Handprints
Literotica Guru
- Joined
- Jul 5, 2007
- Posts
- 547
I was asked to post a public explanation for why this market is currently dead, not just struggling, in a PM. If doing this (prompted public posting) is bad form here, and someone's having a bit of fun with me, please remember that I'm relatively new here and certainly haven't yet learned the informal rules about what's ok and what's not...
Unlike other industries, sub-prime lending doesn't occasionally get sick, then recover: it screams a couple of times, then falls over dead. Ford, when it has problems, still manages to shift the odd truck. In a bad year for Hollywood, a significant tonnage of popcorn still gets sold. Right now, sub-prime lending has more or less ceased to exist in America: they can't make any more loans. Why is this industry so different?
To answer this, I need you to imagine that you're a sub-prime lender. This isn't going to be easy for you: chances are, however much of a cruel bastard/cold-hearted bitch you are in real life, you're a lot better-intentioned than the average sub-prime lender. In the playground of American home ownership, you have just elected, of your own free will, to be the greasy-looking guy standing by the railing, telling the socially-isolated kids that you have puppies in your van...
First off, 99+% of your customers fall into one of three groups: the ignorant, the self-deluded or the unreliable. Let's take them in decreasing order of sympathy.
The ignorant: This segment of your customers is either unable or unwilling to do comparison shopping for mortgages. They don't ask themselves how "no money down", "annual cashbacks", and "low introductory rates" are going to be paid for. They can't work out the effects of an interest escalator and figure every lender's fees must be about the same, right?
You, as a sub-prime lender, adore the ignorant. You've been taught just how to treat them. You'll settle them into your little workstation and get them to tell you every detail of their plans and hopes for the new house. With forty minutes of active listening and encouragement, you can rev them up from just plain loving the place to being ready to die to get it, it's so perfect for them.
And, because it's such a pleasure to deal with people who really think hard about what they need, you'll ask them if they'd mind telling you about the other places they viewed and what the pros and cons were there. That will help you locate their buying hotspots: is no money down a necessity for them, are cheap rates for two years the deal-sealer, do they appear to understand fees? After thanking them profusely for their generosity in helping keep you in touch with the local market, you'll tell them you'd like to try to return the favour: there might actually be a mortgage available right now that suits their needs better than the offer that brought them in the door.
You'll describe a mortgage that minimises all the things you've just learned they fear and loads every kind of fee and escalator into the things you've learned they don't understand. "Doesn't that sound like it might just be the right one for you?" Now, you've got a pair of nodding heads sitting across the desk from you, who honestly can't believe their good luck. But you've still got to get them from nods to signatures.
Thankfully there's a never-fail tactic at your disposal, thanks to 50 years of utter tactical stagnation in the auto sales game. "I just need to run this plan past my manager," you say. Then you let them stew for 10-20 minutes, depending on your read of the situation. If these people have come to the likes of you for a mortgage, you just know they're veterans of the used car market. And now you've got them on the edge of panic, certain that your manager is going to kill the deal, knowing the salesman always comes back with a slightly worse offer. Why wouldn't they think that way? It happens every single time you buy a used car.
So you use your number-one, grade-A closing tactic: you blow back into the room with a grin on your face and say: "We sure caught him in a good mood! Congratulations, homeowners!" They'll rip the pen out of your hand...
NOTE: If you have a low income and math scares the hell out of you, you don't have to put up with this kind of shit. When you want to buy a house, go around all the thrifts and banks in your town and look at the stickers on the doors. You're looking for ones that say "FHLB Member" or "Federal Home Loan Bank Associate." These banks participate in government-funded programmes which are designed to ensure that people with low incomes can get an affordable mortgage, honestly sold.
You can back your research up with calls to the Better Business Bureau: they don't get involved with mortgage complaints, as a rule, but they know every bit of banking gossip in their communities and they'll steer you towards state regulators who will tell you who's being complained about and who's not. In truth, these FHLB loans get the kind of scrutiny from regulators normally reserved for a plebe's boots at West Point. You'll be in honest hands.
If you can't decide between mortgage offers from different FHLB members, any accountant in your home town will be delighted to spend an hour explaining them to you for USD100(ish - not in Manhattan). Accountants don't actually make their money accounting for things, they're really paid mostly to explain things. They're good at it, even with people who hate math. Find one who's been practicing for a long time in your area (if there's a credit union near you, they'll likely help you find one) but don't use anyone who sells mortgages on the side. You'll consider it USD100 well spent.
And don't let the sub-prime guys near you: you're miles too good for them!
The unreliable: "Yeah, I had two bankruptcies and one repo and a couple of default judgments. But I'm ahead on all of them now and things are looking really good..." Some people do get bad credit histories through no fault of their own: getting laid off ten weeks before your wife gets sick will screw up anybody's rating. Whether you deserve to be in this category or not, you're going to pay through the nose for a mortgage in both interest rates and fees. These are the main suppliers of grist to your sub-prime mill.
The self-deluded: If six different banks have told them that they can't afford what they want - and probably explained, in detail, why they can't afford it - you have every right, in my view, to screw the living daylights out of them. You know for a moral certainty that you're dealing with a future defaulter, so you will load every conceivable fee into the mortgage - all at the top end of the scale, natch - and match it with a future interest rate that Croesus couldn't pay. Go wild - these customers are your cash cows.
So you've been a busy little lender and pretty soon you've sold thousands of mortgages. Unlike a normal bank, which sees mortgage payments as a key source of future income, that last thing you want to do is own the crap you've sold. You're too smart to tie your future to the uncertain mercies of the ignorant, the unreliable and the deluded. Luckily, you don't have to.
If you kept all of the loans, you'd have interest income coming in 50% faster than other banks - because of the high rates you charge - but 100% of your loan book would be high risk. That's an extremely dangerous way to do business. However, a little bit of your loan book might be a useful thing to another guy, whose main worries are the low returns he's getting from his portfolio and his inability to find ways to better them. You can sell him a little bit of your loan book, so his assets are now, say 98% safe and boring but 2% high risk. He's happy with the additional income your mortgages generate and you're happy to have moved some of your crap off your balance sheet and onto his.
The mechanism by which this is accomplished is the Residential Mortgage-Backed Securities (RMBS) market. You combine all of your loans into a pool, then sell bonds which pay off as the interest and capital repayments on those mortgages come in. A typical RMBS offering might combine 50,000 mortgages into a USD10bn pool.
Your high-risk, high return crap is actually very valuable to some people, who can use small doses of it to increase their investment returns. (They have other properties like lack of correlation with certain other securities that add to their value but their main attraction is high interest payments.)
How do you set the interest payments on the bonds? It has to be high, because you need high returns to offset the high risks. But you can't pay out more than the mortgage owners pay in. Typically, the pools pay out about 1.25% less than the average mortgage rate in the pool. (The math is brutal and I'm not the guy to walk anyone through the mechanisms.) A year ago, that meant you, as a sub-prime specialist, could offer bonds that paid 9-13% interest, when the average AAA-rated, nothing-but-perfect-borrowers, RMBS from real banks could only manage 7-8%.
RMBS are traded in huge volumes every day (ok, until recently) just like stocks: the price at which they change hands depends in small part on current supply and demand and in large part on expectations for future supply and demand. However, there's one really important thing worth noting: unlike stocks, RMBS change hands in units of USD100,000 (much more commonly, USD1m) and the market is almost exclusively populated by extremely smart, numerate guys whose nerves make a hunted rabbit's twitching look like a Zen master's calm. Returns in bond markets are highly asymmetrical: 100 days of perfect performance will absolutely be wiped out by one hour of taking it in the shorts. As a result, these guys are risk-avoidance machines who treat all the risk they buy like a poison they're being forced to inure themselves to. Give them a credible reason to stop taking the poison and they'll leave a contrail.
So, if expectations for future supply and demand are what drives RMBS prices, when should you expect RMBS prices to crash? How about when interest rates are going up (making repayments more expensive) or when house prices are falling (reducing the value of the stuff that underpins the loans)? How about when it's both at once?
But, hard-nosed sub-prime lender that you are, you ask: "Why do I care, I already dumped all my shit on somebody else? Hell, I even sold the rights to collect the interest on the loans I sold - that paid for my new Range Rover."
Here's your answer. When RMBS buyers come to believe that missed interest payments and lower house prices are arriving, the price they'll pay for the bonds plummets. The yield on many sub-prime RMBS (that's the interest rate they promise divided by the market price of the bonds) is now over 20% and climbing. Buying won't pick up (which decreases yields by increasing market price for the RMBS) until highly risk-averse buyers come to believe they have seen, or are about to see, that the worst is over.
Right now, if you want to issue a new RMBS, you have to at least match the market yield. That means you have to provide 20+% interest. The only way you can do that is to charge homeowners 21.25+% interest on their mortgages. Your customers may be dumb but they're not that dumb. You can't make any sales on rates that high. You can't make sales at lower rates unless you're willing to hold the loans, which you're too smart to do.
As a result, there is no longer any significant sub-prime lending in America and you, at least, can enjoy the relief of no longer having to pretend you're a sub-prime lender.
Hope that helps,
H
Quick PS: Why do disasters, meltdowns, windfalls and booms happen so much more often in financial markets than anywhere else? In nature - and in human populations - characteristics that have varying intensities tend to be distributed along a bell curve. Financial results aren't. They are distributed (in every sector of finance studied in the past 20 years) along a power curve, which has skinnier shoulders and fatter tails than a bell curve and, because of something called frictional costs, tends to be centred slightly to the left of neutral. That means events which would be super-rare in a bell curve environment happen much more regularly in finance. We learn to live with it, usually at investors' expense...
Unlike other industries, sub-prime lending doesn't occasionally get sick, then recover: it screams a couple of times, then falls over dead. Ford, when it has problems, still manages to shift the odd truck. In a bad year for Hollywood, a significant tonnage of popcorn still gets sold. Right now, sub-prime lending has more or less ceased to exist in America: they can't make any more loans. Why is this industry so different?
To answer this, I need you to imagine that you're a sub-prime lender. This isn't going to be easy for you: chances are, however much of a cruel bastard/cold-hearted bitch you are in real life, you're a lot better-intentioned than the average sub-prime lender. In the playground of American home ownership, you have just elected, of your own free will, to be the greasy-looking guy standing by the railing, telling the socially-isolated kids that you have puppies in your van...
First off, 99+% of your customers fall into one of three groups: the ignorant, the self-deluded or the unreliable. Let's take them in decreasing order of sympathy.
The ignorant: This segment of your customers is either unable or unwilling to do comparison shopping for mortgages. They don't ask themselves how "no money down", "annual cashbacks", and "low introductory rates" are going to be paid for. They can't work out the effects of an interest escalator and figure every lender's fees must be about the same, right?
You, as a sub-prime lender, adore the ignorant. You've been taught just how to treat them. You'll settle them into your little workstation and get them to tell you every detail of their plans and hopes for the new house. With forty minutes of active listening and encouragement, you can rev them up from just plain loving the place to being ready to die to get it, it's so perfect for them.
And, because it's such a pleasure to deal with people who really think hard about what they need, you'll ask them if they'd mind telling you about the other places they viewed and what the pros and cons were there. That will help you locate their buying hotspots: is no money down a necessity for them, are cheap rates for two years the deal-sealer, do they appear to understand fees? After thanking them profusely for their generosity in helping keep you in touch with the local market, you'll tell them you'd like to try to return the favour: there might actually be a mortgage available right now that suits their needs better than the offer that brought them in the door.
You'll describe a mortgage that minimises all the things you've just learned they fear and loads every kind of fee and escalator into the things you've learned they don't understand. "Doesn't that sound like it might just be the right one for you?" Now, you've got a pair of nodding heads sitting across the desk from you, who honestly can't believe their good luck. But you've still got to get them from nods to signatures.
Thankfully there's a never-fail tactic at your disposal, thanks to 50 years of utter tactical stagnation in the auto sales game. "I just need to run this plan past my manager," you say. Then you let them stew for 10-20 minutes, depending on your read of the situation. If these people have come to the likes of you for a mortgage, you just know they're veterans of the used car market. And now you've got them on the edge of panic, certain that your manager is going to kill the deal, knowing the salesman always comes back with a slightly worse offer. Why wouldn't they think that way? It happens every single time you buy a used car.
So you use your number-one, grade-A closing tactic: you blow back into the room with a grin on your face and say: "We sure caught him in a good mood! Congratulations, homeowners!" They'll rip the pen out of your hand...
NOTE: If you have a low income and math scares the hell out of you, you don't have to put up with this kind of shit. When you want to buy a house, go around all the thrifts and banks in your town and look at the stickers on the doors. You're looking for ones that say "FHLB Member" or "Federal Home Loan Bank Associate." These banks participate in government-funded programmes which are designed to ensure that people with low incomes can get an affordable mortgage, honestly sold.
You can back your research up with calls to the Better Business Bureau: they don't get involved with mortgage complaints, as a rule, but they know every bit of banking gossip in their communities and they'll steer you towards state regulators who will tell you who's being complained about and who's not. In truth, these FHLB loans get the kind of scrutiny from regulators normally reserved for a plebe's boots at West Point. You'll be in honest hands.
If you can't decide between mortgage offers from different FHLB members, any accountant in your home town will be delighted to spend an hour explaining them to you for USD100(ish - not in Manhattan). Accountants don't actually make their money accounting for things, they're really paid mostly to explain things. They're good at it, even with people who hate math. Find one who's been practicing for a long time in your area (if there's a credit union near you, they'll likely help you find one) but don't use anyone who sells mortgages on the side. You'll consider it USD100 well spent.
And don't let the sub-prime guys near you: you're miles too good for them!
The unreliable: "Yeah, I had two bankruptcies and one repo and a couple of default judgments. But I'm ahead on all of them now and things are looking really good..." Some people do get bad credit histories through no fault of their own: getting laid off ten weeks before your wife gets sick will screw up anybody's rating. Whether you deserve to be in this category or not, you're going to pay through the nose for a mortgage in both interest rates and fees. These are the main suppliers of grist to your sub-prime mill.
The self-deluded: If six different banks have told them that they can't afford what they want - and probably explained, in detail, why they can't afford it - you have every right, in my view, to screw the living daylights out of them. You know for a moral certainty that you're dealing with a future defaulter, so you will load every conceivable fee into the mortgage - all at the top end of the scale, natch - and match it with a future interest rate that Croesus couldn't pay. Go wild - these customers are your cash cows.
So you've been a busy little lender and pretty soon you've sold thousands of mortgages. Unlike a normal bank, which sees mortgage payments as a key source of future income, that last thing you want to do is own the crap you've sold. You're too smart to tie your future to the uncertain mercies of the ignorant, the unreliable and the deluded. Luckily, you don't have to.
If you kept all of the loans, you'd have interest income coming in 50% faster than other banks - because of the high rates you charge - but 100% of your loan book would be high risk. That's an extremely dangerous way to do business. However, a little bit of your loan book might be a useful thing to another guy, whose main worries are the low returns he's getting from his portfolio and his inability to find ways to better them. You can sell him a little bit of your loan book, so his assets are now, say 98% safe and boring but 2% high risk. He's happy with the additional income your mortgages generate and you're happy to have moved some of your crap off your balance sheet and onto his.
The mechanism by which this is accomplished is the Residential Mortgage-Backed Securities (RMBS) market. You combine all of your loans into a pool, then sell bonds which pay off as the interest and capital repayments on those mortgages come in. A typical RMBS offering might combine 50,000 mortgages into a USD10bn pool.
Your high-risk, high return crap is actually very valuable to some people, who can use small doses of it to increase their investment returns. (They have other properties like lack of correlation with certain other securities that add to their value but their main attraction is high interest payments.)
How do you set the interest payments on the bonds? It has to be high, because you need high returns to offset the high risks. But you can't pay out more than the mortgage owners pay in. Typically, the pools pay out about 1.25% less than the average mortgage rate in the pool. (The math is brutal and I'm not the guy to walk anyone through the mechanisms.) A year ago, that meant you, as a sub-prime specialist, could offer bonds that paid 9-13% interest, when the average AAA-rated, nothing-but-perfect-borrowers, RMBS from real banks could only manage 7-8%.
RMBS are traded in huge volumes every day (ok, until recently) just like stocks: the price at which they change hands depends in small part on current supply and demand and in large part on expectations for future supply and demand. However, there's one really important thing worth noting: unlike stocks, RMBS change hands in units of USD100,000 (much more commonly, USD1m) and the market is almost exclusively populated by extremely smart, numerate guys whose nerves make a hunted rabbit's twitching look like a Zen master's calm. Returns in bond markets are highly asymmetrical: 100 days of perfect performance will absolutely be wiped out by one hour of taking it in the shorts. As a result, these guys are risk-avoidance machines who treat all the risk they buy like a poison they're being forced to inure themselves to. Give them a credible reason to stop taking the poison and they'll leave a contrail.
So, if expectations for future supply and demand are what drives RMBS prices, when should you expect RMBS prices to crash? How about when interest rates are going up (making repayments more expensive) or when house prices are falling (reducing the value of the stuff that underpins the loans)? How about when it's both at once?
But, hard-nosed sub-prime lender that you are, you ask: "Why do I care, I already dumped all my shit on somebody else? Hell, I even sold the rights to collect the interest on the loans I sold - that paid for my new Range Rover."
Here's your answer. When RMBS buyers come to believe that missed interest payments and lower house prices are arriving, the price they'll pay for the bonds plummets. The yield on many sub-prime RMBS (that's the interest rate they promise divided by the market price of the bonds) is now over 20% and climbing. Buying won't pick up (which decreases yields by increasing market price for the RMBS) until highly risk-averse buyers come to believe they have seen, or are about to see, that the worst is over.
Right now, if you want to issue a new RMBS, you have to at least match the market yield. That means you have to provide 20+% interest. The only way you can do that is to charge homeowners 21.25+% interest on their mortgages. Your customers may be dumb but they're not that dumb. You can't make any sales on rates that high. You can't make sales at lower rates unless you're willing to hold the loans, which you're too smart to do.
As a result, there is no longer any significant sub-prime lending in America and you, at least, can enjoy the relief of no longer having to pretend you're a sub-prime lender.
Hope that helps,
H
Quick PS: Why do disasters, meltdowns, windfalls and booms happen so much more often in financial markets than anywhere else? In nature - and in human populations - characteristics that have varying intensities tend to be distributed along a bell curve. Financial results aren't. They are distributed (in every sector of finance studied in the past 20 years) along a power curve, which has skinnier shoulders and fatter tails than a bell curve and, because of something called frictional costs, tends to be centred slightly to the left of neutral. That means events which would be super-rare in a bell curve environment happen much more regularly in finance. We learn to live with it, usually at investors' expense...
