By Patrick Wood
Banking used to be simple. When you borrowed money from a bank, the bank owned your mortgage and you paid the interest and principal directly. This is easily understood by this graphic representation:
Things got complicated when bankers got greedy, figuring the could make a whole lot more than just simple interest. The scheme is called securitization, as depicted by the following flow-chart.
In its simplest terms, securitization is a process whereby illiquid financial instruments (e.g., mortgages) are purchased and combined into pools. The pool is then structured where shares can be sold to 3rd party investors like banks, pension funds and even governments. Any type of asset can be securitized as long as it has a steady flow of cash associated with it. The cash flow is the incentive for purchasers to make their investment.
There are many fees that are paid along the road to successful securitization. The original borrower pays “points” to the initial broker and/or banker. The pool operator receives the rights to income at a discounted price. The investment banker who syndicates the sale charges hefty fees plus commissions paid to the selling broker/dealer or investment representative.
The investment bankers are the primary enablers and drivers of the securitization process. Right behind them is the Federal Reserve, who is supposed to be a watchdog on shaky banking practices.
Investment bankers have many tricks that help to make securitized investments more attractive. Appraisers are employed to give favorable valuations (and often greatly inflated) to the underlying properties. Credit agencies are employed to give favorable ratings (again, often greatly over-rated) to the investments, thus promoting confidence. The credit risk is often mitigated by adding insurance policies, different classes of investors, hedging against failure by purchasing or selling derivatives. It gets more complicated than we want to discuss here.
Currently, Attorneys General in New York, Ohio, and Colorado are investigating illegal appraiser activity with respect to banks and other lenders pressuring appraisers to fudge their appraisals. The Securities and Exchange Commission is currently investigating illegal activity at credit rating companies who might have been pressured into issuing artificially high credit ratings.
For the investment bankers, most of their profit is taken out of the “enhancement” value at the expense of the underlying investment that is being purchased by unsuspecting investors. In other words, the ultimate investor is gettingÂ hosed from the start but the house of cards doesn’t fall until the cash flow starts to dry up — as in, John Doe can’t make his house payment and goes into default on his mortgage.
Securitizations made against the sub-prime lending markets were simply the weakest links in the financial chain.
This is exactly where greed starts to really show up: when bankers decided to relax borrowing standards, they began to allow loans that never, ever should have been made. In other words, borrowers had deficient or delinquent credit histories, little documentation on income and over-appraised properties. Adjustable rate mortgages (ARM’s) were tailored to fit the income of the borrower, which was already too small for a normal loan. Thus, when the ARM adjusted upward, up went the payment amount and the borrower finds himself delinquent and facing bankruptcy.
Those holding the securitized investments all of a sudden receive less income and are forced to “revalue” their investment down to the reality of income actually received plus the prospect of additional declines in income in the future. Remember that these assets were over-inflated in the first place, so investors are forced into taking huge hits on their balance sheets.
Since securitized assets are quite illiquid, it is very hard to find another buyer. If you are lucky enough to find one, the buyer will be interested in offering you a “pennies-on-the-dollar” type of price.
It is insufficient to blame the credit collapse on the subprime market. Because it was the weakest element of an overall flawed investment market, It was simply the first segment to blow up. The rest the market (non-subprime) is following right behind it.
Now that people are looking for someone to blame for this debacle, the banking community, including even the Federal Reserve, is shifting the blame to the consumer for having made poor borrowing decisions in the first place. After all, nobody forced them to submit an application for a loan that they couldn’t afford. They should have known better.
Yet, it was the banking community that structured the loan offers that lured unsuspecting borrowers into their lair. For years, TV ads for mortgages and credit cards dominated the airwaves. Many consumers received dozens of credit card offers by mail each week. Is it right for the bankers to say that they were merely responding to market conditions, to give the foolish consumers what they demanded? In fact, the average person looks to his banker as an “expert adviser”, expecting knowledgeable answers that will be in the borrowers best interest.
I think not. Their markets were artificially created by the very advertising they flooded us with. Advertising creates expectations that can only be filled by purchasing the advertiser’s products.
According to a recent statement by Treasury Secretary Henry Paulson, former chairman and CEO of Goldman, Sachs, the Treasury will now step in with a plan that “helps investors and lenders avoid unnecessary and costly foreclosures that are not in their interest.” He has also talked of a rate freeze on Adjustable Rate Mortgages that are soon to reset to a higher interest rate.
You can imagine how the owners of securitized investments feel about that. Having been guaranteed a certain rate of interest, they will meet any government intervention or price-fixing with a flood of lawsuits.
Of course, a tsunami of lawsuits, mortgage foreclosures and bankruptcies would be fatal to at least a few U.S. banks. Yet apparently, to assume responsibility for their own mistakes (or even criminal actions) is too much to ask of them.
If the banking crowd succeeds in taking another full drink from the public treasury, it will cost the American taxpayers billions in the end.
Meanwhile, don’t expect thatÂ the banking crisis is limited to just the subprime lending market: It’s merely the tip of the iceberg!