Subprime 2.0: this time it’s different… this time it’s crypto

Since I first started working in finance, the better part of a decade ago, I don’t think I’ve gone a single day without hearing about the 2008 financial crisis.

The financial crisis had a fair impact on many people’s lives, a big impact on our economy, a massive impact on financial firms and an astronomical impact on financial publishers.

So, I guess that’s why we hear and write about it so much.

From my own personal point of view, it had zero impact on my life, and zero impact on the lives of my friends and family.

However, I am constantly told that it actually did have a huge impact on me and my friends and my family.

It’s likely I’m simply not smart enough to understand how that crisis ruined and continues to ruin my life. But it could also be the case that it didn’t, and we simply write about it all the time because it influenced our business so much.

Like most things in life, I guess it’s all about perspective.

The reason I bring it up is because one of the main drivers of that crisis was what Investopedia terms the “subprime meltdown”. And thanks to a recent development in crypto, we may be about to take that whole subprime meltdown ride all over again.

How the subprime meltdown ruined our lives

Before I get to the new crypto subprime situation, let’s just have a quick recap of the subprime meltdown.

If you’ve watched the film The Big Short, you’ll already know all this. That film explained the whole thing in the space of about five minutes. But in case you haven’t seen it, here’s a much less flashy explanation, courtesy of Investopedia:

Following the tech bubble and the economic trauma that followed the terrorist attacks in the U.S. on September 11, 2001, the Federal Reserve stimulated the struggling U.S. economy by cutting interest rates to historically low levels. As a result, the housing market soared for several years. To capitalize on the home-buying frenzy, some lenders extended mortgages to those who could not otherwise qualify for traditional loans because of a weak credit history or other disqualifying credit measures. This period even sparked the NINJA loan: no income, no job, no asset – no problem, money was easy flowing. Investment firms were eager to buy these loans and repackage them as mortgage-backed securities (MBSs) and other structured credit products.

Many subprime mortgages were adjustable-rate loans with reasonable interest rates but could reset to a dramatically higher interest rate after a given period. And they did when credit and liquidity dried up during the teeth of the Great Recession. This sudden increase in mortgage rates played a major role in the growing number of defaults, starting in 2007 and peaking in 2009. Significant job losses throughout the economy did not help; as many borrowers were losing their jobs, their mortgage payment was going up at the same time. Without a job, it was nearly impossible to refinance the mortgage with a lower fixed rate. The ensuing meltdown caused dozens of banks to go bankrupt and led to enormous losses on Wall Street and hedge funds that marketed or invested heavily in risky mortgage-related securities. The fallout was a major contributor to the lengthy economic downturn that followed.

So, basically:

  • Super low interest rates drove people away from savings accounts and into the housing market. Since you could borrow at basically zero cost, why would you not get yourself a house?
  • Mortgage lenders were giving out mortgages to people who had bad credit, low incomes, and no savings – for no money down.
  • These mortgage debts, along with higher quality mortgage debts were packaged up into income-paying investment products.
  • Those investment products were given high ratings by agencies and sold to pension funds, hedge funds and all manner of other institutions and investors.
  • The housing market began to falter and so did the economy.
  • Mortgage rates went up, house prices went down and people started losing their jobs. So many of those bad mortgages were defaulted on.
  • The debts were called in, the people couldn’t pay and the packaged up investment products collapsed, along with a number of financial institutions and the economy.

At least, that’s roughly what happened.

Why the subprime meltdown was so bad

One of the reasons why the whole subprime affair was so bad was because the borrowers ended up so far removed from the original banks they were borrowing from.

To quote Investopedia again:

Residential mortgage-backed securities (RMBS), in which cash flows come from residential debt, and collateralized debt obligations (CDOs) were effectively removing the lines of communication between the borrower and the original lender. Suddenly, large investors controlled the collateral; as a result, negotiations over late mortgage payments were bypassed for the “direct-to-foreclosure” model of an investor looking to cut his losses.

So instead of the borrowers being able to negotiate deals when they got into financial difficulty, they were simply foreclosed on.

They had no one to negotiate with or talk to, they were just a number in an investment vehicle.

Humans became for far removed from the process that banks even began foreclosing on houses that never had a mortgage.

I write about this phenomenon last June:

In 2009 a retired police officer and his wife bought a house in cash.

In 2010 they were informed Bank of America was going to repossess it.

They called and wrote to Bank of America explaining that they didn’t even have a mortgage and owned the home outright, but to no avail.

As the proceedings progressed they hired a lawyer, went to court and eventually Bank of America backed down.

However, they were still out of pocket by $2,534 in lawyer fees. As is usual in these kinds of cases, the court ordered Bank of America to pay the couple’s fees.

But the bank ignored the court order.

So after five months of calls and letters by the couple’s lawyer, they decided to repossess the bank.

They legally foreclosed on Bank of America and turned up at the local branch with a bunch of police officers, the media and a removal truck.

Within an hour the couple had a cheque from the bank for $5,772.88 to pay their legal fees and additional costs.

It’s a crazy story, but it goes to show how ridiculous the situation got.

Will crypto-powered mortgages lead to subprime 2.0?

Fast-forward to today and we have a big announcement by a firm called Fluidity.

This summer, Fluidity is launching Ethereum-powered mortgages.

From Fluidity:

“We’ll tokenize the house, which will effectively take the collateral that is the equity of the house. You’re pledging the house and you get an advanced rate back in terms of dollars.”

Sounds pretty cool, right? Other than the fact is has that same issue of separating the borrowers from the people they are borrowing from.

Still, it sounds pretty cool. At least it does, until you find out more about how it will actually work.

From Coindesk (emphasis mine):

In short, borrowers will need to submit online credit checks and personal information just like any other online loan platform. Fluidity processes the information and creates a smart contract with a tokenized representation of the mortgage. Lippiatt said these loans could then be packaged together and resold as securities through an exchange like AirSwap.

In his view, underbanked and low-income borrowers who are able to make repayments represent a prime opportunity for such loans.

“The whole portfolio will be a composition of a bunch of different loans,” he said. “We’re looking at methodologies by which we can deploy [underwriting] more algorithmically.”

DeFi smart contracts will provide theoretically auditable records, plus Lippiatt said Fluidity plans to offer cheaper rates than banks. Still, the process itself offers the borrower a quasi-traditional mortgage. It’s the issuer and subsequent traders who gain the most functionality from this blockchain system.

Okay, so they are going to offer cheaper rates than the banks to low-income borrowers who don’t have bank accounts. And they are then going to package these loans up and resell them as securities.

I actually can’t believe what I’m reading. This is like an extreme parody of what caused the subprime meltdown and subsequent financial crisis.

And it’s being billed as a good thing!

It seems highly unlikely the people creating these products have no knowledge of the whole subprime meltdown. But if they did, surely they wouldn’t be going about this in the way that they are.

Don’t get me wrong, I think tokenising assets is a great idea, especially tokenising stocks and bonds. I’ve written about that many times. And I’m certain it is going to happen – and much sooner than most people realise.

But tokenising (arguably bad) mortgage debt, packaging it up and reselling it as securities just seems utterly stupid. Surely that’s just summoning subprime meltdown 2.0.

Let me know your thoughts: harry@southbankresearch.com.

Until next time,

Harry Hamburg
Editor, Exponential investor

PS As we’re on the topic of crypto, don’t forget Sam Volkering is holding his latest crypto briefing this Tuesday. In it, he’s going to share two crypto plays that could turn £50 into as much as £10,000. Yes, really. To find out more and get your name down to watch, follow this link now.

Category: Cryptocurrency

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