What really goes on with Black-matter SIVs. A Micro-case study. My Experience with Prosper and how it is Similar to the Current Mortgage Debacle.
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, most 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. Sounds 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 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 multiple 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 one default? That is right, 50. So naively investors view the risk as minimal so long as this individual pays in a timely manner. But suppose this individual doesn’t pay and multiple parties are impacted. This is massive leverage on the downside. Now you can understand why one home that is declining or in foreclosure is impacting multiple lenders and not only one. Also, you can understand the difficulty in distributing the money recovered in a foreclosure to large numbers of individuals. There are many more subtitles 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 said 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 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. But we still have to deal with the major subprime rate reset wave of Q1 and Q2 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 is now starting to ooze out.
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 argue 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 large numbers of these companies will go under and guess what, they already are. 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 in one basket. But of course these companies decided to chase these unsustainable returns and the definition of unsustainable 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.
Companies will need to face the music on their dime. 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 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? 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? Many people want to issue the warning call 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. The fact that the US Treasury was involved on this causes me to pause and wonder what the hell is going on in Washington.
We have a lot more information that will be hitting the market in the next few days. On Friday we will have Countrywide’s 3rd quarter results and in the following days, the 3rd quarter foreclosure results for the state of California. Make sure you read between the lines and learn how to prosper. McDonald’s didn’t get rich by giving people a free lunch.
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20 Responses to “What really goes on with Black-matter SIVs. A Micro-case study. My Experience with Prosper and how it is Similar to the Current Mortgage Debacle.”
Dr. Bubble, yet another fantastic entry. I have maybe a few questions and I’m wondering if you can give me your thoughts. In theory, I am a believer in letting the free market work and letting the chips fall where they may. I don’t believe in bailing out greedy or lazy financial companies, commission hungry agents, fraudulent brokers, wild would-be Donald Trumps, or ignorant homebuyers. I don’t want to support privatizing profit and publicizing loss. I don’t want to punish prudent savers and waiters. So here is one question. If we had no public bailout, would the fallout from this situation be so bad, that it would punish everyone anyway? I mean, if we just let the chips fall and let it all be marked-to-market… if we let everyone homeowner and bank in trouble go under with no public safety net, would the fallout be so stark that that the medicine is worse than the cure? Or is that exactly what the financial industry is counting on – that they can take whatever risk they want because as a whole they are too big to let fail? If you were head of the Fed or something of that ilk, what would you do in a perfect world and what would you do in the real world? And finally, I think a lot of this whole mess lies with the ratings agencies. Aren’t they the ones who are supposed to assess the underlying assets? Shouldn’t they have seen what you and countless others saw with the Real Homes of Genius? Or other obvious frauds in flipping? I’m wondering, in this so obvious ponzi scheme, how could they not know? Do you think it will come to be known that rating agencies were bribed or unduly influenced? Can’t they be sued for negligence?
Once again, I want to thank you for your excellent blog and helping me to understand so much that would otherwise go completely over my head!
Your daily reader, Debbie
Bravo, Doctor, bravo.
I am a believer in capitalism. I do not believe in bailouts for risk-takers. The rewards ought to be sufficient over the long run to provide incentives. If the government provides incentives to risk-taking after the fact, it will encourage our civil society to live in a permanent state of near collapse. That is not productive.
As you wrote, the government does have a necessary and vital role in regulating capitalism–but only insofar as market failures are concerned. For example, it is widely agreed that governments ought to preserve wilderness areas, because privately-owned wilderness has inherent free-ridership problems. Externalities like smokestack emissions would increase without collective oversight. Patents are provided, again because of free rider problems, and so on.
But when persons use the free market as it was intended–taking risks, innovating, trying to enrich their own interests–and fail, the government has no legitimate role to play. Let risk-aversion regulate the market, and let legitimate free-market losses reinforce and clarify each individual’s choice.
I am relatively risk-averse. I set an aggregate target for for growth of equities and real properties (I am quite pleased with inflation plus 4%), and then plan a retirement around that modest target. I do not overreach, and I have missed fantastic opportunities because of it–but I sleep like a baby at night. And I am liquid enough that when opportunity presents itself, I will be able to adjust–along with weathering serious economic downturns.
If the government takes actions, after the fact, to bail out the folks who have “acted rationally” and leveraged themselves into inextricable losses, what message is sent to me, a net saver? That savings and prudence are the real risks? I hope not, for all of us who believe that rules are rules for a reason, and that changing them after the fact just brings us a few steps closer to the mob–the state of nature in Hobbes’ way of thinking.
Great article! But as I noted before, back in the 80’s when the prime lenders realized a growing mkt. in “creative financing”, and these “sub-prime co’s” were relaxing U/W guidelines to reach out to a broader base, (mostly self employed), the smell of $ was overwhelming! The alternate doc programs back then had required legitimate, verified assets, equity, or other forms of documented verification to insure pmt. As the influx of these “underground income clients” wore down U/W requirements further, and further, till we had very little information on the borrower, and what info. we had, did not have to be verified! What investers did with the pkg. of these loans,was nothing less then criminal! But you have to start at ground level, originations. Major sub-prime lenders emerged creating their OWN guidelines. To obtain a greater share of the market, competition demanded these new type of lenders to relax qualifications even further. As an U/W in the 80’s for a major bank, I witness first hand, and I, and my co-workers warned the powers that be of the impending forclosures. In the mid 90’s it was clear that lenders answer to the rising buybacks was to re-fi these loans again with even less U/W guidelines. If that was not bad enough, we even created NEW programs to get clients to qualify. In order to sell these loans we increased the rate to the client. The inflation of the market value can be directly linked to the greed of all concerned in the selling process. That being said, denial of the situation that exist now, and not addressing it, will only delay a crash with even more impact on our economy. Now is the time to get back to basics. We need to identify, and acknowledge sub-prime was a mistake! That we are in the bussiness to finance homes that the public can afford, and keep! It’s that simple! Don Stephens M.C.A.( Retired )
The problem is that someone is going to have to pay the piper, and, typically, it is the middle and perhaps now, the upper middle class. The super rich will avoid the carnage, via insider knowledge or manipulation of the tax system. For an enlightening read, please take a look at Perfectly Legal by David Cay Johnston. Interesting discussion of how the tax system works. This will be vital to understanding the coming waves of financial insolvency that will rock the U.S. and world boats. BTW, Johnston is a Pulitzer Prize winning reporter for the N.Y. Times. The book is not a polemic, but a fact based analysis of the system. I ran it by my brother in law, a very sharp CPA who works with the L.A. wealthy, and he confirmed that the information is correct. So, the question is, how are the losses going to be amortized over the masses? Either higher taxes to bail these fools out (a la the 1980’s and the S&L “Crisis” that allowed the masses to bail out the wealthy via taxation) or print more $—- also known as inflation. BTW, I’ve been a real estate broker for over 30 years and all the old timers I know, both lenders and brokers, couldn’t believe what was going on. Look to Greenspan and Company for explanation for ruinously low interest rates for too long a time. What I find interesting is that all those hedge fund people making tens of millions (the poorer ones) and up couldn’t figure this out, but still kept feeding the furnace of demand (aka their clients) with these faulty lending instruments. They didn’t know? Come on.
Good read, Doc.
Read this for a good take on the Ratings agencies role in this debacle (tips to Depew at Minyanville).
https://image.minyanville.com/assets/FCK_Aug2007/File/einhorn_%5B1%5D.pdf.
Research the present bill offered by Chairman Frank in the House. In part, it offers to let homedebtors who can “prove” they never had the ability to pay on a loan – the right to recoup every nickel they paid in interest AND principal for said loan. For example, if they had a stated income loan. Hmmm. Think that might be ripe for abuse? Some of the data suggests that for certain periods in 05 and 06, Countrywide let 91% of their PayOption clients not have to prove income.
People liked the 100% increase in “value” because that money came from someone else. They hate the 50% downturn in “price” because that comes from them. So long as it’s OPM, sure, it’s all good – but when it’s your own money? Squawk!!!! Let the government bail me out!
Debbie, very good questions. I’ve wondered the same thing.
Basically, if we let it all implode, including foreclosures, everyone’s 401K (including mine) dropping due to all funds getting hammered by this, everyone’s home dropping in value, etc…. is it really so bad? I mean, here in L.A., I’ve seen homes go from 600K to 1.2M (on paper) over the last 3-4 years. If that home drops to 900 / 700 / 500K in the next 2-3 years, isn’t it really more of a return to how it should have been?
I’m probably going to lose my job a couple months from now because my employer has made several bad decisions (this is high-tech product development in an established company, not a risky startup or anything to do w/ housing). Where’s my bailout? I’m entitled!!!
I’m a strong believer in personal responsibility and self-determination. I’ll do what I have to do to survive & provide for my family. Unfortunately, I feel that most people want to ride the high times, and scream for subsidized relief when things go south.
I wouldn’t give up on proser just yet.
I think it holds a lot of promise, but from the inception it brought two groups of people together. The naive lender and the “liaing: borrower.
So far (over a year or so) I have been able to get slightly over my target rate of 9% by following two simple rules both derived from my reading of the current mortgage debacle…..
1.) build a profile slowly and steadily
2.) If the loan doesn’t make sense for the borrower, there is something they aren’t telling you.
Nice post.
You say you’re still positive on Prosper, but positive compared to what? Absolute gain? Relative to CDs?
Great questions and comments. You should watch this video for insight on the mentality of someone in the industry:
SIVs Explained: http://calculatedrisk.blogspot.com/2007/10/sivs-explained.html
It is a humorous take on what is happening. To address the question that this is too big to fail, just wait until the end of the video and listen to what is said. This pompous attitude of “well, we will go after your retirement†is actually laughable. The majority of Americans have nothing saved. In fact, a recent studied showed that the average net savings of Americans nearing retirement is approximately $50,000. And since people are living much longer, the remaining money will come from entitlement programs such as Social Security and Medicare/aid (which of course I will never see a dime of but that is another story). Unless Social Security invested in the mortgage markets, most people will not be impacted. Again the operative word is most but again this fear mongering from politicans and the media is comical; sadly a large number of our population buy into this. “I’m afraid they’ll go after my money!†“Well, how much do you have saved up?†“Nothing, but I’m afraid they’ll go after MY MONEY!†In fact, prior to the Great Depression only about 1 million people had a stake in the stock market and the country’s population was 100 million. So again, these people suffer from the ivory tower syndrome and have no idea of the issues that the lower to middle class of America are facing. They think their issues are the issues of all. In fact, they forget about who will benefit from this. Renters are okay. Those that bought homes prior to the bubble will be okay. New buyers will be able to purchase homes without absurd mortgages and qualify for funding that is connected to their income.
And keep in mind we already have multiple safety nets. First, the FDIC will protect $100,000 of your savings. The next issue is money market accounts which don’t have protection – another article I read talked about these people investing in subprime. Oh boy. The government is already helping here at least in savings. Next, you will only lose your home if you cannot make the payments. Well of course if you didn’t read the damn mortgage then guess what, you either pay the absurd payment or lose your home. You won’t be out on the street, you’ll simply rent. And lenders? Again, reread this article. I am no longer investing in Prosper because the returns weren’t appealing. I still have multiple loans outstanding and god only knows if people will follow through with their payments. Praying is normally not a good reason for investments to go up. Should the government step in and repay my defaulted loans? Of course not.
I still think Prosper is a great place for borrowers. Since most defaults occur in the first few months and I haven’t made a loan in a few months, my ROI looks to be around 7 to 11 percent. Not bad but nothing worth the risk; there needs to be better access to prospective buyers credit information (i.e., a FICO like report).
And by the way, some folks are starting to walk the plank for CFC:
http://www.ibtimes.com/articles/20071025/countrywide-cisneros.htm
Time to jump ship and fall on your sword.
Reports Suggest Broader Losses From Mortgages
“Every time economists and Wall Street executives think they have acknowledged the full extent of the losses from the meltdown in real estate mortgages, more bad news turns up.”
http://tinyurl.com/26y8z6
Buffett says mortgage ills might linger at least 2 more years
http://tinyurl.com/22xoyc
Do you want to know the definition of madness? Countrywide reports a loss of 1.2B and their stock is up 30%. Molizo is saying they’re well-positioned to take market share from companies exiting the martgage market. I cannot believe he can say that with a straight face!
Here in cali a lot of investors are buying now while the market is down or bad. Renting out and waiting for the market to get back up so they can flip everything. Buyers markets are perfect opportunities for investors. Take advantage my friends…we’re sitting on oil here.
real estate is always a good asset to buy. This market simply means that properties are “on sale”. When everyone i scared to death, thats when its time to strike. I doubt its smarter to buy when everyone regains their confidence and the “specials” are gone. Think about it this way, would you buy designer clothes for yourself before Christmas or after?
Is real estate dead? no. Is real estate on sale? YES. Time to go grab some deals.
The writing is on the wall. Every statement issued by the Government is amended later to reflect a downturn or change in something to reflect a worsening outlook. Now when I see anything whether its housing, finance, politics whatever I am immediately a skeptic. The lies to protect and cover their worthless hides are so thin now even thet don’t believe we are that stupid…..or do they? I would not buy anything for a few years. My own opinion.California prices to me are laughable but then I live in Boston so I am not laughing as much as I used to.
Question for RichDad411:
How do you plan to finance all the “deals” you’re going to do? How do you plan to handle the negative cash flow while you wait for the next buyer to pay you off? How will the next buyer finance his purchase from you? Assume that he needs to sell his property to buy yours; how will the buyer of his property finance the purchase. Remember, when your “deals” go up in “price” after you are somehow able to finance them, you must assume that they are not doing so in a vacum; other properties are going up also.
Yes, there will be some special “deals” that work out, but not most of them and many will be left holding the bag who bought at the first false bottom. Is it worth the risk that you might not be one of those special few who get lucky?
As a good friend of mine once said; “I don’t want the cheese, I just want out of the trap”.
Good luck, I’ve got a feeling you’re going to need it.
All I can really say is, that is a really hot picture. 😉
Incredible that lenders are still being so selfish about the whole thing. But then everyone is…
I just got a Real Estate Professional that has been specializing in Short Sales since the 1970s to do a 70 minute Audio Recording for my site, AnonRecordings.com
Each disc is only $3. On the recording he says that RE Agents can do great in this market, if they are actually WILLING TO WORK.
This richdad dude is certainly not the richdad who’s written the book.
In fact the author’s opinion is that we are in so much trouble and there is no much worth considering in the insane market, you’d better keep more cash and wait for the people like the 411 like pretenders lose out on his negative cash flow and buy his property for much less. Just go read his yahoo finance comments.
Rock on my friend 411.
Doc- I’m glad to see you know of Prosper. I’ve been a member for a year and half and have done very well. My “secret” is only loaning to people who don’t have any current delinquencies, and less than one in the last seven years. No matter what they’re credit score is, the best way to judge people is on their past behavior. The other thing is to keep your investment there reasonable. I only have about $2,000, but am making 16% after defaults (one).
I agree, there are many similarities to the current credit debacle. It really comes down to greed in a lot of cases.
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