Professor Elam

2 responses to “Lehman Exits the Sub Prime Business”

1. 

   jerry

   August 29, 2007

   BW writes: “[T]here is a growing gap between mortgage assets and the capital needed to support them, according to Fox-Pitt Kelton analyst Paul Miller. That’s because by de-leveraging, banks and other finance companies have to sell mortgage holdings at a discount.”
   Would you mind explaining the “leverage” concept? I’m not understanding this part of the atricle.
   Thanks
   Jerry

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2. 

   Dennis Elam

   August 30, 2007

   Good question Jerry. This is another example fo taking the original idea too far. Just like eliminating down payments and principal payments leveraging removes the original safety net.
   Leverage is the use of debt to magnify earnings. For example, let us suppose we run a car lot. And we own the cars ourselves using our own money. We sell say ten cars a month and make $300 per car for $3000 net income. Now we employ leverage. We borrow money to finance and hold twice as many cars as we normally have. If we sell them we make $6,000 less the interest on the loan. So we are now making more money than if we had not borrowed or employed leverage. This is fine, assumeing of course, we can sell the cars. If we can’t sell the cars and the loan is called, we will have to have a fire sale to come up with the money. This is happening right now on car lots come to think of it. With too many 2007 models, and the2008s coming off the line, GM Ford and even Toyota have gone to 0 % financing to induce buyers to take the cars off their hands.
   The same thing happened in the sub prime mortgage market. Normally one would lend money on say ten houses, sell those loans in the mortgage market to investors or insurance companies. Then with the cash in hand, we make ten more loans again. Well why be satisfied with the income on ten loans, let’s crank this game up! In the hady atmosphere of new metrics and fancy math models that claim a new paradigm is possible, let’s not just borrow double or triple let’s borrow say ten times the amount of the mortgages we sold to go loan ten times as many! Whoppee, as long as we can keep the game going, the balls in the air, the homes keep selling, the mortgages keep getting bought, we will make ten times our normal profit. And hey we are a smart hedge fund with no regulation. Ain’t this fun, and we can take even more investor money in to do it! but like the juggler there is a limit of just how many balls we can put in the air. If the homes stop selling because folks all ofa sudden can’t make their loan payments when higher interest adjustable rate mortgages kick in, whoops, now the investors are not getting paid on their mortgages and are looking to us to make them good. Well this is no fun. This is when Bear Stearns could not pay off their investors. Like GM and Ford, all we can do is start selling the mortgages, or cars in the GM case, for whatever we can get. Get a copy of the Sat morn Dallas paper and look thru the new car ads. They are discounted by the factory and the dealer, they are zero percent, they are beggin you to take the cars off their hands. The same thing is happening in the mortgage market. The mortgages have to be discounted to find buyers. This is why the FED has flooded the markets with liquidity. There as to be enough money available to re finance the mortgages that are being sold because ten times leverage canot be employed. And so when the mortgage is discounted the seller may be and in fact will be losing money.
   We had a market meltdown in CFC Countrywide Financial as investors doubted CFC could get the money to finance all the mortgages in their pipeline. And so CFC dropped from 42 to less than 20 as other lenders simply closed their doors.
   And of course the problem was not solved with a few loans and a drop in the overnight lending rate. Their are billions more mortgages out there with adjustable rates that will be raised.
   September and October are justifiably famous as bad months for the stock market. This year should be no exception.

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