Lenders Lend — Are You a Believer Yet? — Altered Circumstances Changes Behavior

by Jeff Brown

Real Estate Investments Broker

Author website

What constitutes real knowledge? By real, I mean knowledge that is truth, not logically provable by means of rational debate.

If that sounds ambiguous, let me focus the picture a bit.

After the 1927 real estate collapse, the infant Federal Reserve Board decided the best course of action was two-fold in nature. Constrict the money supply, and raise interest rates.

They arrived at that strategy, one which in hindsight would seem to have caused (or at least exacerbated), instead of avoided the Depression, by means of rational debate, logically put forward. We can assume they thought it was clearly the right thing to do. Put plainly — they weren’t trying to cause the Depression.

They were tragically incorrect. Their logic was akin to ‘proving’ the world is flat, which was rationally believed — and logically, God forbid, scientifically proved — for centuries.

How might history have been altered, had the Feds flooded the banking system with cash while simultaneously slashing interest rates? Again, logic tells us they’d have more likely than not, avoided the Depression.

In reality though — we don’t, rather we can’t know that. We can convince ourselves by virtue of the last 80+ years of experience since then — but in the end, we just don’t know for sure.

The Wall Street Journal is now reporting the Treasury Department is in the late stages of negotiations with major lenders to avert next year’s tsunami of interest rate adjustments on over 2 million sub-prime loans.

I’ve been telling anyone who’d listen, for over a year now, lenders were simply not gonna foreclose on hundreds of thousands of homes. The thought itself is ludicrous. The Wall Street gang(sters), better known as either Bears, or one-way @$%^&#’s, are gonna be beside themselves when this is announced. So many of them are invested in bad news — in the most literal sense. They need the economy to tank, at least a little. They’ve shorted everything but their four martini lunches. 🙂 For many of them, good economic news is now bad.

Many other Wall Streeters will be elated by this news. The Bulls for instance. In fact, it may be this agreement that acts as the final straw for beleaguered Bears. They may now throw in the towel, or as I said here, finally blink.

Staying on point, the Bears apparently used logic in assessing the future of all these loans.

They concluded lenders would stand idly by while hundreds of thousands of their loans were bound to go belly up? Apparently, they did.

They bet lenders and their investors would behave against their own best interests.

It’s reminiscent of the many times federal income taxes have been significantly cut. There are two distinct schools of thought when it comes to the results of income tax cuts. One treats it as a zero sum game. Lower taxes equals less money collected — period. The other takes into account human nature and therefore human behavior. One says, and proves on paper the world is flat. The other, backed up by empirically documented results, proves the world is round(ish).

Every time income taxes are reduced the two schools pull out their swords and go to battle. It becomes very complex, which is unnecessary, because the results are so easily documented. You’d never know that though, because the zero sum school have hidden (or so they convince themselves) agendas which are violated by lower taxes.

What’s happened every single time income taxes have been cut? Actual dollars collected by the Treasury Department increased — and yes, adjusted for inflation. The three most recent examples are the Kennedy tax cut in the early ’60’s, the Reagan tax cuts in the ’80’s, and the Bush tax cuts a few years ago.

In each case, the Treasury Department reported increased dollar amounts collected as the cuts were implemented. The question though is why? The answer is the same as why lenders will probably go for this ‘voluntary’ interest rate freeze on sub-prime loans.

Human beings tend to behave in a manor protective of their own interests. I’ll pause here so you can make note of that incredible pearl of wisdom. 🙂

When the ’80’s tax cuts were implemented, the top marginal rate was, OMG!, about 70%. It was cut by more than half. Geez, I dunno. Ya think you and I might be more inclined to work harder for more money, if we actually get to keep some of it? Back then, the California top marginal income tax rate was over 11% if memory serves. That means, gulp, once you arrived at the top of both tax schedules, you were allowed to keep a whole 19¢ after taxes. Let’s see — go to work for 19¢ on the dollar, or do something else with my time? Please don’t say the rich never paid those taxes, because the incomes to get to that point weren’t as high as most folks think. In fact, if you live in California today, you’re at the top rate way before you ever reach even $50,000 income.

We, as human beings, behave differently under different circumstances. Another pearl. 🙂

The Treasury Department may never arrive at an agreement with lenders and investors. I’m bettin’ on it though. We’ve all had to swallow tough pills in life. For lenders and their investors, this is surely a bitter pill. I believe they’ll swallow it voluntarily.

Let’s pretend you and I are partners, and have invested (loaned) $50 Million to homeowners, all of which are sub-prime. Our choices, very soon, will be clearly defined. We can 1) Go along with the proposed agreement and keep receiving payments on initial and/or teaser interest rates OR 2) Stand tough and let the default/foreclosure chips fall where they may — guaranteeing the erosion of our originally invested capital.

#1 keeps us going while both significantly (hugely) reducing the number of defaults/foreclosures in the next year — therefore preserving much more of our originally invested capital.

#2 almost guarantees we’ll have tremendous losses through missed interest payments and actual loss of invested capital. Not only that, but we’ll ensure insult to injury because of all the extra costs involved in selling the foreclosed properties.

The underlying principle remains: Lenders LEND. Threaten that and they’ll figure a way. This agreement, if reached, will not only give them a way to keep lending, but will give them cover by allowing them to appear somewhat altruistic. Without this agreement, once the foreclosure tsunami hits, they won’t be lenders any longer.

They won’t allow that to happen.

Here’s an afterthought. There have been some Wall Street types who’ve recently adopted the strategy of buying sub-prime loans in large packages at significant discounts. The sellers of these loans had to think the discount was better than holding them and risking all the losses from defaults/foreclosures. If this agreement with the Treasury Department is reached and widely applied, those who executed this strategy will realize huge returns.

Maybe they relied on the axiom — Lenders Lend. 🙂