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Originally Posted by KC Jones
Excellent post 
However I would add a 4.5 in there...
4.5 These securitized debts (repackaged into investments that could be sold), were then leveraged into credit derivative swaps. I seriously don't know what the **** that really means despite reading about it, but as far as I can tell it's a side bet placed on whether or not the original debts will be paid. However we allowed side bets worth far more than the initial debt. So maybe you had 50 billion in actual mortgage debt out there, but with 500 billion in side bets on whether or not it would be paid. AND these finance wizards BORROWED to make these side bets. |
mmm....securitizations are perfectly valid lending arrangements. Swaps are generally designed to limit risk, not increase exposure, but maybe there is a nuance there that goes beyond what I know.
Securitizations packages are in their simplest form not all that complicated.
Let's say that you start a hardware store. It grows into something big -- a chain. You want to offer your customers a credit card because they're profitable for you to run. Here's the problem -- your customers are buying your stuff and walking off with the goods, but all they have given you is a promise to pay in return. And the promise is that they will pay not tomorrow, but within 30-60 days, on average.
So a guy buys a hammer and pays you in 60 days. Fine. But now you're down a hammer, and of course Stanley or whoever made the hammer expected to be (and was) paid within 30 days of selling you the hammer 6 months ago. So first you had to carry it on your shelves for 5 more months without getting paid for it, and now you hav eto wait up to another 60 days before you're going to get paid for it.
And -- oh yeah -- now you need to get another hammer from Stanley to put on the shelf to replace the one you sold, and you'll need to pay for THAT one within 30 days.
Multiply that by thousnads of hammers and stuff, and you've got a serious problem -- not enough money to cover all these costs while you're waiting to get paid for the stuff you've already sold. You know (and are correct) that you will make a profit on your credit cards if only you can afford all this.
So instead of waiting for 60 days to get paid, you get a loan to help you buy the new hammer and whatever else need while waiting to get paid. So what do you do? You collateralize the payment stream of all the credit card payments that are owed to you and take a loan against it all.
So you're owed $100K by all your credit card customers. You need money to restock your shelves. You borrow it. But not everyone has the same risk tolerance, and not every dollar owed is able to be borrwed at the same rate.
Using random number (I don't know the actuals), Bank A, which doesn't like risk, says "I will loan you $20,000 against the first $20,000 paid to you by your credit card customers. Because I get paid first, it's a low rate loan. I will loan you the money at 5%".
Insurance Company B says "well, I don't like risk much, but I can handle a little. I will loan $30,000 and be second in line behind Bank A. The loan will cost you 6%."
(total of $100K in receivables now has $50K of loans against it)
Insurance Company C says "risk isn't bad, and my portfolio is too boring anyway. I'll be third in line, for $20K, but the rate is going to be 7%."
Weird Lending Company D says "risk is great, but I learned all I know from Louie the Legbreaker. I'll loan you $20K, but the rate is 9.5%."
The last $10K -- nobody will loan against it. It's yours and yours alone. So now you can take loans of up to $90K to restock your shelves, pay a carrying cost and you're good. The late payments and other charges on the credit cards should about cover or exceed the interest rate payments you need to pay to your 4 lenders.
3-5% of your borrowers will default, so that money is lost, but overall, it's all good and profitable, and instead of paying 5% or whatever of your sales to Visa or MasterCard, you can issue your own credit cards and keep some of those profits.