BANKS THAT IGNORE THE MISTAKES OF THE PAST ARE DOOMED TO REPEAT THEM----PART TWO

A MINI-HISTORY OF FINANCIAL FOLLY, continued Now here we are again in 2007-08 facing the same greedy borrowers, lenders, appraisers, realtors, builders and stockholders. In the 1980s it was called the “Savings and Loan Bailout.” Today, how does “The Sub-prime Mortgage Disaster” sound? DEJA MOO? The script has been rewritten somewhat, but the consequences can be just as traumatic. It’s Deja Moo----I think I’ve heard this bull**** before. This time around, there is no safety net. In a worst case scenario, the housing industry, the financial industry and the tens of millions of people whose jobs depend on them will feel the squeeze. Think of it as a nation-wide Enron: jobs lost, pension evaporated, investments disappeared. The guilty parties in the Savings and Loan Bailout got slaps on their wrists, and were told, “there there, don’t do that again.” “There, there.” What a fearsome punishment. Don’t you just hate it when someone tells you, “there, there.” The bad boys stood in the corners for some years, and as quick as they could devise new twists in the lending game, they were back at their posts. Only this time, unlike the 1980s when their misdeeds were covered by Uncle Sam’s deposit insurance, now they were playing with Real Money. No bail-outs. No cavalry to the rescue. If you messed up---as so many did---you lost your job, your home, your investments. This new 21st Century banking mega-goof involved making bad loans and then selling the IOUs to middleman packagers who bundled lots of loans together in “pools”, then sold the pools to big-time Wall St. investment banks, who then sold big chunks of the pools to mutual funds companies, who finally sold small chunks of the big chunks to…..guess who…..you and your friends and neighbors and relatives and pension funds. Complex? You bet. But let’s put some names on the players and it might help you understand why it’s going to be so complicated and costly to unravel the whole mess. HERE COMES THE GOBBLE-DE-GOOK---BEAR WITH US You’re Boris the Borrower. You want to buy a home, but you have peanuts for a down payment, your credit history stinks and your income is from odd jobs every now and then. Buy a home? Not in this lifetime. Then you see an ad on TV: Ladbroke the Loan Broker is offering home loans to the poor, the hungry, the homeless---and at an interest rate of just one percent per year! A phone call to Ladbroke gets you involved in making an application on the phone. No obligation! You’re an honest fellow, Boris. You tell Ladbroke that you don’t have any money for a down payment. “Not to worry,” says Ladbroke. “And my credit stinks.” “Not to worry.” “And my income is quite irregular.” “Not to worry….go and find a house you want to buy and get back to me.” You shop around and see your dream house: $150,000. The house is owned by Selma the Seller. $150,000 boggles your mind, but then Ladbroke sends Applebaum the Appraiser to drive by the house and give him an appraisal. “$200,000, minimum!” says Applebaum, gratefully folding the hundreds that Ladbroke has slipped him and sliding them into his pocket. “Call me any time.” Ladbroke can’t verify Boris’s income from work, so he just writes “$50,000 per year” on the Income line of the application, and Boris signs off on it. The loan application is approved for $160,000----$10,000 more than the purchase price of $150,000 (“Remember,” Ladbroke tells Boris as he pockets the extra $10,000 as his fee for arranging the loan, “We told you that you didn’t need a down payment.”) Boris pays Selma the $150,000 in cash, and she splits. If by chance Selma took back any IOU from Boris for any part of the price----as is often the case----she has to pray that Boris doesn’t flake out. Ladbroke now owns an IOU from Boris, with the house as collateral, for $160,000, $10,000 of which he has already put into his pocket. Boris is so thrilled he doesn’t read the small print in the loan agreement. And even if he had, he wouldn’t have understood the legal gobble-de-gook. So he glosses over the sentence that says, “The interest rate shall be one percent per year for the first 30 days of the loan, after which it will be adjusted to 14%.” Boris is so happy that his monthly payment will be a slam-dunk $125 (for the first month) that he’s numb to any other data. The standard going interest rate for good quality loans at that time was about 7%. A good loan means that the borrower has good credit and good income, and the house is worth at least 10% to 20% more than the amount owed. Because of all those good qualities, such a loan is known as a Prime Loan. Take away those good qualities and the IOU becomes a “Sub-prime” loan, a name which will live in infamy. Boris settles down in his new house and make his first monthly payment of $125. When he is notified that from the second month onward his payment will be $1,750, he goes into cardiac arrest. THE PLOT THICKENS Meanwhile, Ladbroke has taken Boris’s IOU to Home Sweet Home Financial Corporation (HSH) and offers to sell Boris’s $160,000 IOU to HSH for $160,000. At that same time, Ladbroke also sells HSH another nine iffy loans he has arranged from other borrowers, totaling $1.5 million, and from which Ladbroke has pocketed over $100,000 in origination fees. Why would HSH buy Ladbroke’s loans---including Boris’s? They’re getting a high-interest rate loan on their books and they didn’t have to go through the whole application/ appraisal/ legal/ accounting processes, which would have cost them thousands of dollars. The whole $1.5 milllion package of loans that HSH bought from Ladbroke will generate $210,000 a year of interest once the 14% rate kicks in. If HSH had loaned $1.5 million at the standard rate of 7%, their interest income from that would have been $105,000 per year. So in addition to cutting their expenses, they’ve given a huge boost to their income. Further, as icing on the cake, Ladbroke gives a personal written guarantee that if any of the loans go into default, he, Ladbroke, will buy them back. Sounds good, but what if Ladbroke turns out to be a flake? (Details at 11.) All of this lending activity is fed by a crazy housing market---prices are going up faster than realtors can change their listings, and as the prices go up, so does the rush to buy before prices go up even higher. The extra-easy availability of home loans, in turn, feeds the buying frenzy. Now things get a bit tricky---to say the least. HSH bundles those 10 weak loans, plus a number of stronger ones, into a package they call “a collateralized debenture.” The bad loans are somewhat balanced by the good loans, and the high interest on the bad loans give some extra star-power to the whole package. Because of the bad loans, the package is inherently weak (“…a chain is no stronger than its weakest link…”) but HSH has dressed it up to look like a quality investment. (And let’s not forget Ladbroke’s personal written guarantee, which by now has been written up to sound like a warranty from heaven.) A securities analyst (who doesn’t examine the portfolio as closely as it should, or looks the other way) gives it an A rating---instead of the B or C it deserved---high enough to appeal to big investors. Personal Security and Prosperity Mutual Fund Company (PSP) is just one such big investor. They negotiate with HSH to buy the Ladbroke package for $1.3 million---a $200,000 discount from the face value. Why would HSH part with that collateralized debenture for a $200,000 loss? Two possible reasons: 1) HSH has begun to smell something rotten in the loan portfolio, and they want to get out while the getting is good. And/or 2) interest rates have climbed even higher, and HSH can now invest that $1.3 million at 16% and earn $208,000 per year instead of $182,000 at a 14% return. Plus, when the mortgages eventually are paid in full, they will have taken in the full $1.5 million plus interest. Yes, this higher rate investment is more risky, but to HSH that’s the name of the game. “A turtle never gets ahead until it sticks its neck out.” PSP is now going to blend the HSH debenture into its various mutual fund groups and sell shares to the public. The glowing sales literature for the mutual funds holds out the “hope” that investors will earn 6% per year, which is a good return at that time. PSP will charge investors a 5% up-front loading fee and a 1% per year management fee. An investor who carefully studies the PSP prospectus to see where his money is being invested will see dozens and dozens of stock, bonds and other securities, among which will be an “an A rated collateralized debenture” from HSH in the amount of $1.3million. Looks good. What’s to worry about? BLINDED BY GREED---SO WHAT ELSE IS NEW? This story, and millions like it, represent quintessential greed run amok. Everyone in all these daisy chains of mortgages is counting the profits that they hope to be reaping down the road. And nobody, NOBODY, is paying any attention to the warning signs that something really bad is about to happen. Nobody, NOBODY seems to recall the Savings and Loan Bailout of barely 20 years ago. What now? Now Boris defaults on his loan. Poor guy, he really worked hard to make the payments, but $1,750 per month was beyond his reach. Boris tries to reach Ladbroke, whose number is no longer in service. Boris is evicted, the mortgage is foreclosed and PSP, via HSH, now owns an empty house, which they can’t sell because the whole town is filled with Borises, and there are no buyers, just evictees. Matter of fact, all ten of the loans that HSH bought from Ladbroke are delinquent, and HSH then has to tell PSP that there’s a problem. Word leaks out to the media that PSP has some serious problems in its portfolio, particularly the mortgages that they had bought from HSH. Before you can blink, investors who own PSP shares want to dump them as fast as they can. The shares fall from $10 to $8 to $6. Every month there are reports of more bad loans in the PSP portfolio, and the shares drop even further. CASUALTY COUNT PSP is in trouble.....Banks that have loaned money to PSP are very worried...... Shareholders who own stock in PSP or any of its 24 other mutual funds are worried.....The pension plan manager at your job, who has 10,000 shares of PSP invested for workers’ retirement is worried......HSH has already gone out of business because its credibility has been totally destroyed and 7,563 employees lost their jobs......Ladbroke has moved to Florida where he sells used Saturns at a Tallahassee dealership (Surprise?).....Housing prices in most major American markets fall by about 10%, leaving countless families owing more on their mortgages than their homes were worth.....New home starts drop like a stone, putting tens of thousands of construction workers out of work. Things aren’t much better in the used home market, thus idling thousands of real estate agents across the country.....Banks became super-cautious regarding new home loan applications, so countless would-be home buyers have to look at much tighter credit scrutiny and higher interest rates....Stock prices for lenders and home builders plunge, and investors in general, spooked by the fear of the plunge spreading into other industries, flee the market..... And Boris? He’s back to Square One: Poor, hungry and homeless. This, in a rather large nutshell, is the Sub-Prime Mortgage disaster. Tomorrow: What Does All This Mean to You?