Politicians want growth so they allow rates to stay low. (Give the people what they want to get elected)
Dad used to pay 10% for his $50,000 mortgage but times have changed and people want things they can’t afford – NOW! They want bigger, nicer houses and they don’t want to pay an arm and a leg. Thanks to low rates times are good – really good. In fact, times haven’t been bad for so long, most young people don’t remember any hardship. Get the biggest house with the cheapest and most flexible mortgage you can get and forget about it.
Low interest rates create demand for home-loans. (Money is cheap)
Your sophisticated older brother just got his MBA and is now a Wall Street banker. He hatches a pretty nifty scheme. He loans you $5,000 at 2% interest to build a new tree house. You only have a paper route so things are going to be tight. But who can turn down money at these rates? You deserve to get that tree house of your dreams. It’s the age of the tree house owner.
Securitization “takes risk out of the equation” for “lender” since they turn around and sell the loans to investors in the form of bonds. (Banks no longer care if the loan goes bad)
Your older brother never used to loan you money in the old days because he didn’t trust you to pay him back. However, he doesn’t care anymore because he has an MBA classmate who is a hedge fund manager who has some investors who will buy your loan from him. The risk is so spread out among investors that no one will get hurt too bad. Once he sells the loan to the Hedge Fund Manager your brother makes a $50 fee for being the middle man and no longer has any risk. Not bad for a days work. Time for a cigar and a martini.
Securitization “takes risk out of the equation” for Hedge Fund managers and their investors because of Wall Street Magic. The Rating Agencies think this stuff should be AAA rated (Investors think a bad loan is a good loan because of financial engineering and leverage).
The Hedge Fund investors think your loan is a great investment because you will be committed to paying it back since you really love that tree house and would do anything to keep it. Besides they only bought a piece of the loan – a $1,000 piece that only goes bad if you can’t pay back the other $4,000. They also own small pieces of thousands of other tree house mortgages – they are “diversified”. What are the chances of all of them going bad at the same time? This scheme is so clever that the old rules of risk and reward don’t even apply anymore. MBA’s are great. Tree house prices have never been better and only seem to be going up, up, up.
Hedge Fund managers use leverage to enhance the yield on these loans in order to attract investors. That 2% interest rate is now yielding 20% because they are using borrowed money and very little of the investors money (If my returns are better than the next guy’s I can raise a billion dollar fund instead of $100 million. I make 2% off the top and 20% of any profits. The bigger the better baby. If I lose my investors money I’m still worth millions)
The Hedge Fund Manager wouldn’t be able to get anyone to invest with him if his returns were only 2% so he borrows money from a bank and – shazam! – his returns are magnified to 20%. Investors can’t believe how bright this guy is so they give him billions of dollars to invest. The Hedge Fund Manager calls your brother and tells him to find as many tree house buyers as possible – it doesn’t matter how bad their credit is.
A flood of home buyers drives up home prices. (Home buying Tsunami takes place)
The gang in the neighborhood hears about your deal and your brother is flooded with loan requests. Everyone it seems is buying tree houses.
All of this buying jacks up home prices until they inevitably become overvalued creating a bubble. (Buying frenzy leads to the assumption that home prices will only go up)
The tree house you bought 2 years ago for $5,000 is now worth $10,000. You sell it to a kid down the street who doesn’t have one and you get yourself a bigger tree-house for $15,000. It seems too good to be true but – hey -it’s the American Dream in action isn’t it?
Investors stop buying loans. Securitization window shuts. Banks are forced to keep loans on their books that they can’t sell. (The music stops – the tide goes out)
Your brother (now a public company) gets an email from the Hedge Fund Manager saying he doesn’t want to buy any more tree-house “paper” because his investors are saturated. That’s a shame because your brother has already made 10 new $15,000 loans ($150,000 in total) in the last 2 days that he will be stuck with if he can’t find another buyer. In the meantime, until he can sell these loans to someone else he will have to turn down any new loan applicants. The guy who was going to buy your tree house can’t get a loan anymore so your home value stops going up. Your brother starts looking around for other buyers but they only offer to pay him $100,000 for the loans he already made for $150,000. Good Lord! If your brother sells them at that price then he will lose $50,000! He decides he should just wait it out until someone offers him a fair price.
At first, Banks point fingers at other Banks and say they didn’t participate in the sub-prime market. This turns out to be patently false. Over time, Banks are forced to write-down these loans because of mark-to-market accounting which means you can only value them at what someone else is willing to pay. This creates falling stock prices and the need to replace loan-loss reserves. Banks get nervous about lending to hedge funds who in turn must start selling assets to pay their debt down (Supply and demand balance reverses. Asset values begin a downward spiral).
As time goes on, your brother is forced to report to his shareholders that he has $150,000 in debt and assets now valued at only $100,000. Shareholders begin to sell the stock because your brother’s company isn’t worth as much as he told them it was worth last quarter. The bank who lent the lion’s share of the money to the Hedge Fund Manager is starting to get nervous so the Hedge Fund Manager is forced to start selling his tree house paper (and/or other GOOD assets) at a discount in order to pay his banker back. This devalues your brother’s assets even more so the stock price continues to drop. Everyone used to be buying (pumping up values) but now everyone is selling (deflating values).
Banks can’t make new loans because they are sitting on mounds of toxic assets. This makes their stock plummet to the point that they may fail. No one wants to lend money to or do business with a bank that might fail. No one wants to keep money in a bank that might fail. (Cool Bank won’t talk to Nerd Bank. Cool bank doesn’t realize it is a Nerd Bank too)
Since your brother can’t sell his bad loans, he doesn’t have enough capital to make new loans. His stock continues to fall. Other banks are worried that your brother might have to file for bankruptcy so they won’t lend him any money.
No one trusts anyone anymore and there is a crisis of confidence. (The whole system just freezes up and all hell breaks loose)
No one is lending money to anyone anymore. The true value of the huge tree house loan market is uncertain because there are no buyers. Besides, why buy something for a 20% discount today when you figure you can wait a little while and get it for half price. On top of that, the buyers that used to be flush with cash no longer have any cash because it was all borrowed money that isn’t available anymore. You’re brother is screwed.
Government (The Fed), the lender of last resort, steps in to keep the money flowing (time to call in the enforcer).
Dad takes off his glasses, puts down his paper, and says to your brother, “You’ve been doing what???” Dad knows the situation is bad so he takes pity on your brother and loans him money until things blow over. This is probably just a temporary thing.
Fed money is used to make bank balance sheets look better but no one is fooled and the root problem isn’t going away. Banks horde the cash so liquidity is still tight. (Banks still won’t lend money. Everyone is still too scared for their own skin).
Your brother uses the money from your Dad to stave off bankruptcy showing his shareholders that he’s got enough cash to make it through tough times. However, he still won’t lend any more money because he still has the bad loans and needs to hold onto that extra cash for some breathing room. He continues to wait and hope things get better.
Government (The Treasury) decides it needs to step in and take over. They don’t want to let the banks fail no matter how poorly they have been managed. The alternative would be much worse – market forces would cause asset backed securities to decrease in value (perhaps to fair market value), the stock market might go down, we might go into a recession, and people and companies could no longer leverage themselves to the hilt in order to satisfy a never ending desire for growth at any cost. (Time for a “Bailout”).
Against his principles, Dad decides he has no other choice than to save his eldest son from the mess he has made for himself. Without consulting Mom, Dad declares he is going to buy up all of the tree-house loans your brother made. After all, the alternative would be much worse – market forces would cause tree house loans to decrease to their true value, the stock market might go down, the country might go into a recession, and you, your brother, and the Hedge Fund Manager could no longer continue to make and or take out risky loans.
Congress says they aren’t so sure about the Treasury department’s idea. (Wait just a minute – is this really the right thing to do?)
Mom steps in and says she isn’t sure about Dad’s idea. Is bailing your brother out really going to teach him a lesson? Wouldn’t it be better to let him learn from his mistakes? Why weren’t you keeping track of what the boy was doing anyway?
The Government railroads Congress and doubles the national debt by selling Treasuries to foreign governments. The dollar is devalued further in the process. The Government uses the cash to buy the toxic mortgage-backed securities from the banks. The banks now have fresh cash and no toxic assets. (The Government now owns the problem).
Dad overrules Mom because there is not enough time to debate it and she doesn’t know anything about high finance anyway. Dad takes out a second mortgage on the big house for $120,000. Your brother starts making tree house loans again but there are no buyers for them. His business is quite modest in comparison to the good old days. You are still paying off your loan as best you can and cannot sell your tree house because no one on your street can get a loan anymore because your brother is playing it safe.
Outcome #1 – Bad Scenario – The Government buys the toxic assets for 80cents on the dollar and sells them over the next ten years at an average of 40cents on the dollar. The $400 billion shortfall is made up by tax increases. The dollar is so weak that international investors pick up so many U.S. companies and assets on the cheap that they alone profit from America’s eventual rebound.
Dad buys up your brother’s loans for $120,000. Over the next ten years he is able to finally sell them for $60,000. Dad makes up the difference by telling you that half the salary of your first job (at a foreign-owned company) will be used to pay him back. Gee – Why do you have to pay for your brother’s screw-up?
Outcome #2 – Best Case Scenario – The Government does a great job buying these toxic assets and sells them to someone else at a profit!!! To whom we have no idea – The Chinese are happy with their $700 billion in Treasuries. The US Taxpayers never have to pay taxes again (even though there is still a Trillion dollar deficit).
This is a pipe dream so I am not even going to try to think of an analogy.
Outcome #3 – Worst Case Scenario – The Government buys the toxic assets for 80cents on the dollar and is only able to unload them at fire sale prices. The $650 billion shortfall is made up by tax increases. The dollar is so weak that international investors pick up so many U.S. companies and assets on the cheap that they alone profit from America’s eventual rebound.
Dad buys up your brother’s loans for $120,000. Over the next ten years he is only able to unload them at fire-sale prices. Dad makes up the difference by telling you that your salary and your children’s salaries will be used to pay him back. Dad can’t afford to send you to college like your sophisticated MBA older brother so you are unable to get a job. This means your Dad is unable to pay his 2 mortgages. Dad goes bankrupt and becomes a drunk. Mom says he told him so and divorces him. Your brother seems to be doing pretty well though living in Hong Kong and working for a foreign investment bank – debt free without a care in the world. Life is pretty good for him. He doesn’t make tree house loans anymore though – he sells exotic synthetic thinga-ma-jiggys. He calls you on Christmas to tell you it’s just like the good old days all over again – only this time he will be more careful. Good for him. There are no Christmas presents under your tree.
Drew Sudduth is a managing director of Southwest Mezzanine Investments, a unit of Growth Capital Partners.