Abstract Finance: Lending and
Investing in a Dissembled,
Automated World
James B. Heian, Accounting
February 20, 2008
Copyright James B. Hein 2008
A Giant Abstraction

Old-bank/s&l at risk-three c’s (collateral,
credit-worthiness, character)


New-technology puts space and time
between those at risk (investorslenders) and customers-borrowers


Many banks/s&ls, local focus
Few giant players, global focus
Losses-$120 todate; $400 possible
Major Lenders/Originators
Fannie
Mae-FNM
Founded
Freddie
Mac-FRE
1938
Bank of
America-BAC
Citicorp-C
1970
1813
1874
Countrywide-CFC
1969
Assets
843
813
1,884
1,460
200
Liabilities
802
785
1,764
1,325
186
41
28
120
135
14
Equity
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 applicationARM, 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-lend
Those 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!