SRF Heavy Industries

Say I’m a bank. I have some money. Or perhaps I have some other assets worth some money. Federal law allows me to lend four times the assessed value of the assets I have on hand–once I’ve signed the necessary paperwork with the Securities and Exchange Commission, anyway.

Used to be five times the value until the crash that fueled the Great Depression. But there you go.

But say I have money to create loans against. Call it a thousand dollars because the math has fewer confusing zeroes in it if you work with 1800s money.

Say I loan out four thousand dollars, then, in a handful of one-year loans at an interest rate of ten percent. Say, two thousand dollars of those loans are lost in defaults. People simply don’t pay it back and I get their collateral, if any. I receive twenty-two hundred dollars in a year’s time, spend maybe a thousand dollars in operating my bank for a year and paying dividends to my own investors, and end up with twelve hundred dollars in assets to loan against. So next year I can loan out five thousand dollars. Plus a little bit more once I assess the value of the collateral I collected.

Why in the world my original checks for four thousand dollars are ever honored is beyond me. The original one-thousand-dollar heap is never transferred out, just financially offset on the books, at the rate of $1 equals $4. The dollars that pay off the offset seem to be real one-for-one dollars. It seems a bank operating like that is a kind of money fountain, splashing cash everywhere in a showy fashion, but secretly soaking up wealth created by (some of) the borrowers who manage to turn the seed capital into a cash crop.

Say I have a thousand dollars and I loan you four thousand dollars to buy a house. That’s a big wad for me, and I’d like to see it back. Because until you pay me, I can’t loan out any more money. Even more, I have to pay myself and my staff out of the payments you make. So I make damned sure you have the means to pay me back.

But say I’m not a bank. I’m just a broker. I make arrangements to find someone who will promise to pay forty-four hundred dollars next year in exchange for four thousand dollars today. I get someone to sign, using a house as collateral, and wave the paperwork in the air until I find a taker. I then collect ten bucks as an originator fee–a commission from the bank that purchases the mortgage, as it were–and then I go find another person who needs some money and has a house to use as a stake.

I soon discover, as a broker, that if I lie about the value of the house, I can get the borrower more money. And I find if I lie about the broker’s ability to pay the loan back, then I can get the borrower a better interest rate. The more I lie, the more mortgages I can broker, all at ten bucks a pop, or even more, since I most likely make a percentage rather than a straight amount. And since it’s not my money I’m loaning, bad loans will never come home to roost at my own coop. I am merely paid for my time. And my lies.

Amazingly enough, these mortgages have value as assets. The paper they’re written on might not be worth much, but the people who own the paper collect the payments as they come in. Or, if payments fail to come in, they end up owning the houses used as collateral. That’s worth something. A team of highly-paid wizards look at your stack of mortgages, tell you what they’re worth, and, if you’re a bank, you can then loan out four times that amount of money.

Say I’m a bank that finds out that six hundred dollars’ worth of my thousand in assets is really only worth one hundred because they’re bullshit loans made to people incapable of paying, using houses worth half their stated value as collateral. Suddenly my thousand-dollar nut is only worth five hundred total. Federal law requires me to have only two thousand dollars outstanding in loans, and … hmm. I appear to have about twice that outstanding, and more of that money is coming back as deeds to worthless houses every day. This is a crisis. I can’t pay my staff out of the payments that are coming in, much less my own salary and dividends to my investors. I have no use for worthless houses. I can’t afford to pay brokers to sell them, and no one has the money to loan to new borrowers so they can but them.

I am now officially busted. I can’t make any more loans and I can’t pay my operating costs. I can either beg the tax-base for two thousand dollars so I can remain in business, or I can offer the whole schmear for sale to someone with two thousand dollars to give me for the remaining assets and deep enough pockets to absorb the missing two grand on the off-chance they’ll be able to turn this around in a few years’ time.

That’s the mortgage crisis in a nutshell. I realize it’s an awfully big nutshell.

Also, it’s not over. Homebuilders built huge subdivisions that are now standing empty because buyers can’t get loans to move into them. These places are standing around rotting, like an un-lived-in house will. Investors are also buying a lot of crap houses that have been foreclosed on, which are also standing around empty and rotting. But hey, these packages are being evaluated as assets, sold to banks, and being used by those banks to loan money against. But since they’re real estate packages, they’re listed as likely to appreciate in value. Instead, however, they will be rotting. And then when it gets out that these securities are also horrendously overvalued, there’ll be another huge series of bank collapses. You have been warned.

The roots of this problem:

• Loan brokers who won’t suffer if they overinflate the value of the loans they broker and are, in fact, paid more if they do so.
• Housing inspectors who overinflate the value of properties they assess with the incentive of kickbacks or recommendations that turn into extra business.
• Teams of wizards who overvalue asset packages that include bullshit loans by unprincipled brokers. Possibly through the incentive of bribes, kickbacks, and invitations to really wild parties.
• Banks that are allowed to loan out many multiples of the value of whatever assets they have on hand and therefore have every reason to have those assets valued favorably, because, magically, every dollar lied about is actually four real dollars.
• That magic-money-fountain four-to-one ratio that magnifies any troubles experienced when banks reevaluate their assets into four times the trouble.

This is what you get when you have naughtiness in a cash-reinforced positive feedback loop that has a magnifying lens at the end of it.

Any questions?

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