My Experience with Prosper and how it is Similar to the Current Mortgage Debacle. [¹]
Click here for a link to complete article:
By Dr. Housing Bubble | 27 October 2007
As Dorothy and her entourage approach closer to unveilling the mortgage Wizard of Oz, everyone is doing their best impression of Baghdad Bob on the housing yellow brick road. "Please turn your heads, there is nothing to see here," state the embattled mortgage lenders. Of course they need to hold up this front for fear of further deteriorating market sentiment. This week, in what has become a monthly spectacle and a routine funnier than comedy Def Jams, the National Association of Realtors once again had to readjust their housing numbers toward the downside. If anything, you can take a look at what the market expects and subtract a few hundred thousand from these expectations since no one has any idea how bad the mortgage portfolios really are. I’m surprised no one in the mainstream media is calling these experts out by how off they are.
On the flip side, we think we have an idea of the toxic black lagoon sewage these companies are holding onto. Take a look at the Real Home of Genius [[at the link above: normxxx]]. These homes’ collateral via a mortgage is sitting in a hedge fund portfolio near you. Now we are hearing all these archaic names such as SIVs or M-LEC and glorious words such as mezzanines. I’m thinking many of these hedge fund managers and banks took an English 101 course where they were forced to read Orwell’s 1984 and realize that giving an entity an ironic name may actually keep folks at bay. We have the words 'secure' and 'security' thrown into mortgages that are quite the contrary, and Option ARMS where you really have only two options, really bad and awful. Think about other clever titles such as Operation Freedom and you’ll catch what I’m saying.
Another clever idea which seemed to have merit is Prosper.com. Prosper is an online marketplace where potential lenders are able to fund people that may not have any other option or are looking for more competitive rates. I decided last year to enter the game with a marginal amount of play money. As my eyes twinkled with 24 percent returns on D rated clients, I figured, "hey, I’m only putting $50 into this loan so what’s the big deal? I’ll balance it out with a 9 percent loan from an A rated customer." The reason I bring this up is the similarity of what is going on in the current mortgage markets. On Prosper each loan is amortized over 3 years.
At first, lenders may be drawn to the prospect of unbelievably high returns. The catch is that you need to find reliable risk and reward and continually make these bets each and every time. You are provided a snap shot of prospective borrowers including late payments, income, debt to income ratios, and also a brief profile personalizing the reason they are looking for a loan. In fact, you’ll sometimes see a suggestive picture on the loan and amazingly some people would find this sufficient to fund a horribly rated loan. Well, maybe I’m not surprised but that’s besides the point. You’ll also find folks trying to start a business, guys looking for a down payment on their fiancées engagement ring, others looking to consolidate debt, and of course those thinking they are the next Donald Trump. It is actually a great place to be a borrower, but as I have come to find out, not a really good place for lenders on the long-term.
As usual, there are people that are making fantastic returns on Prosper. But these folks are professionals and know what they are doing and are much more the exception than the rule. In fact, the folks that do the best are the lenders that have the ability to vet loans much deeper than your average armchair investor like myself. I am still positive for my investing career with Prosper but far from the glorious 24 percent returns I once envisioned.
So what occurred that stunted my returns? There’s a couple of things that go wrong even with running complex risk analysis models. In fact, some lenders on Prosper use complex formulas relying on the credit ratings the agency provides. What happens is first, your potential returns are front-loaded and look attractive from the start. That is, you are receiving the maximum on day one since all loans are current. As time goes on and you start experiencing defaults, your returns begin to diminish. You can only go down. Since the model is based on continually reinvesting your returns for comparable gains, you must keep the game going and finding solid borrowers. Therein lies the problem. Of course this amazing potential attracted a lot more lenders and the pool of borrowers grew but not at the same rate.
Well it did grow, it is only that prime borrowers grew at a much slower rate. In fact, a prime borrower is prime because he doesn’t need last ditch financing. So you have a slew of money chasing potentially high yields and a growing group of subprime borrowers. Sound familiar? With only a few defaults, your portfolio can go from fantastic, to mediocre, to barely breaking even.
If anything, this gave me an idea of what these mortgage lenders with their pie in the sky projections were thinking. They somehow felt that there would be an unlimited supply of [quality] borrowers and they could simply keep reinvesting over and over. Well as you are seeing with the early defaults in the current market, these lenders and purchasers of debt were spread so thin that a few defaults were enough to turn their A-rated portfolio into junk. It doesn’t matter if you own an entire piece of crap or only a tiny sliver, it is still crap.
There is Such a Thing as Spreading Risk too Thin
Therein lies the false perception of risk. With the asset backed markets and collateralized debt obligations, these companies felt that they would be able to slice the debt into exotic tranches and hungry investors and hedge funds would eat up this stew of debt for higher yields. And they did for several years. In fact, this is the perception with Prosper. You’ll see a borrower requesting $2,500 and multiple investors chipping in $50. So the risk is spread out over 50 individuals. But what if this one borrower loses their job or is unable to make the payment? Guess how many people are impacted by that one default? That is right, 50. But naive investors view the risk as minimal— so long as this individual pays in a timely manner.
But suppose this individual doesn’t pay and many parties are impacted. This is massive leverage on the downside— one individual impacting 50. Now you can understand why one home that is declining or in foreclosure is impacting multiple lenders and not just one. Also, you can understand the difficulty in distributing the money recovered in a foreclosure to large numbers of individuals. There are many more subtleties of course but please do not let the housing complex try to make you feel like a fool who simply cannot understand the current situation. Weren’t they the one’s that swore we wouldn’t be facing the issues we are currently facing?
Option ARMs are for High Quality Top Rated Customers
I hope you are starting to realize that an enormous amount of mortgage debt outstanding is simply radioactive toxic banana republic sewage. UBS data suggests 80 percent of Option ARM borrowers pay the minimum. Meaning, these folks are [already] hedging their bets that their home will rise in value so when it comes time to sell, they won’t have to face the music of their negative amortization. As we all know, housing isn’t going up but going down. Since these folks are paying the absolute rock bottom minimum, what other option do they have? Even refinancing into a simple low-rate 30 year mortgage will raise their monthly payment. Many of these Option ARMs will hit a major reset wave from 2010 to 2012. And we still have to deal with the major subprime rate reset wave in H1 of 2008. In another ironic play on words, Countrywide holds a large amount of "PayOption" ARMs in their portfolio. Since most people elected the do not pay option, they are simply sitting on a mortgage volcano hoping that it doesn’t erupt even though steam and lava are now starting to vent.
Dr. Strange Love and Learning to Love Mortgages
So all this seems rather dire. I’m sure many of you have realized the play on words for the title of this blog. What can we do? What are our options? This is where we have to lay out ground rules and stick to our philosophical leanings; and of course arguing philosophy is like trying to come to a reasoned decision about what is the greatest movie of all time. Everyone will give you a perspective based on their own experience or beliefs.
Many of these companies underestimated the risk involved with these mortgages; if we are to believe in true market capitalism we have to let the market work its way out. What this means is that a large number of these companies will go under and guess what, they already are doing so. People should be angry at management for not diversifying into other industries during the good times. Take a look at GE and Proctor and Gamble for example, they haven’t lasted this long by putting all their eggs into one basket. But of course these companies decided to chase these unsustainably high returns and, by definition (of unsustainable) that is something that cannot go on forever. In our nation, historically, returns on housing are on par with inflation. These last 10 years have been an enormous anomaly.
Most companies will need to face the music on their own dime [[all should, but then there are those "too big to fail" and the FOG— friends of George: normxxx]]. If our belief is that government should bailout people that made irresponsible investment decisions then we do not believe in capitalism. Government is there to protect and provide support in unforeseen circumstances such as the horrible fires we are having here in Southern California. No one saw it coming and there is a need for assistance. But to say that this mortgage debacle was "unforeseen" is a blatant lie. Take a look at the archives here and at other sites and you’ll realize many people were ringing the warning bells even when everything was supposedly going fine.
I’m completely fine with banks and lenders reworking their own mortgages and swallowing the cost of refinancing their own loans. No problem. I do have an issue when these lenders want government sponsored entities to subsidize their greed by pushing off bad investments into the public sector. What we then have is a type of cronyism and corporatism that was prevalent during the roaring '20s and subsequent Great Depression.
In fact, if we are going to open the government wallet, why shouldn’t you be reimbursed for that money you lost in Vegas last year? [[I think you have to have a net worth of around $10 billion to qualify for a 'handout!': normxxx]] Or what about that high rate you had on your first vehicle? Shouldn’t you be able to retroactively go back and reassess your loans and get current market rates refunded to you? What about people that already lost their homes? What if you bought your home before all this housing speculation and want to refinance your loan? Shouldn’t you have the same option to defer your payments? Too many of our 'leaders' are warning that many people will be out on the streets.
Actually, that is why renting is an option and the majority of Los Angeles County, a county of 10,000,000 people, are renters. But even if you dig deeper into the data, many of these homes that are going into foreclosure are sitting empty! We have would be Trump investors buying 2nd, 3rd, and 4th homes with ridiculous mortgages that are now coming home to roost. They gambled and lost. Do you want to bail these folks out? How do you distinguish between a flipper and a legitimate owner in trouble? Again, if these lenders and hedge funds want to rework the mortgages then more power to them. But this new talk of a conduit with an absurd acronym of M-LEC is simply a way of reshuffling the chairs on the Titanic [[to postpone the day of reckoning for a few big banks: normxxx]]. The fact that the US Treasury was involved on this causes me to pause and wonder what the hell is going on in Washington.
|
M O R E. . .
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
No comments:
Post a Comment