If you've been listening to the news with half of (or even your whole) ear this week, you've heard about the "sub-prime mortgage crisis" and you've probably noticed, also, that the media seems to be presenting this as a crisis for lenders.
Even some of the news outlets that I have respected are just spitting out the words like parrots, "lenders are in a crisis." A "crisis for lenders" they say.
Lenders? It seems like "the media" is implying, "the good lenders bent the rules a little bit, with all their generosity and compassion, to lend money to certain people who now are refusing to make good on the loans, now thrusting these good lenders into crisis." Why a crisis for lenders?
Is that really true?
I submit to you that there's no real harm to lenders, except a little bit of reduction of their extremely high profits of recent years. The only devastation here is the slow and persistent robbing of the middle class to make the ultra richer even wealthier. Please let me explain.
First, let's be honest about who it is that will feel the pain.
At this time, it is estimated that as many as 2.2 million more families face the prospect of losing their homes in just the coming few months.
It also pays to state the obvious: The sub-prime lending activity was absolutely critical to the inflating of the real-estate values in America, thereby lining the pockets of the powerful at the very time when the middle class pockets were devastatingly empty. Cause and effect goes something like this:
- For the last five years, decently paid middle class jobs have been disappearing permanently and been replaced by fewer and lower paying jobs, thereby increasing the suffering to the middle class.
- Meanwhile, the ultra rich, US industry leaders and stock investors have been increasing their wealth, in part due to their increase of investments in factories and jobs overseas, and, in part due to the generous tax breaks offered by the Bush administration.
- As the gap between the "haves" and the "have nots" increases, consumer spending shows decline, which worries the ultra rich, the US industry leaders, and stock investors. In other words, the ultra rich want to be ultra rich but they also want the declining middle class to continue to spend money so that the ultra rich can continue to experience enormous profits (ie. think Exxon, insurance companies, biotech, etc.)
- The Iraq War increases profits tremendously for a huge cadre of defense contractors; Bush's Medicare Drug Plan increases profits tremendously for insurance and drug companies; and, the shipping of jobs overseas increases profits for the American owners of manufacturing companies - but the drop in consumer spending still worries the ultra rich (note: it's not the lack of food, clothing, or shelter for the declining middle class that worries them, no, it's the fact that fewer middle class people are buying over-priced products).
- The Federal Reserve lowers the interest rates several times without much impact on consumer spending, until, one day, the Fed lowers it enough to encourage the middle class to try to refinance their loans.
- The surge of middle class mortgage refinancing has many positive effects for the ultra rich - the middle class "takes equity out" of their properties and temporarily participates in a surge to buy more televisions, vacuum cleaners, plane tickets, cars and gasoline; and, the surge causes real estate prices to skyrocket thus translating into higher interest payments and profits to lenders.
- As middle class jobs continue to be devalued and continue to evaporate and disappear, more and more middle class families have difficulties paying their mortgage or medical bills.
- Lenders seize opportunities to get immediate profits through points and origination fees by rushing in to sell these struggling middle class families more refinancing packages, thus increasing the families' overall monthly payments (think about all the refinance junk mail you've seen in your mailbox over the last 3 years).
- As middle class families continue to lose jobs and salary levels, more begin to default on their loans.
- More and more middle class families lose the roof over their heads.
The main reason some prime borrowers end up paying sub-prime prices is that they are solicited by sub-prime lenders and go along with the deal pitched to them without ever contacting a mainstream lender. This is sometimes referred to as "steering". Very few sub-prime loan officers will give up commissions by referring qualified applicants to mainstream lenders. The deals will very likely go down at sub-prime prices, therefore, and regardless of how qualified the borrowers may be.
The lenders take huge amounts of profit right upfront, as points and fees. When the borrowers default, the lenders are simply not in crisis. The only crisis that a lender would have is if a particular lender got greedy and conveniently "forgot" to place the increased points and fees (collected upfront) into reserve as protection for the lender against these defaults.
Consider how banks make their money. As a general rule of thumb, they pay our low rates on the short-term deposits from their banking customers - and, they charge significantly higher rates on long-term loans, such as mortgages.
Banks love and simply adore what are known as positively sloped yield curves. So, in that they love to see "spreads" between their inputs and outputs, banks covet even more the huge credit spreads they can achieve by lending to "poorer" borrowers. In other words, banks charge higher interest rates to the poor borrowers, also called "risky" borrowers. Since risky borrowers are charged far more than so-called "safe" borrowers, the banks clean up with lots of profit.
Even so, banks aren't happy with just the profits they make from charging these borrowers the highest interest rates. They also want to amass huge profits at the front end by charging really high points and fees to these "risky" or poorer borrowers.
By looting the poor, banks had found a brand new and highly lucrative way to prosper - by taking a page from the loan shark handbook. Once some banks began doing it, all joined it. Making loans to regular borrowers at the lower interest rates just didn't have the gleam anymore.
Now, you ask, well, if the banking companies make so much money from these loans, then, how come many of those companies are in financial trouble now? Here's where the banking companies got in trouble....
Making a loan and keeping it until it was repaid thirty years later was so old-fashioned and no longer seemed the most profitable way to do business. Banks decided it was far better to collect exorbitant fees upfront for arranging the transaction and then to pass the risks of the risky borrowers on to investment groups that were now buying blocks of "after-market" loans to add to their investment portfolios.
Keep in mind that these exorbitant fees charged by the initiating banker were usually rolled into the loan balance and therefore making the monthly payment amounts even higher for these poorer borrowers, thus, making these loans even more "risky" and therefore harder for these lower income borrowers to pay.
Other than hurting the borrower by raising the monthly payment amount, what's so wrong with these banks taking such high fees at the front end and then selling the loans off to investment groups?
Well, first, by front loading the loans, they make them riskier.
Secondly, the after-market buyers saw what was happening and how the banks had loaded the loans with fees and became worried about assuming the risks. So, the banks reluctantly agreed to sell their blocks of loans with "liquidity puts."
These "liquidity puts" gave the buyers of these loans the option to return the loans to the loans sellers if there was no other market for them.
In other words, the buyers of the loans wanted to be able to sell the loans off again. Then those buyers wanted to sell them again, and so on. However, if the market dried up for re-sales, then, the buyer could pass them back to the bank they bought them from. This is similar to taking merchandise back to the store and getting a refund. Well, loan buyers have begun calling in their "liquidity puts."
This causes a problem for the originators because of bookkeeping mistakes. The originators should have placed some of their exorbitant upfront profits into "reserves," that is, reserved back in case of loan returns. Instead, though, the originators realized all those upfront revenues as profits or gains for shareholders. When the loans were returned, the initiators lacked liquidity.
So, it was liquidity problem - but not a profit problem - for the banks. This fine clarification is critical. Remember, the banks and lenders aren't hurting in terms of profits. They made very handsome profits off these "risky" borrowers with their upfront fees.
The ones that are hurt are the borrowers. You know them. Those regular middle class folks that live near you, next door, or maybe with you. Just regular working folks that are hanging on for dear life to keep from slipping into pure poverty.
Despite the fact that the "economy" (think: CEOs with factories overseas, those owning stock in drug companies, etc.) has been growing at a slow but consistent rate, median income has been dropping in nearly every state, in some cases, quite dramatically -- in excess of 10% in five states. Here are the median income changes from 1999 to 2005:
Next time you hear about the sub-prime crisis, please don't shed even a single tear for the lender, but, please think about your neighbor.
Obviously, there has been a tremendous looting of the great majority of Americans by the ultra rich, who not only have absorbed all that economic growth for themselves, but are actually "taking away" the small gains made since the early seventies. Indeed, we have heard for years that incomes have barely risen since then, but now it seems quite likely that under Bush, we have seen an absolute income drop, returning to the levels of the 1960s.
When you hear "sub-prime crisis", remember, you may have a middle class neighbor that is doing without food or heat to try to pay off that upfront profit-taking by the looters.