By Paul V. Montesino, PhD, MBA
If you recall my Enron V- Part I’s early warning about spending a shorter amount of time reading my articles on the causes, characteristics and solutions to the current home mortgage crisis than the length of time it might take to cure the crisis itself you will see what I meant. The problem is still hot. As evidence that the rotten American roots of the crisis have produced branches all over the world, the British government announced Sunday that it would bring Northern Rock, a struggling mortgage lender, under its control. It was the first British nationalization of a bank in more than ten years. So here we go again.
Borrowing the automobile financing securitization example of our previous article, I want to help you visualize the components of that crisis and then, at the end, simply change the name of automobiles for homes and you will know exactly how today’s home mortgage crisis worked its way to our doors, no pun intended, and I will be home free, no pun intended here either.
To explain the forces that caused so much misery I want to start with the investors, the folks who supplied the large funds needed to buy the cars, and then later on with the borrowers who bought them with the loans. Imagine if you have one million dollars in the bank. That is a lot of imagination, isn’t it? Think for a moment what you would like to do with that money to make it grow as much as possible and as safely as possible, a respectable proposition I would say. Above all you want to get as high an interest rate on your money as you can for as long as is sensible. That means that you want your investment to produce a better rate of return on your money than any other investments you could have made elsewhere during the same time your money is invested. If other interest rates go down while you are enjoying higher or equal rates you do well and feel as a winner. If rates, on the other hand, go north you suffer financially and mentally because you feel cheated.
When banks lend money to car borrowers at a specific rate, let’s say six percent average, they want to recover the principal funds as soon as possible without having to wait for the individual borrowers to pay their debt for 36, 48 or even 60 months. It is much faster to turn around and look for those investors who, like you, have millions of dollars to invest and want a nice safe return for their money. What the banks want to do is transfer the loans from their books to the investors as securitized loans, essentially bond securities similar to stocks, who now will receive the six percent on the million dollars invested less the operating cost to the banks of servicing the individual automobile loan payments and the guarantee fees charged by insurer agencies that tell the investors that the securitized loans are legit. As folks pay the principal amount of their loans to the bank, the bond balances are also amortized down and the investors get part of their principal back. The banks get operating revenues, at a profit hopefully, and more money to lend. It becomes a cycle that can balloon into many millions of dollars and profits for all parties concerned. All parties, except the automobile borrowing consumers.
You can see here that it behooves the dealers to frontload as much of the cost to the cars as possible and pass those costs to the car buyers, and the banks would prefer to charge their borrowers whatever interest rates the market can bear. If they can get nine percent for the car loans and only have to pay six percent to the investors the banks pocket the difference. At this point I want you to start replacing in your mind the idea that this is a car business with the thought that it may really be a home you are dealing with instead. We will deal with the big difference when we complete the other side of the investment equation, the borrower-buyer.
As a car buyer, you have many options. You can pay the loan on time as promised, you can pay the loan on a late basis or you can stop payments altogether. If you pay your loan as promised, your payments of principal and interest will be directed slowly to the pockets of the investors as they originally expected. There will be a match between their bond principal and interest receivables and their receipts. If you pay the loan late, the banks will still have to pay the bond investors on time and will have to recover at some time the amount shortages with your own funds and the late fees charged to you.
Banks don’t like to do that and they try to make sure that only premium quality folks borrow money to buy cars. The word was “try.” Sometimes it does not work like that. If you stop paying the loan altogether, there is a high probability that the car, sometimes damaged and undervalued, will be repossessed and the loan liquidated at a discount. In many cases, longer term car loans resulted in situations where the value of the cars were less than the loan balances and their owners opted to abandon them. There is no way the bank could pay investors with the automobiles repossessed and, even if you were legally allowed to do so, which is not what the banks promised in the securitized documents, the investors probably live in another state or even another country. What is the bank going to do, ship a Chevy to London to pay a loan in Boston? Not by any mile. You can see what would happen if all of a sudden the economy enters a recessionary period and people lose their jobs and delay or stop paying their loans altogether. Hell, as the old saying goes, would break loose. It is what is happening now all over the United States with the home crisis. And, as I hear more and more, it is what is starting to happen with auto loans again and even credit cards.
Trying to remain true to our intention not to write too long a story we are stopping here to continue in our next article Part V where the home situation finally appears on our radar.
And that is my Point of View today.
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