Gain on sale

In 1998, ten years before the mortgage crisis hit the country, there was a mini crisis of the same sort that should have been a warning of things to come but was largely ignored. There is an old saying that love is blind but this episode assures us that love of profits is just as blind. Throughout the country there were small family owned mortgage lenders who specialized in high risk loans. They stayed in business by require large 50% down payments. Applicants with that type of cash and poor credit were not easy to find so these companies spent lots of time and money searching for eligible prospects. They looked for people without a credit history or people whose incomes were irregular because they were paid bonuses based on performance or seasonal business. Like all mortgage lenders as soon as they closed a deal they used the new found down payment money to finance the next loan. Beside the large down payment these companies hired their own appraisers so they could be sure the value of the property had not been tinkered with. In order to expand they needed more cash to make more loans so they combined the loans they had into bundles and sold them to investors. Sound familiar as this practice of securitizing loans would become the basis of the toxic mortgages that nearly brought down the country. Finding investors to purchase these bundles was labor intensive and costly so these companies began to look for other sources of cash. To the rescue comes Wall Street in the form of Bear Stearns and Lehman Brothers. These firms were willing to provide the cash since they could get interest from their cash and fees generated by the loans. They further envisioned incorporating these mortgage companies and selling stock in them thus generating additional fees. In those days there was an accounting rule called gain on sale which meant you could count as an asset the expected return on a loan over the life of the loan. It was left to the discretion of the mortgage lender to determine how much this would be and you can guess what happened. They projected the rosiest possible outcome. Next they expanded the concept to car loans and the race was on. Profits were pouring in and the business was growing faster than anyone had predicted. You could now buy a car, new or used and finance it on the spot. Don’t worry about the payback of the loan just make the sale. Then came the unexpected. In the summer of 1998 Russia had to devalue its currency and the whole house came tumbling down. Within a year most of these mortgage companies were bankrupt and as the dust settled the survivors began gearing up for the next big game, which would culminate ten years later with the big mortgage crisis that we are still suffering from and it looks like the survivors are once again getting ready for round three. Too big to fail is now too too too big to fail so the next unexpected problem should be a dandy.