Five thieves
Five friends from Wall Street gathered to play poker one Friday nights.
Mort, politely asked for the floor before the game could start. “Instead of trying to clean each other out tonight, let’s just this once discuss an idea I have that can make all of us a ton of money, Mort suggested.
Fed, the unspoken boss of the game, who acted as dealer holding the cash and handing out the chips, spoke next. What Fed said usually prevailed, and Fed nodded his assent. The others, Mort, Schlock, Bags, Rate all politely agreed to give Mort 10 minutes.
Mort began in a controlled tone: “You all know I sell mortgages, and frankly the business is rewarding enough, but it’s pretty dull because of the rules we have to play under. Anyone who wants to buy a house or barrow against one must qualify by having income and collateral. If the buyer doesn’t quality, we can’t do business with him, and he does not get a house. The rules are federal and people are always checking tax returns and property values.
This qualification routine is obsolete and really slows down business in our modern era. Then there is the issue of interest rate, which is low by historic standards but are still too high for marginal people to ever pay back a 30-year loan. My idea would allow everyone to have a mortgage and own a house, maybe even a cabin on the beach. If we can do this, I will be able to sell unlimited mortgage, and all of us can benefit. To do this we need to restructure the way mortgages are paid.
Mort became animated. “The way I see it,” he said “interest rate the buyer pays must be fixed so the pay-back is real low at first, so the new buyer can afford the payments for few years. If we could give them a 3% interest only loan for the first 3 years, and defer all the payments on principle for a few years the borrower will not mind paying twice as much later on. Trust me, buyers don’t think ahead very far. If he can afford it today he will buy the house and trust in his good luck for next years. So what do you say, boys, is this a good idea? This way people can buy a house for less than it costs to rent it, at least for a few years.”
Schlock, the Wall Street stock broker, was the youngest player and the most aggressive, spoke first. “look men, Mort is right, there is serious money to be made in his idea. You all know I sell stocks and bonds, and if you don’t mind me saying so, I am good at it. There is a lot of money around looking for a good return. I can package Mort’s mortgages into stocks and sell them to the public. I know how to create a security around almost anything promises a good return. Why not pool mortgages and sell stock and bonds in the pool, paid by the mortgage payments?
Schlock went on: Suppose we call these mortgages “Sub Prime” because prime means the best. They will have a negative case flow for a few years until the acceleration kicks in, but I can handle the equity part of this deal by selling stock in the pool to pay all our fees and make up the deficit. The big money to finance all these mortgages has to come from commercial banks like our friend Bags, who has all those customer deposits to invest.
Bags, you are the only one who can come up with big bucks because you can borrow from Fed at the discount rate to fund this, we can’t. What do you say about this?”
Bags is portly and wears a pin stripe black suit, even at the poker games, but he too, is young. Though thought of as conservative with other peoples’ money, the men in this room know Bags thinks like a high-roller but pretends to be cautious.
Bags begins: “We are a pretty big bank and we buy mortgages for our investment portfolio, but we are used to getting 6.5% return. We want to know the buyers can pay, unless someone else underwrites the risk. I think Mort’s scheme has potential. We can give some short term finacing but we cant invest in these sub prime mortgages, we banks are under rules that must be observed. But there may be a way.
Schlock, if your new pool company could issue bonds secured by the mortgages, we could take these bonds as collateral and lend big bucks to you and your pools could buy Mort’s sub prime mortgages. We have more lenient rules on lending against bonds than mortgages. I can give you almost unlimited dollars so long as Fed keeps the short-term rates low.” Bags continued as an afterthought: “There is one hurtle you must cross if we banks are to provided all these billions you are talking about. The pool’s bonds have an investment grade rating for quality or we banks can not take them into our portfoleio. Get your bonds rated AAA, and we have a winner.”
At this point there was a long silence. Rate was older than the others and often dozed off after a few scotches. Rate’s company had been in the same business for over a hundred years providing quality ratings for other peoples securities, that were often depended upon by investors, but were primarily issued for the purpose of rule compliance, like in this case. Rank loves a big fee with a minimum of work. Rank spoke:
“What is in it for me, if I swear by Schlock’s bonds secured only by Mort’s funny mortgages?”
Mort jumped up and spoke in high excitement. “Sir Rate! I know your very careful, but this can be really good for you. Your fees you chages the pool can be a little higher than normal and we won’t complain. And the volume will be terrific, we are not talking about just one pool, there will dozens maybe hundreds of pools that will need ratings, it will be like cutting cookies for you, if you have seen one mortgage you have seen them all. I plan to sell mortgages to millions of people who never thought of buying a home. Investors could even buy an extra home to rent out. We might even start a house building boom to keep up with the demand. Your ratings are indispensable. Think of what you are doing for society”
“OK, Schlock” said Rate, “we will give your plan a try. I can’t guarantee a rating before I see your paper, but if everything pencils out the way you have described it, we can probably eek out an AAA rating on the first fund, and we will see how it goes after that.
Good, responded Bags, we will take the Rate AAA rated bonds, Schlock’s pool issues as collateral for a loan.
Great, chimed in Schlock, I will use the money I borrow from Bags to buy the new Sub prime mortgages from Mort. And I can’t wait to start selling stock to the public in the Pool. We will use the money we raise from the stock to fund the up front costs.
“Wonderful, Mort chimed in. I will get busy right now advertising that anyone can buy a house using our new mortgage structure. Schlock, be sure you over fund so you can pay the fees up front to yourself, Rate and me, because I am going to sell these mortgages with almost nothing down.
Everyone in the room knew a history was being made and that the housing market would never be the same.
Fed rose with a smile and spoke for the first time, and everyone listened. “In our view of the economy inflation is well under control. We think we can lower the discount rate to as low as 2% over the next few years, and Bags will be able to borrow from us to make the loans he is talking about, and make a profit on every dollar he barrows. This plan of yours will spur real estate investment to a gallop. We at the FED like it. And I can talk to my friends down at the Congress about getting some rule changes pushed through that will make Mort’s plan even easier than he knows.”
Everyone rose and faced Fed. They knew Fed had the clout in Congress. “I’ll drink to that,” said Mort, raising his glass. And the rest shouted, “Hear, Hear!”