,040,000 over the course of the next 20 years, making a nice profit. And the whole thing could be treated like a regular bond or stock market investment–the bank could continue to process the collection of the actual mortgage payments, just like it would process dividends on a mutual fund investment.

The problem is that since the banks expected to sell off the mortgages to eager investors hoping to cash in on the property boom, they didn’t really care too much about checking that the mortgages were sound; and the investors didn’t really have any way to check on the actual person paying the mortgage.

However, there’s language written into these mortgage transfer securities stating that if there’s fraud, the bank which sold the mortgage is legally obligated to offer to buy it back at the original price–which is now often ten times the actual value likely to be extractable from the homeowner. Fraud like, say, people lying on their mortgage applications, or inflated property appraisals, or e-mails on bank computers suggesting that they knew the market was a bubble that couldn’t last. Then there’s the issue of companies like S&P, who helped the banks to structure the subprime mortgage securities to look as good as possible on paper.

So if too many mortgages fail, and investors start demanding that their junk bonds be repurchased by the selling banks, those banks will go under. At that point, the FDIC and the government will have to step in, and we’ll basically have a taxpayer-funded bailout of a bunch of big corporate banks who defrauded investors. It’ll be the Savings and Loan crisis all over again.

How about pressuring the investors not to call in the cops? Well, unfortunately a lot of the investors are in foreign countries. Some of them are foreign countries. With the current state of US diplomacy, a conversation that starts with “Hey, we were wondering if you could eat a few billion dollars in losses to fraud so that we don’t have to bail out our rich corporate buddies in full public view” might not go too well.

But never mind, it may not come to that. A crack team of financial experts are trying to come up with a way to salvage the situation. We know they’re experts because, as the Chronicle points out, they’re exactly the people who got us into the mess in the first place…