Think Like a Bank and Prosper
nFrom the 2005 magazine profile on Joseph and the FranklinSquires model:
Q: How can there be no risk?
Gabriel: You have to understand how to think like a bank. You see, banks do risky things but they manage their risk to near zero.
Everyone wants to be the banker. Koerber and Joseph realized that banks were making good money off investments, even risky investments. A bank wouldn’t really jeopardize its profits without being able to wrestle its risk down to near zero, right?
At his 2006 seminar in Provo, Koerber noted, “[Banks] collateralize investments with property, and loan officers never inspect a home before a loan is extended.” He added that banks don’t need to inspect homes because “banks have a mathematical formula,” to manage risk. For Koerber, the comparison was simple: banks made money off homes without ever setting foot in them; they used “formulas” and “balance sheets” and could then understand how to make a buck and not sweat the risk.
But since the onslaught of the economic crisis, banks have been in a sweat.
Barrett Slade, BYU associate professor of finance, sees the credit crisis as one that caught a lot of players—from consumers and small-town banks to Wall Street investment firms—in a deal that was just too good to be true. High returns from subprime mortgage-backed securities created a hot ticket while the market was sizzling, but the financial risks were underestimated.
The basics of real estate before the crash were pretty simple, Slade explains. First, an average bank originated a home mortgage with the customer. The bank then sold that mortgage to Fannie Mae or Freddie Mac, the government-sponsored housing assistance entities. Then the package went on to Wall Street. Investment bankers sold shares in a huge number of mortgages, pooled together to make mortgage-backed securities—the good, the bad and even the toxic mortgages.
Everyone now knows how this story ends, but some forget that when lending regulations and underwriting practices weren’t so loose, mortgage-backed securities were very beneficial. “Since their inception,” Slade says, “mortgage-backed securities resulted in lower mortgage-interest rates, which have made more homes affordable to more people.”
Problems arose, however, as banks sold mortgages to mortgage clearing houses, such as Fannie Mae and Freddie Mac. This made banks no longer responsible if the mortgage went into default. Soon underwriting standards slipped and lending regulations loosened as banks had less accountability for mortgages they were just selling to some other entity.
With lowered standards, riskier mortgages were slipping into Wall Street investment portfolios and posing as sure things. Things got tricky for the gatekeepers in this process—investment-rating agencies. They were tasked with rating the risk of mortgage pools, an effort that meant untangling an already complex ball of paperwork that might involve hundreds of individual mortgages from hundreds of families, each with its own unique financial situation.
The risks were there, but obscured by a robust real-estate market, Slade says. Now the various entities that used to look after individual mortgages were less accountable. If they sold the mortgages or the mortgage-backed securities up the money river, it became SEP—Somebody Else’s Problem.
Because standards had dropped, enormous loans were being made to consumers who needed only to fill out a little paperwork. Completing an application for a $500,000 loan became a mere formality, like signing up for a Blockbuster membership.
“As a result of poor underwriting standards, people could get a loan with little or no documentation,” Slade says. “This resulted in many individuals obtaining loans that were doomed to failure right from the start.”
Meanwhile, investors were making bank on shares in these toxic mortgages. While investors might get a reasonable 6- to 7-percent interest on investments in prime mortgage-backed securities, the subprime investments had a juicy 9- to 12-percent interest rate that was too tempting.
Meanwhile, home prices were becoming increasingly unaffordable as the market was flooded with speculative investment properties. These spec homes, which were stripped of equity and/or “flipped,” in turn flipped the market itself on its head. According to Slade, the problem with speculative investors is they believe home prices will always climb and that property can be sold again and again for a profit, or that equity can be continually refinanced and mortgaged and stripped out for liquid cash.
Utah, Slade says, sets itself up for real-estate bubbles and fraud. “That Utah has nondisclosure of real-estate transactions is one of the reasons why I believe the local real-estate market cycles so hard. I believe it is also one of the leading causes of real-estate fraud.” In other states, he says, real-estate transactions require affidavits that detail sales price, the parties involved and whether or not the parties are related as family—all critical information for sniffing out bad or fraudulent deals. In most states, these documents are backed up by criminal penalties for falsifying them; in Utah, records show transfer of title and little else.
With bad information, the “herd mentality” sets in. Businesses exploit loose bank regulations for speculative investments. “The herd can be created by Ponzi schemes,” Slade says. “It doesn’t take much to get the herd running, like when people find themselves chasing excessively high returns.”
When spec homes are overleveraged, without real value appreciating and the equity stripped out as liquid cash and invested, investors might make a lucrative profit. But when the investment stops offering returns (because the whole scheme eventually bottoms out), homes start going in to foreclosure. Repossessed homes are like real-estate plague, infecting whole neighborhoods and driving down home prices. Sellers can’t find buyers, as most buyers won’t buy until they know home prices have hit absolute rock bottom. The ripple effects are very damaging, especially when consumer confidence plummets, home construction drops off, spending shrinks and unemployment mushrooms. Case in point: Utah lost nearly 12,000 jobs between the fall of 2007 and the fall of 2008.
Koerber denies doing speculative investments. He says his equity milling doesn’t mean equity stripping. “Someone who is stripping doesn’t have any responsibility—it’s synonymous with flipping,” Koerber says. “They are trying to buy, then borrow all the equity out and move on to the next property. We tried to hold onto the property and continue to leverage equity and put somebody in the home and get profits in there for the long term.”
Koerber acknowledges equity stripping is the kind of speculative market gambling that helped cause the bubble but says, simply, that his company was in it “for the long haul.” He also points out that many of his homes were bought wholesale at cash value, which should have kept comparable home values low, thus deflating the bubble.
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