Consider the following example. A bank has 10-year mortgages for 100 mln on their books, which generate a yearly cash-flow of 4%, i.e. 4 mln p.a., as people service their mortgage debt.
Of course, there is a risk to the bank from having 100 mortgages on their books – people could fall behind in paying them or simply default. Besides 4% is not a very exciting return in the world of masters of the universe.
So the bank, or rather the executives of the bank, might want to sell these mortgages so they can make a more lucrative use of the bank’s money. Selling the mortgages will probably generate less than 100 mln and the bank would forgo the cash-flow income of 4 mln p.a. Therefore there must be a better solution.
There is indeed one. It is called special purpose entity (SPE) or special purpose vehicle (SPV). It is a legal entity, much like a corporation, but not entirely like a corporation. It is more like the legal hull of a corporation containing almost only financial assets.
Since it is a separte entity, it is no longer represented on the banks books, the fianacial and legal risk is thus off-loaded.
So our bank, let’s call it Bank A, goes on and establishes this SPE, which we call SPE1, and intends to sell to it the mortgages for 100mln.
The SPE1, however, does not have cash yet, so it needs a loan, which luckily, Bank A, being a bank, is able and willing to provide – however, at 6% interest p.a. Bank A doesn’t want to be commited for 10 years for 6% only (interest rate risk. Besides SPE1 is risky, we’ll see below why), so it makes the loan 5 years only. This could also be two years, but let’s make the example with 5 years.
Having received the cash, SPE1 now buys the mortgages from Bank A for 100 mln. Bank A has now 100 mln cash back in its accounts, a loan at 6% p.a. to SPE1 outstanding (interest, i.e. an income of 6.76 mln p.a.) and the loan will now be available for re-investing in 5 years instead of 10. In fact, 26.76mln will be available for re-investing after the first year already.
Best of all, the 100 mln in cash received for the sale of the mortgages are immediately available for issuing new mortgages. So that the game can start anew with an SPE2.
The clever bank executives get a bonus for increasing profits by more than 50% in one year (just by rearanging the balance sheet, but of course they won’t say so, they are clever). Bonuses are necessary, say the executives, to retain such talent that comes up with brilliant solutions like this. Of course, when they talk about ‘talent’ that must be retained, they are really talking about themselves.
Balance sheet Bank A before and after off-loading mortgages to SPE1
Now, SPE1 needs to generate an income of at least $26.76 mln p.a. over 5 years in order to repay the loan with interest to A. How does it do that, after all the mortgages still do only pay 4%, or 4 mln p.a.?
SPE1 could issue shares or bonds. Lets assume bonds. SPE1 issues 1 mln bonds (e.g. CMOs), $30 each at 2% p.a., but that would just postpone the day of reckoning.
The 30mln generated in year one can be used to service the loan (with 26.76mln for year one), and the bondholders (o.6mln for year one) and we haven’t even factored in that SPE1 also has talent that wants to be retained.
However, for year two already, SPE1 will need a new source of funds, which it has to find for example by issuing new bonds/shares, or other types of debt, etc.
There is a whole host of such debt instruments with names like CDOs, CMOs, CLOs, CFOs,RMBS,CMBS and more. There are even CDOs based on CDSs. This bullshit is called financial ‘innovation’.
My conclusion then is that, over a longer period of time, this is as sure to crash as the usual pyramid scheme. Why? Well, because it IS a pyramid scheme.
The only real thing in this game are the fees and the bonuses, the rest is just smoke and mirrors used to hide the true state of affairs.
In fact, mortgage securitization is another example of the mechanism I described in a previous post.