Abstract Finance: Lending and Investing in a Dissembled, Automated World

James B. Heian, AccountingFebruary 20, 2008

Copyright James B. Hein 2008

A Giant Abstraction Old-bank/s&l at risk-three c’s

(collateral, credit-worthiness, character) Many banks/s&ls, local focus

New-technology puts space and time between those at risk (investors-lenders) and customers-borrowers Few giant players, global focus

Losses-$120 todate; $400 possible

Major Lenders/Originators

Fannie Mae-FNM

FreddieMac-FRE Citicorp-C

Bank of America-BAC

Country-wide-CFC

Founded 1938 1970 1813 1874 1969

Assets 843 813 1,884 1,460 200

Liabilities 802 785 1,764 1,325 186

Equity 41 28 120 135 14

Equity/assets 4.9% 3.4% 6.4% 9.2% 7.0%

Revenue 43.6 43.1 147.6 117.0 24.8

Expenses\ 39.5 40.9 126.1 95.9 22.1

Net income 4.1 2.2 21.5 21.1 2.7

Revenue/assets 5.2% 5.3% 7.8% 8.0% 12.4%

Loan Origination

Good Old Days!

Customer-Bank/S&L

Loan application-30 yr; 80% loan/value

Credit assmnt

Wild West Today! Customer-Loan

broker Loan application-

ARM, Fixed rate Credit assmnt-

FICO

Technology: Loan Characteristics Loans can be written with various

cash flow characteristics: Standard fixed rate fully amortizing Variable rate Interest only for period Increasing cash payment Balloon payments

Computer calculations enable variety

Risk Assessment-Borrower

Nationwide credit reporting agencies- Experian, Equifax, TransUnion Giant databases--errors and omissions

common FICO score (Fair Isaac-late 1950’s)

Appropriate for short-term consumer credit--less reliable for mortgage lending

Loan Origination

Good Old Days!

Appraisal-local/MAI

Loan committee

Abstract/title insnce

Wild West Today! Appraisal-drive

by; database Financing

commitment Title insurance

Risk Assessment-Property Value Property Valuation-appraisal factors

Highest and best use; Location; Size; Cost; Condition; Income from; Assessment

Comparable values-recent sales Appraisal Institute (MAI) Values inflated in contrast with history

Current studies indicate property values 25% too high in selected areas

Risk Assessment-Property Rights Title to property-fee simple Real property rights

Water Mineral, timber, farming, grazing, hunting,

air, etc. Easements Development

Liens against property-taxes, assessments

Risk Abatement: Property Title Insurance

Title insurance--guarantees title as specified in the purchase/sale contract

Firms tied to major lenders Four major title insurance firms >

80% of market Giant databases of ALL county

records—mirror image

Risk Abatement-Private Mortgage Insurance for Non-conforming Loans

PMI-Private Mortgage Insurance-for loan/value > 80%

Primary insurers (Mortgage Insurance Company-MIC) AIG United Guaranty, Genworth MC,

Mortgage Guaranty Insurance Corporation (MGIC), PMI MICo., Republic MIC, and Triad Guaranty IC.

Loan Origination

Good Old Days!

Funding Closing-Bank/S&L

Wild West Today! Funding from afar Closing-attorney

Sale and Servicing

Good Old Days!

Bank sold % Bank serviced

loan

Foreclosures rare

Wild West Today! Loans sold 100% Servicing by

major entity Foreclosures

common

Securitization

Packagers clump loans owned by Countrywide, major banks, and others,

Packages underwritten by major investment banking houses and sold to investors Citicorp, Merrill Lynch, Bear Stearns,

hedge funds, municipalities

Risk Assessment-Agencies Assess Overall Default Risk

Credit rating agencies for corporations: Moody’s, Standard and Poor’s, Fitch

Assess probability of loan default with respect to clump of loans (CDO)

Market concentrated! (Three firms)

Risk Abatement-Insurance for CDO Investors

Two major firms and others provide insurance against defaults for CDO’s AMBAC (ABK) MBIA Inc (MBI) Security Capital Assurance (SCA)

$2.3 Trillion at risk

Technology: Systems for Payment Processing (Servicing)

Major banks/financial institutions service or bookkeep loans—collect payments from borrowers; split into principal, interest, fees, etc; remit to owners Countrywide-$1.2 trillion; fee 1-25

basis points for efforts

Incentives to Over-lendThose who win: Loan originators (Banks and others)-earn fees

based on volume of $ lent Underwriters forming portfolios for sale-earn

fees to package and sell based on volume of $ offered

Rating agencies-considered loans to be low risk; earn fees based on packages sold

Those who lose: Investors (Including Banks that hold loans) CDO insurers--earn fees based on amount

insured Taxpayers??!!

Conclusion Sophisticated, complex industries grown up to

support Lending Investing in debt instruments

Including risk assessment and risk abatement firms

Conflicts of interest and mis-pricing of risk common!

Highly concentrated industries—brokers, lenders, credit ratings, title insurers, etc.

ABSTRACTIONS of those at risk from those assuming risks!