In our 12 Angry Men email discussions, one Angry Man asked why one of us didn’t rant about the “subprime mortgage meltdown”. After some consideration, and at the risk of offending those in finance with considerable more precision than I can provide, I delve into the topic. One of the reasons for the reluctance to address the topic is its complex nature. To truely understand what occurred, you have to understand securitization and structured investment vehicles. But as one who participated in a company who securitized credit card receivables, as I researched, I discovered several underlying commonalities. In fact, there is a lot of commonality with the way Congress and our government manages the Federal budget. When one sees so many threads aligned together, there is a suspicion of a whole cloth of consensual conspiracy, a tapestry of belief that underlies the way we view risk.

Before 1970, banks maintained portfolios of loans, serviced those loans, and generally covered the amount loaned by use of deposits, or by debt incurred by the bank itself. Regulatory agencies required that banks maintained a certain level of liquidity reserves, i.e. they couldn’t loan more than say 80% of the amount they had on deposit . When loans matured and the principle was paid, it could be relent to another. This serial process set limits on the amount of growth in the country as growth requires a pool of capital to finance that growth. The more capital available, the more growth. This was particularly true in the home building and mortgage industry. Mortgages were particularly bad because the cash assets were tied up in fixed terms of 20 or more years. Demand was high for new homes.

The solution was to package loans up as a “managed asset” and sell them, transferring the long term debt, future cash flows and risk to third party investors. Two benefits arose from this: accounting rules treated the movement of debt to a third party as a sale, and thus the debt could be moved off the bank’s balance sheet (and reduce the liquidity reserve required by regulators); and the bank received immediate cash, albeit discounted, from the sale which allowed it to originate more loans. Investors who purchased the asset received the interest cash flow and eventually the principle back. Moreover, such asset backed securities (ABS) could be traded between investors like any other security. Trading is important in that it allows information relevant to the asset, such as credit quality, to be reflected into the price of the asset. Assets which aren’t traded have no mechanism to establish their value (price).

Now if I go out onto the street and lend the first 100 people I meet $1000 each, with their promise to pay it back in one year with some interest, (say 6%), I have receivables of $100,000. Further, I make them sign a piece of paper that says that they will pay me back. Now I go to another person, who happens to have some money he wants to invest. Hey, I’ll trade you this package of notes for $100,000 and you can keep the interest. Does he take the offer — I suspect not. What would I have to do to entice him into taking the offer?

First I would need a plan as to how I would collect the principle and interest, i.e. how I would service the loan. The investor doesn’t want to be bothered with running a collection operation. So either I have to do it or I have to hire someone to do it for me — both at a cost. Hmm. I could create a spread in interest rates. Charge each person a higher rate than I offered to pay the investor and use the difference to pay for the servicing. Hey, I could even wet my beak a little. I charge 6% and offer the investor 4% and use the 2% to pay for servicing.

But then I remember that the forth and fifth person I loaned the money to were bums. Hmm. How likely is it that they will just drink up the money and never pay me back? But that first guy has a cashmere coat and a nice haircut — he would probably pay me back. But the 10th guy was a used car salesman. Maybe I had better look at these loans and arrange them in order of who is likely to pay me back. In fact, it sure would have been better to look a little closer a them before I handed them the money. So I divide up the loans in to three piles. All the bums in pile three, all the used car salesmen in pile two, and all the cashmere coats in pile one.

So now my plan is to take all of the loans to guys in cashmere coats and package them up as an asset based security. Since the risk is very low that these guys will default and not pay me back, I am essentially giving away a sure thing. For sure things I offer a 2% rate.

The used car salesmen loans, I also package up. These guys are more risky so I offer the package for 4%. And since many of these investors don’t know me personally, I need to convince them that I haven’t slipped a bum or two into the used car salesmen group. So I go to Joe the Bookie. Now Joe really doesn’t know much more than I do, although he has one advantage — everybody knows Joe. Joe make a cursory glance through my package and doesn’t recognize any bums, sees a few car salesmen he knows, and decides that my package is worth a couple of B’s (It’s not really A list material, but it’s not that BBa-d either.) So when I offer this to my customers, I tell them “Joe says it’s not too BBad.”

The remaining bums are kind of a problem. I know I can’t package them up and offer them. (I mean, I could try, just to get rid of them, but I’d have to offer 6-8% and Joe would say to toss them in the junk.) No, these I’ll have to keep and make an aggressive attempt to collect my money. Hopefully, the 2% I get to keep for servicing will cover any loss. And who knows, some of the bums are trying to reform.

So I manage to sell of a couple of groups of my packages and get back some of my money. Plus the 2% is generating some cash flow. I decide to take the money from the sale and lend it out again, but this time I’m going to be really really careful about lending it to bums. I’ve just learned how to securitize my debt — cool beans. Since my assets are loans, these are asset-backed securities (ABS). If they were loans collateralized by homes, or mortgages, they would be mortgage backed securities (MBS).

  Loans to Cashmere Coats Loans to Used-Car Salesmen Loans to Bums
  Securitized Loan to Cashmere Coat Securitized Loan to Used-Car Salesman Securitized Loan to Bum
Rate 2% 4% 6-8%
Risk Low Medium High
Joe’s Rating AAA BBa ‘junk’

[News flash!!! — Today the government announced that ‘bums’ are henceforth to be known as ‘homeless people’ and that since it is in everyones’ interest to own a home, the government is going to make it easier to loan money to the homeless people. Fanny and Freddie are no longer going to require that the homeless people put down 20% on an empty refrigerator box to live in.]

As I look around, I see that all of my friends are loaning money right and left, competing with Fanny and Fred. I better get on this bandwagon if I want to stay in business. I guess I’ll accept a few more used car salesmen this time, and maybe a few more bums —err homeless people than I initially planned.

Next installment: How to give used car salesmen cashmere coats.