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 | |
 |
 |
 |
|
| 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.
March 4, 2008 at 11:16 pm
I just got the JetBlue business credit card and boy am I glad – I just got half off of my coast to coast flight from L.A. to Ft Laud, FL.
That saved me over $400 bucks. Plus I get double rewards points for using it to pay my cell phone bill, gas bill, etc. I love this credit card – no fee for the first year too. I got approved instantly over at this site:
http://www.applybusinesscards.com
March 5, 2008 at 11:12 am
I see from Rob (who’s so enthusiastic about his new JetBlue card that he linked their site as his website name) that the credit industry has certainly learned their lesson from the stuff APO is discussing! No more risky loans to everyone and their brother…
This is a key reason why the general government reaction to the subprime meltdown should be “too bad, you made your bed, now lie in it”. Targeted bailouts may make sense in some cases, but the vast majority of lenders, borrowers, and middlemen were all trying for a quick buck, and need to pay the price.
March 5, 2008 at 12:14 pm
This is what is wrought when we have an entire country who is bad at math. “What could possibly be the downside of New Math?” they asked as they stressed that students felt good that their reading comprehension skills were never tested by such horrible things as ‘story problems’ with ‘real-world applications’. This is why people with a high school degree should be able to read at a high school level.
When the lead up to the Great Depression is taught, it is with a smug disassociation from the human ignorance, greed, and imprudence that causes people to accept risky collateral in massive quantities with the thin hope of not causing a global disaster. Congratulations, crappy history teachers & students, you’re now 0/2 on that count.
And Rob, either as a person or as a bot, represents the worst of these. He’s either hoping to get slave wages for spamming threads manually or he’s the result of a programmer selling his slim skill at bot-writing to a disgusting marketing firm that makes no contribution to the betterment of mankind whatsoever.
So, for those of you playing the home game:
1) Don’t fear story problems.
2) Don’t get instantly-approved for anything.
3) Don’t reward people whose efforts to make a quick buck cause a global financial meltdown. Even people who rebuild their homes in a flood zone in a hurricane alley are more deserving of a hand-out than these people. They dug their own flood plain and spun up their own hurricane.
March 6, 2008 at 12:18 pm
But at the same time something could be done to add a little more transparency to the credit card industry, etc. You are right to say that it isn’t exclusively their fault – but with their variable rates and interchange fees, the list goes on, they are not being held to any standards whatsoever. I’ve done some work on this with unfaircreditcardfees.com and you can’t tell me that the whole blame lies with the consumer.
When you have interchange fees that aren’t even directly charged to consumers but get passed on to them in the end of the way the system is clearly broken.
March 6, 2008 at 1:02 pm
Kyle —
I am not supporting the credit card industry, just using part of it as an example for securitiation. Their bad habits are not germaine to the arguments of the sub-prime meltdown.
They are, in fact, accountable to certain standands. If they are a national bank, they are regulated by the OCC. If they are a credit union, by the NCUA, etc. But I take your point.
One of the ‘transparency’ problems is that the regulators move, and rightly so, slowly in the face of innovation spurred by increased competition. Credit issuer’s are lemmings — any innovation will spread across issuers within a couple of months. When AT&T introduced the “no-fee” card, the others fell in line with similar offerings within two months, and a year later you couldn’t find a card with annual fees. (as an example).
Charles Schumer attacked this “openness’ issue with the Fair Credit and Charge Card Disclosure Act of 1988 which mandated disclosures of the terms and conditions in boxed tables and specifing type fonts and sizes. These disclosures, now found in every offering, are known in the industry as the “Schumer box”.
The problem with the Schumer box is that is functions the same as the magicians right hand — that is to say it distracts the audience from what the left hand is doing. And what the left hand is doing is to:
Decrease the grace period, over which you owe no interest on purchases from the traditional 1 billing cycle to as low as 15 days.
Eliminate grace periods on cash advances.
Provide for additional overlimit fees, late fees, inquiry fees, etc.
Design in interest rates which decrease slowly with good payment history, and increase exponentially with a single missed payment.
Perform arbitrary portfolio repricing by giving you the option to either pay up your balance and leave or to acceed to the increased rate.
Create reverse balance transferrals.
Create extensive list opt-ins for affiliates.
All of which are disclosed in a minimum of eight pages of 6 point text. And all of which are being done to offset the essentially dead telemarketing channel and the abysmal return of direct mail solicitations. This has lead to the death of monoline card issuers. There are none left. All card issuers are now part of larger financial depository institutions.
So consumers are left holding the stick when all this occurs, but by the time any regulatory body addresses it, the industry has moved on — or disappeared.
March 7, 2008 at 1:01 am
I love north americans
You guys live your life as if there is no repercussions for your actions.
It shows in your dealings with the outside world and with each other. You make bad decisions based on nothing but wishful thinking and then you want somebody to dig you out of the poo.
If you want to live on credit do not be surprised when somebody calls in your marker. If you want to gamble on the sub prime then prepare to go down in flames. Guess what if a deal seems too good to be true it probably is.
The US constantly tries to change the rules mid game and screams you are anti-American if somebody queries it.
Sometimes daddy is not gonna bail youse out so you will have tae do ya time yourself.
March 7, 2008 at 9:47 am
AOC —
Not only has the credit industry not learned a thing, but it seems that the fallout from their run-amuck-ness has spurred them to new heights.
I have a land line (God knows what for!) and I am receiving 10 calls a day from telemarketers. About four are for ‘warranties’ and ‘extended warranties’ — apparently my dealership has leased its client list — and the other six are for opportunities to ‘fix’ my mortgage, eliminate my ‘repricing baloon payment’, or get a great deal on new low downpayment/ low interest rate mortgage.
What was Malcolm’s line in Jurassic Park. Oh yeah….”You didn’t earn the knowledge for yourselves, so you don’t take any responsibility for it. You stood on the shoulders of geniuses to accomplish something as fast as you could, and before you even knew what you had you patented it and packaged it and slapped it on a plastic lunchbox, and now you’re selling it, you want to sell it!”
March 19, 2008 at 4:25 pm
wow,great article,love the 12 angry men scenario. Very intersting writing.
I found some videos on the internet around this subject, maybe you have time to look I think you will find them interesting.http://car-loans-1.com
March 19, 2008 at 4:30 pm
Well at least car loans are collateralized, even though the value depreciates by half when you drive it off the lot. You would think that the spammers would at least know how to anchor a link. Geeze.
April 14, 2010 at 3:19 am
great advice and sharing,I will buy one this nice jeans for me .thanks
April 25, 2010 at 8:54 pm
Benzoyl peroxide – this is a solution that is present in most face washes, bar soaps, creams and other acne formulas today. As with everything, too much is not good, so make certain that you use it with caution to avoid skin reddening and drying.