Debt Free

So, you want to be debt free? So does American Home Mortgage Investment Corp.(NYSE: AHM), who filed for bankruptcy protection in U.S. District Court this morning. I wish I would have shorted this stock last week when I first noticed the downward trend from $18 a share to $10 in 30 days. Selling it short, while a risky move that I typically shy far away from, seemed much safer, given the deep financial problems faced by the mortgage lender. Even I was unprepared for the total collapse of the stock only a few days after my post on the possibilities of short selling it. Now the gains seem locked in for those who did so, as with their bankruptcy filing, AHM looks to have gone down the road pioneered by New Century Financial and many others lately.

The thing is that American Home Mortgage, although lending in the sub-prime market, really specialized in mortgages for those with less than perfect credit, not even the true, sub prime market. In theory, these borrowers are much less likely to default on their mortgages than sub-prime borrowers and should have somewhat insulated AHM from the problems in the sub-prime mortgage industry. Could this be a big sign of things to come in the mortgage industry?

Their problems began because they sold the mortgages they originated, a practice known as “selling the paper”, to investment banks and other investment groups. If the price these investors are willing to pay drops too low, it spells trouble for the mortgage originator. It's really a type of self fulfilling prophesy. If the price paid by investors sinks, it forces the mortgage originator to restate the value of their loan portfolio downward. That, in turn, causes the creditors that lend money to the mortgage company to demand more money in reserve to guard against default. If the mortgage company is unable to comply with their demands, the creditors can call their credit lines. Recently, American Home Mortgage seemed to be in a pretty strong position to deal with any problems, as they were sitting on over $800 million in cash at the end of March. Unfortunately for AHM, that was deemed an insufficient amount of cash to protect them against defaults by their borrowers.

So, what does all this mean for you, as a homeowner and mortgage holder? What if the mortgage company you used to finance your home goes out of business, an event that seems increasingly likely? Are you off the hook altogether? “WhooHoo, I got a free house!!!” Hold your horses! It doesn't work that way, as much as you'd like to get a free house. Your mortgage most likely wasn't even held by the originator anymore. In the majority of cases, it was packaged with hundreds or thousands of other mortgages, and sold to an investment bank or group in the form of a bond. Many investors actually hold the bond. Ironically, if your 401(k) or mutual fund is invested in the bond that your mortgage is a part of, you could actually, in some small part, be paying for your own retirement with your mortgage payments. Think about that for a second!