September 4, 2010

An oldie but goodie: "What Ever Happened to It’s A Wonderful Life?"

What Ever Happened to It’s A Wonderful Life? by Kent Hickman, finance professor at Gonzaga University.

"In It’s A Wonderful Life, Jimmy Stewart runs the family savings and loan business. His financial institution made money the old fashioned way by paying depositors interest and lending the money out at a higher rate. For example, by paying 3% on deposits and making home loans at 7% Jimmy could make about 4% on deposited funds. In this simplified example, over the life of a 20 year home mortgage, he would expect to earn about $4,000 a year on $100,000 worth of deposits. The bank also earned $1,000 in fees when the he first made the loan. Because his bank knew that it might need to hold on to the home mortgage for twenty years, Jimmy would only lend the funds to folks who had a job and weren’t already deeply in debt. Even then, he would only loan up to 80% of the value of the home just in case the house had to be sold in order to repay the mortgage. It was called prudent lending and although it wasn’t terribly profitable, it was safe.

Now let’s introduce something new called financial innovation. Modern-day Jimmys found that they could sell the $100,000 home loan to a third party. This enabled the same $100,000 deposit to be lent again, then sold again, on and on, each time earning $1,000 in loan fees. Now, rather than earning $4,000 or $5,000 in a year using that $100,000 deposit, the modern-day Jimmy could earn $12,000 by making one loan a month and just re-selling each loan and collecting the fee. Soon the business was very profitable, far beyond what Jimmy or Frank Kapra could have dreamed of.

It is easy to see that the way to make even bigger profits is to make as many loans as possible, perhaps one a day using that same single deposit. Where can Jimmy find enough homebuyers who qualify using his prudent lending standards? The answer is that he is no longer concerned with those standards because his bank is not going to hold on to the loan. The safety of the loan is not Jimmy’s concern; it is the problem of the investor who buys the loan from him. And the modern-day Jimmy also found a way of alleviating the fears of those investors about the quality of the loan by using credit default swaps. These are insurance policies on the loans. Jimmy can buy these policies in the unregulated derivatives market. With these, Jimmy can be assured that investors will buy all those loans he is making because they know the loans are guaranteed by the swaps.

Jimmy has created a money machine. He can make loans to almost anyone and sell these loans because of the credit default swaps. His bank is so busy that it actually hires extra people and opens offices all over the country to make as many loans as possible. His employees are paid based on the volume of loans they make. So, naturally, some of his lenders are even forgetting to ask their loan applicants if they have a job.

No one has any worries. The bank is so profitable that every year Jimmy is paid a huge bonus. Jimmy’s employees are making a lot of money, too. There is a lot of demand for houses because anyone can now afford a house, so house prices skyrocket. Because house prices are going up and up and up, Jimmy will loan homebuyers 100% of the purchase price of their houses. There is no reason to worry because in a month or two the house will be worth a lot more than it is now. Investors are making a good return with the mortgages that they bought from Jimmy and they can sleep soundly at night because these mortgages are insured with credit default swaps.

Someone asked Jimmy if he was sure that those credit default swaps were really a safe guarantee, “…you know, just in case?” Jimmy responded, “Don’t worry, I bought those from one of the biggest and most famous investment institutions in the country.” Jimmy went on to say that the financial institution that was behind the insurance had assets worth hundreds of billions dollars.

Then something bad happened: Oil prices went up and interest rates went up and people could not afford the higher payments on those home loans that had adjustable rates. Homeowners started to sell the houses that they could no longer afford and house prices fell. Now that those homeowners weren’t able to make their interest payments, the investors who had bought Jimmy’s loans tried to collect on the credit default swaps from the famous financial institution. The trouble was that those hundreds of billions of dollars of assets that the famous financial institution had backing up their guarantees were also home loans that someone just like Jimmy had made…

So, that is what happened, more or less, in the epilogue to It’s A Wonderful Life By the way, like the original movie, everyone gets to chip in and bail out the bank, but in this case our Jimmy is not weeping by the Christmas tree. He’s been fired and has left town. We are left to do the weeping while Jimmy is sipping 20-year-old Scotch at his estate in Westchester County."


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