The Zeitgeist

I’ve spent a lot of my life working at financial services companies, almost all of it at so-called “money center banks” like JPMorgan and Citigroup, as well as at brokerages like BearStearns, and if there’s one thing I’ve learned about the money business is that Wall St. is about money, not sentimentality.   In other words, if the option is to make a new deal to salvage value in an underperforming deal, a deal gets made.  No one wants to lose money. (Pretty obvious, huh?)   

This is why this whole sub-prime mortgage melt-down is a crisis that never had to happen.   What this is really about is, in my now outsider opinion, is a failure to communicate.  These “sub-prime” loans refer to loans made to people with less than optimal credit scores.

If your FICO score is low, the only way a bank for mortgage company is going to lend you money is to be able to secure a higher return for you — this usually means for a fixed-rate mortgage an over all higher rate (say 1- to 1.5-points above what someone with a “perfect” FICO score would be offered) or for an Adjustable Rate Mortgage (”ARM”) a higher ballon or reset rate (the rate the mortgage floats at after the initial “low” interest rate expires). Traditional mortgages are pretty obvious, they’re straight-forward amortization loans.  And, as typical with a mortgage, you wind up paying 100-170% of the amount borrowed to the lender over the life of the loan; and why lots of people add 1 or 2 additional full-payments per year as “additional principal” payments in order or pay down the end of the loan and bring their overall payments down.

If we look at the attraction of ARM loans to lenders, CDO (Collateralized Debt Obligation) holder, and other pools of money that have been used to underwrite these sub-prime loans is that their rate of return is, on paper, astronomical.  If a $500,000 30-year mortgage at 6.5%, the total interest paid to the lender is $637,722. 

The same $500,000 at an intro rate of 1.25% and then jumping to 7.5% after the first year, then after some variable number of years at a that fixed rate will change, sometimes monthly, up or down depending upon the prevailing long-term bank rates, usually with some cap on the annual rate of change (i.e. the rate can only go up a max of x.y % per year, but can drop down as low as the lowest prevailing rate).  What this means is that the lender stand to make 400-500% returns over the life of the mortgage.

Of course, in the real world, people who could not afford large mortgages in the first place got sucked in by the intro “teaser” rate and got slammed.  However it didn’t have to be this way.  The only reason there is a  ”credit crunch” is because either the banks, or the shareholders in these loan pools got greedy to the point where they forgot the most important of all of the Wall Street adages:

Bulls Make Money  

  
Bears Make Money

Pigs. Get. Slaughtered

 Of all the large mortgage lenders in the US, only County-Wide seems to have understood what the right solution was:  Renegotiate the loans down to traditional, yet still profitable fixed-rate mortgages.   It really appears the Merrill, Citi, BearStearns (who lead of this mess with a hedge-fund collapse earlier this year) and all the others were either unable, or unwilling to understand that making a 100-170% profit on a traditional loan was better for them, and their shareholder than making 0.0000% profit on defaulted loans.

In a nutshell, these lenders had a choice to make:  Perfectly respectable profit, or a total loss of both their potential interest AND their principal.

Oh, and as an added bonus, they are causing potentially hundreds of thousands, if not millions of people to be forced out of their homes, and inflict long-term damage to an already shaky US economy. Oh, one more insult to add to the self-inflicted injury?  CEO’s like Merrill’s O’Neal, and Citigroup’s Prince walked away with severance packages in the hundreds of millions of dollars, in addition to the millions in salary and bonuses they had already collected from their firms.
If these guys were such great-deal makers, they surely could have found a way to re-cast these loans into safer fixed-rate mortgages.

In a fantasy-world where “accountability” exists these guys would have to pay back every cent they were paid in salary and performance bonuses, return their exit packages, and spend the rest of their lives in jail for the damage they’ve done.   This makes Enron look like small by comparison.