Mortgage Loans: The Greatest Scam on Earth?

Let it be clearly understood that I mean to say mortgage lending is a conspiracy only to the extent that the lending institutions do not provide full disclosure up front. It is not a conspiracy to the extent that there is deliberate cover-up and deceit and misdirection for the purpose of hoodwinking you. After all, mortgage lending is legal by suitably accredited lenders.

You no doubt think that when you apply for and receive a mortgage loan, the lender takes the relevant sum of money from his reserves and hands it over to you on your signed promise to repay the money over an agreed period with interest added so as to cover the lender’s losses from not having that sum at his disposal to invest or use as he sees fit.

The above, while it sounds reasonable and realistic, is not how it works at all. In terms of GAAP (= generally accepted accounting practice), it would mean that in order to cover the credit you get from your mortgage loan, there would need to appear a debit in the same amount somewhere on the lender’s books. Instead, all that you will find in those books is a credit in the amount of the mortgage loan agreement’s nominal value. That is, the current total value, including all interest, of your loan agreement over its contractual lifespan, as signed by you and the lender’s attorneys.

This sounds like a huge magic trick by the lender.

And it is.

Like all good magic tricks, it relies on the audience not knowing exactly how it works or what’s behind it.

What really happens is that the “money” to cover your loan effectively comes into existence from nothing the moment you sign that mortgage loan agreement. That’s because that agreement becomes contractually binding on you as soon as you sign it, and is a legally binding promise by you to pay X amount each month for Y years, i.e. you obligate yourself to be a revenue stream for a total amount Z spread over Y years. Your contractual payment promise has value to whoever owns that signed promise, even though you still need to earn every cent you have promised to pay. That is, you sacrifice a part of your future to cover a current desire.

Remember our banknotes? They used to carry the following message signed by the incumbent Reserve Bank governor: “I promise to pay the bearer on demand at Pretoria X Rand.” (What exactly will the Reserve Bank redeem the note with? Another X Rand note.) It’s the same basic idea: The bank note is a promise to pay that gets passed along, in turn accepted for value by each recipient. It’s not actual payment, just a symbol of it.

And the idea that the Reserve Bank is the ultimate source of the lent funds is equally mistaken. The Reserve Bank is nothing more than a short-term buffer to cover lenders’ fiscal needs.

But I digress, so back to our mortgage lending process. Once you’ve signed that all-important loan agreement, what the lender does next is where the real trickery hides. The lender takes your agreement and bundles it with several others of the same kind according to expected risk profile (typically in bundles of a hundred or so) and sells these bundles on to external investors at less than their nominal (or face) value. This step is called “securitisation” and is a non-reversible transaction in most countries, including SA.

To clarify with some actual figures: Suppose your mortgage loan is for R1,000,000.00 over 25 years at an annual interest rate of 10% with inflation running at 6% p.a. Your monthly repayment will be about R9012.00 over 300 months, which makes the nominal value of your loan agreement R2,703,600.00 over that period, and its net present value (i.e. in today’s money) would be about R1,402,000.00. The lender sells your signed agreement to the external investors for, say, R1,200,000.00 and so not only covers your R1,000,000.00 debt but also makes a cool R200,000.00 profit without having done a stitch of actual work besides shuffling a few papers around. The investors got a cool deal because they have a virtual guarantee that, having spent R1,200,000.00, they’ll receive over R2,700,000.00 spread over the next 25 years, the net present value of which is about R1,400,000.00.

And that, in a nutshell, is the scurrilous practice of mortgage lending where the only loser is the borrower. As a test, you can ask your mortgage lender to show you the original signed wet-ink documents. They will give you an endless run-around because they no longer possess them.

'Luthon64

Remember our banknotes? They used to carry the following message signed by the incumbent Reserve Bank governor: “I promise to pay the bearer on demand at Pretoria X Rand.”

In the old days we were on the gold standard so the money was backed by something but now it is worth what some traders think it's worth. I don't think they would have paid you in gold but at least there was something solid behind it. Now it is just numbers on some computer. Back to the mortgage. You need a place to stay and were I stay I don't think it pays to rent. The rent is close to a mortgage amount and if you buy at least you have a (old) house by the end. Seems to me you get screwed no matter what!

Mefiante
Have a look at the documentary called “inside job”. It was narrated by Matt Damon. Extremely insightfull regarding the context of your post.

Hmmm… I have to admit, finance was never my Strong side and I never heard of Securitization before. Cool topic and some mind blowing concepts.

I would love to know, based on this model, who carries the risk if there is a default on the loan? I pay the bank, every month, for my bond (sometimes extra), so if I cannot pay anymore who looses out? The Bank or the entity providing security?

If they sell my R1,000,000 bond to an external party for R1,200,000 but a year down the line I inherit alot of money and decide to settle my outstanding bond for R1,100,000 - that means someone has lost R100,000?

Now I remember why I didnt take accounting past High School…

How the system came about and why it breeds recurring financial disasters.

Pravin Gordhan comments.

'Luthon64

Yes, but lets say seller A with another bank has no bond and sell his house to buyer B and B borrows the money from bank C.
C transfers the money into A bank account. So C was debited and A credited. So that money had to come from some place?
and C must make a note of the debit transaction?

Apart from the fact that the “money” is really just a bunch of electronic ledger entries, the value to cover the seller’s price came ultimately from a group of investors, as described here in the part about securitisation. The point is that banks simply do not lend you money in the way that they would like people to think they do.

'Luthon64

Meh I’m still trying to understand it, it’s probably not that difficult to understand, think my mind just refuse to wrap all the way around it.

So this has really got to do banks being the only institutions being able to actually create money and it has something to do with something called the credit multiplier. The way it works is that banks are required by law to keep 2.5% of all their demand deposits at SARB, and the rest they can use for lending at higher rates. So one bank can take R1000 in demand deposit and of that R25 must go to SARB resserve and the other 975 he is free to lend out, so the guy borrows that money and pays a gal - the gal takes the money and deposits it and bank 2 now has to keep 2.5% of the 975 at SARB and lend the rest out, and so the cycle continues - in comes the credit multiplier which explains this:
R=2.5%D R is the Resserves and D is the demand deposits annd the 2.5% is the amount of all deposits that needs
Rx1/0.025=D go to SARB
40xR=(delta)D

so that means that the total deposits reflected in banks accross the country can be 40x higher than the actual cash resserves held at SARB

That’s from some old notes from my 1st year economics, and I’ve already forgotten a sizeable chunk of economics, but I nevver really did feel quite comfortable with the whole thing, still don’t, just can’t see that the whole thing will ever feel right to me, even if I do eventually understand it, I don’t think I will ever feel like I do |-O

So this has really got to do banks being the only institutions being able to actually create money and it has something to do with something called the credit multiplier. The way it works is that banks are required by law to keep 2.5% of all their demand deposits at SARB, and the rest they can use for lending at higher rates. So one bank can take R1000 in demand deposit and of that R25 must go to SARB resserve and the other 975 he is free to lend out,

I am no expert, but I feel I’ve read about this enough to say no, that’s not how it works at all. How I understand it is:

At your percentage of 2.5%: Instead of R1000, the bank can take just R25 and keep it in reserve. It can then “create” R975 with it, by borrowing it to you, then undo the “creation event” by selling that debt on the market. Of course, you borrow the money to pay someone. So they go deposit that money straight into an account somewhere. Bam, the bank has just freed enough reserves/gained enough new reserves to extend even more credit, and that’s how you get into that debt-creation cycle, where each R1 in reserve is used to create many times as much debt.

I think we’re both saying the same thing, and with all the mumbo jumbo, I think I’ve failed to make my point, you see out of that initial R1000 deposit and with the standard cash resserve requirement of 2.5% banks can create that “bam” R40 000 seemingly out of thin air and so put more money in the economy. I’m definitely no expert too and this makes no sense, or if does, I just don’t know if it’ll ever feel right to me

I’m not sure whether it’s the mathematical/statistical details that are foxing you or the economic principles that are in play.

Would it help to point out that the total current value of the global derivatives market is about 20 times the world’s combined annual GDP? If you think about it, the value of that market is actually a fiction because it can only exist, if indeed it ever does, at some point in the future.

The whole system is based on the idea of deferring payment, i.e. borrowing against a promise of the future (in the form of a contractual agreement) and that these promises are tradable commodities. Fractional reserve banking practice exploits this idea combined with two assumptions, namely (1) that the economy in which it operates is stable and will grow, and (2) that there won’t be any sudden runs on the bank that might exceed its reserves. Statistical models with empirical data as inputs can then be used to estimate the required size of the reserve fraction.

In short, it’s smoke and mirrors where we only ever pay the piper tomorrow, but never today because, well, tomorrow will always be better than today, won’t it? The system “works” because everyone participates in it to some degree.

'Luthon64

For info … just saw this doing the rounds, so can’t comment yet on this initiative’s value.
http://www.newera.org.za/class-action-lawsuit-against-the-banks/

Ten to one it’ll fail — on the principle of caveat emptor and because signed, legally binding agreements exist. The law makes little room for how a contract came about, only that it exists (on the assumption that the contracted parties were willing signatories), and banks are very, very, very good at pressing the point of contractual obligation without any regard for the fact that the contract was obtained in the absence of full upfront disclosure and/or via misrepresentation and/or a lack of ready/real alternatives. I think what needs to happen is that lending practices by the banks must first be tested successfully against the provisions of the Consumer Protection Act (in order to set the scene) before taking the step of testing them in common and constitutional law. In short, I think NewERA’s effort is admirable but aims too high, too soon.

'Luthon64

The papers have been served. The defendants will probably file a joint motion to dismiss with costs. If NewERA can successfully argue that, they’ll already have gotten further than one would have hoped, and it’ll be wait and see. The case, should there be one, could conceivably drag on for years.

'Luthon64

It seems the world is starting to catch on.

Banksters & their high jinks

'Luthon64

I knew it! My bank manager is not to be trusted. :o

A big step forward on the path towards exposing the underhandedness of banks’ credit practices.

'Luthon64