How do bad deals, such as subprime lending, become good deals with some financial engineering?

Let’s do a thought experiment, with 3 hypothetical deals.

Deal #1: Here’s the deal: You invest $100 with me. I’ll pay you $110 at the end of a year. Except 15% of the time you’ll lose all your money. Would you do the deal?

Of course not, you say. What a bad deal. And you’d be right. The “expected return” on your money is -5%. Can’t get rich that way.

Deal #2: You invest $100 with me. I’ll pay you $117 at the end of a year. Except 15% of the time you’ll lose all your money. Would you do the deal?

Tougher choice this time. You stand to make an expected 2% return over the long haul, 17% return about 6/7th of the time and -100% about 1/7th of the time. It’s still not a great deal. You are taking too much risk for a small expected return of 2%.

Deal #3: You invest $100 with me. I’ll pay you $150 at the end of a year. Except 15% of the time you’ll lose all your money. Would you do the deal?

Almost all would do this deal. The expected value of your return is 35%. You will make 50% in 6 out of 7 years and lose everything 1/7 th of the time. I still wouldn’t do the deal with the baby’s milk money – don’t want to take a 15% chance that the poor innocent will starve. But with “Risk Capital” the deal would probably be done. Risk Capital is the money the affluent can afford to lose in order to spice up their expected returns.

All pretty straightforward so far. But sometimes a bad deal like Deal #1 is all you got. But with a little sleight of hand you can make it a good deal and maybe you won’t be around when the fan gets besmirched. That’s what financial engineering is. Let’s go back to Deal #1 and do some financial engineering.

Suppose you could borrow $90 interest free and collateral free when doing the deal. Now you borrow the $90 add in your own $10 for a total of $100 with which you do the deal.

At the end of the year, if you get back $110, as you will 85% of the time, you return the $90 to the lender and you end up with $20 – hundred percent return on your $10 investment!

15% of the time the investment loses $100, but the lender loses the $90 (it’s non recourse – he can’t come after your other assets) and you lose your $10. All of a sudden this has become a great deal for you – a 100% return 85% of the time and loss capped at 100% of your investment 15% of the time. You would almost certainly do the deal.

Fine, you say, but what kind of lender would be foolish enough to make that loan?
Answer: The Federal Government, if the risk taker is a bank!

You’re a bank, let’s say Giddybank. You have $1 Trillion in customer deposits, which is really a loan to you from your depositors, hopefully at a rate of interest that lures customers to deposit money with you. Without regulations you can invest this money any way you want. Say only bad deals such as Deal #1 are available. If you take too much risk, such as Deal #1, you can eventually have losses and therefore no money to repay the loans. No repayment of loans would mean no further depositors and ultimately no business. So you would take only prudent risks to survive and thrive. Good capitalism.

But here’s the difference – the Federal Government through the FDIC insures the customer loans. You can take a high risk flier with the money, such as Deal #1, highly leveraged, and if the default doesn’t happen (6 out of 7 times in our example) you make tons of money. High fives and bonuses result and the Government declares that the FDIC insurance is working. But when (15% of the time in our example) the risk kicks in and you  lose, the Federal Government swallows the losses. How highly leveraged can you go? It used to be about 12x, but rules were relaxed in 2002 on and banks were allowed to go upto 35x! Think about that – you can use $97 of the loan (from the depositer) and just $3 of your own money and do $100 of Deal #1. Your $3 will produce a $10 return (minus the interest on the loan) or a whopping 333% return. Oh minus the interest on the deposits – how much is that? Answer – 0%. Yup, 0%. The Fed is willing to loan the banks money at 0% indefinitely, thus forcing down the interest that banks pay to depositers to 0% also. That makes the return on Deal #1  333%!

Heck, the deal doesn’t even have to be that good to be viable. Banks can take on even lesser deals, with say a 6% return in a good year and a 30% failure rate. Such deals (subprime loans, e.g.) would be ridiculous in a normal free market, but with the Government providing the free “loan” a bank would be insane not to do it. Or insanely moral, which is insane in a competitive capitalist setup.

Another way the government allows bad deals to happen is by insuring the deal itself. If Deal #1 is a mortgage loan to a bad bet (15% chance of default in our example) in a rational banking system such a loan would not be made. But because our society wants to encourage home ownership the Federal Government set up Fanny Mae and Freddie Mac, agencies that implicitly insure home loans against default. They were supposed to take on some of the risk of home loans in return for many more people being able to afford homes. And if the default rate was low, the cost to society was low and the gain was home ownership.

But with risk back-stopped by the government the banks saw enormous opportunity to profit by making really terrible loans that met no sane guidelines. Fanny Mae and Freddie Mac were co-opted – a collusion between banks and government, horrors! – and the go-go era of subprime mushroomed. The risk was even further kited by creating derivatives on credit, but that’s another story, not part of this blog. The effective leverage went from 35x to 300x or even more.

Profits in non default times were huge! The financial sector in 2007 accounted for 40% of all corporate profits in the US!! But the money made by insiders was even larger than that, in commissions, bonuses and hedge fund affiliates.

The crash inevitably came. The government gave trillions to the banks to make them whole again. The banks took the money, thank you, and the hi-fives and the bonuses continued. Back to leveraged loans, derivatives and so on, as if nothing had happened. We continue to operate with the government underwriting deals such as Deal #1 which only work with leverage and backstopping of risk.

Luckily for the banks most of America cannot fathom the arcana in which the financial sector couches this fundamental Ponzi model. They rail against the government and regulation and capital requirements and disclosure. Also, they say,  the reason they made so many insanely risky home loans is because the Federal Government made them do so by guaranteeing the loans. Good capitalism takes what it can get. There is no such thing as right or wrong.

The truth is that the banks today have a fundamentally flawed business. They cannot make any money in a free, capitalist, risk-reward based financial system. They have to take imprudent risk with other peoples’ money to make the profits that they are accustomed to. And when the kiting stops, the Ponzi deflates, they need the government to unshatter the shattered economy.