May 24, 2012
Predatory Lending: a history lesson (1978-2008)
When we talk about the student loan crisis, a phrase that doesn’t get enough attention is Predatory Lending. You here that phrase in relation to the 2008 housing collapse, but it’s often tagged with the naïve line “Why aren’t poor people smart enough to know why they have to pay back loans?” I discussed why this doesn’t work with student loans in my previous post, but today I want to discuss why that line of questioning doesn’t work with any credit crisis, ever. First, a history lesson:
What happened in 1978?!!! Essentially, we solved our labor shortage. Computers and machine production lines were cutting the need for workers, tax loopholes were opening, “out-sourcing” entered the vocabulary, and the other half of the population (called “women”) were entering the workforce. Capitalists no longer had to pay workers more, so they didn’t. And profits were about to soar- which means everything looks better than ever (other than this chart, which you are only supposed to care about if you hate America).
But the cost of living kept rising. So what do you do if you don’t make any more, but the cost of living is always on the rise? Well, you go on the largest credit-borrowing spree in the history of the world. It was genius really- instead of employers paying workers more, they were lending money to the employee, money that would be paid back with interest. A classic win/lose scenario. And corporations had the money to throw into politics, because while the historic tax rate for corporations had been $1.50 for every dollar paid by individuals, it was dropping to (now) 25 cents for every dollar that individuals pay. And the tax rate for rich individuals was going to drop from 90-somthing% to 35%. We won't even talk about how average CEO pay has risen from 30X average worker to 500X in that same period (that's an attack on the free market geniuses that give us our bread and circuses!!!). In the meantime, the Sheeple think the big problems in the world are Roe v. Wade, the Cold War, a war on religion, and other ridiculous distractions like that. So they end up madly supporting the same politicians that are helping corporations in a predatory scheme.
It starts in 1978- nobody notices until 2008. And even then, the wrong people get blamed.
A family member and I have been exploring the structure of the looming student debt crisis. So I’ll have more posts on this topic in the future. It is pure, unapologetic predatory lending- and you will thank the predatory lender, because you actually think you will pay the loan back and be free. It’s not that different than how most Americans believe, contra all statistical evidence to the contrary, that class mobility is possible. You don’t want to believe you will die in the same city you were born in. You don’t want to think you will have less buying power than your parents. You want to think you can be born in a lower or middle class family and still become President one day. You keep thinking this because you can name a small handful of people who broke the mold, and you think you can too. So you ignore the stats.
We could solve the student loan crisis by imitating any one of the number of countries that have better education systems than we do while also managing to have no debt crisis. But of course, if any politician talks about that, he/she will be blackballed as a socialist and kicked out of office. We are all sadomasochists now.
Said family member sent this to me discussing the current housing crisis. Read it and tell me: who is to be blamed? And who is to be blamed when the exact same thing happens with the student debt crisis? No need to rush your answer- you have at least 5 years before this debt bubble becomes catastrophic:
A. Elderly gentleman with cancer – soon to die from the illness sees an advert on late night TV guaranteeing a cure for the “low, low price of $999 in the easy payments…call 1.800.curecancer.” The gent signs up – makes the payments – cure fails – gent dies anyway.
Summary – all roles of victim and criminal are clear. One could argue that the government had a role as a partner with the drug company by allowing the advert but that’s splitting hairs.
B. Postal worker making 35K and his teacher wife making 15k for a total of 50 (for simplicity) take a phone call over dinner from a mortgage salesman telling them that his bank is offering a one time opportunity to borrow $750k for qualified borrowers to buy the home of their dreams.
The couple says politely, “no thank you, we have a home and we could never afford a $750K mort not to mention the payment.” The salesman (who is making a substantial commission on a $750K loan) says, “oh no – but you already qualify…that is why I called. And – there actually is no payment for the first 12 months – and by then we can roll the loan into a conventional loan – and even then there is no payment because a 750k house will increase by 6% (which is what the trend has been), so 750K x .06 = $45K. So you will have $45K of equity AT LEAST by the time the first payment is due. And by then the payment on the 750k loan will be $2500/month BUT – you can pull $45K out from the increased equity. So - $45k / 12 = $3,750.
So – when the payments actually start in one year you can take the equity out and use that to pay the mortgage so $45k equity/12 = $3,750/month and your payment = $2500/month – so EVEN when the payment is due you still make $ 1,250 FREE EXTRA DOLLARS a month AND you get to live in a $750K house with a pool AND your house keep going up in value AND – you not only don’t have to pay anything you will actually MAKE money when you do have to pay!
So the postal worker says, “you mean to tell me that I can move into a $750K house – and NOT make a payment for the first year…THEN – actually MAKE $1,250 the second year! Right now my monthly mortgage is $600 – so 600x 24 months = $14,400 for 2 years – that is what I pay now. If I do your deal I not only do NOT have to pay a mortgage – I actually MAKE $1,250/month so I am $ 29K actual dollars better off? ($14k in payments he does not have to pay – actual cash – plus the 1,250 he will make the second year after he takes out the home equity loan on the appreciated value).
The postal worker takes another bite of the Stouffers Lasagna and says, “but we could never qualify – we have credit card debt and auto loan debt and I have been behind on some of these payments. In fact, I even got behind on a few house payments last year – thanks for the call anyway.”
The mortgage salesman (staring at $22,500 commission – say 3% of the loan amount), says “trust me – that ain’t a problem.” To which the postal worker chuckles and says “Well, you just call me back when you get it all tucked in and we will find a $750k house and take you up on that offer.”
A week later the mortgage salesman meets with the family in no time at all makes the necessary arrangements and sure enough this family borrows the $750k and eases into the maw of the system.
I would posit that the bank knew the loan would go bad. The mortgage salesman knew the loan would go bad. The economics of the transaction worked for the bank and certainly for the mortgage broker even with the certain knowledge that the loan would go bad. Let us examine the parties:
Mortgage broker: As soon as the docs. are signed he moves on to the next postal worker. In fact he is never heard from again. This guy gets away without even going in front of congress.
The Bank: They initiate the loan (take a fee), package the loan into a MBS instrument (mortgage backed security), take another fee and sell it to a hedge fund (take a commission on the trade).
Hedge fund: Owns the MBS, fully aware that the loan will go bad so hedges the position with CDS (credit default swaps – insurance against default).
Postal worker: moves into the new house and proceeds to enjoy the wonders of modern finance (remember – he is $600/month better off so he is considering a new bass boat).
This entire wonderland works as long as real estate prices continue to rise. What happens when they decline (as they did). Fast forward 1 year:
Mortgage broker: Gone – can’t even recall his name. in fact his name does not even show up on any of the closing documents. This is borderline erotic actually.
The Bank: The end market for the MBS dried up as the hedge funds stopped buying them (cause they saw the downtick in real estate prices). So the bank had to keep initiating the loans because this is how they were generating income which was keeping the stock price up. They were NOT selling them now - they were putting them in their own investment acct and mis-marking them. Basically saying the mortgages were “money good”. Soon enough the postal workers could not take out home equity loans because there was no equity so the defaults began at which point the bank had to disclose the real value of the mortgages (which was zero). Suddenly the entire equity of the bank was at risk so the Fed Government came in and said: “wow – we can’t have the banks go under so we will purchase all the repossessed houses in our vehicle called Maiden Lane and recapitalize all the banks.
Hedge Fund: had all the MBS securities hedged with Credit default swaps. Made a fortune on the short side of all the banks. Understood completely that the Feds would bail out all regulated parties. Then once the fix was in place got long the banks and set up REIT’s (real estate investment trust) to purchase the distressed assets from Maiden Lane (the fund set up by the Fed to warehouse the assets they bought from the banks).
Postal Worker: Moves out of his dream house. Loses his bass boat, car, new tv…all the things one generally buys with free money. More importantly, he cannot buy another house because his credit is ruined AND he has the shame of having a home foreclosed on him. He can only afford a crappy apartment because his credit is so bad.
So – did the postal worker act foolishly? Was he morally corrupted for taking out the loan? Did he behave greedily? Was he stupid? Are we free to say “he should have known better?” Can we casually question his morals because he defaulted on his mortgage?
I would submit that the bad actors here are the banks who made the loans. The banks who incited everyone in the food chain to suck the postal worker into the transaction.
To that end, there is not one single student loan being made right now that the initiators are not completely aware of the fact that it will go into default. I honestly believe a fool and his money are soon parted so if a fool shows up and offers me $250K – and they know I have no way to pay it back, I am obligated by Adam Smith’s Free Hand to accept the money and behave as an economic being – and make no effort whatsoever to repay the loan. ZERO – NADA – no effort at all.