### Milkmaid Investments

December 07, 2007
– Comments (6)

... The milkmaid was carrying her milk in a pail on her head, daydreaming about how much butter she can make with the milk. She thinks that when she sells the butter, she can buy a lot of eggs. The eggs will then hatch into chickens. And the chickens will bring even more money, so she can buy a new dress... *While daydreaming she tossed her head scornfully, and down fell the pail of milk to the ground. And all the milk flowed out, and with it vanished butter and eggs and chicks and new dress and all the milkmaid’s pride. ***Never count your chicks before they are hatched...**

I am going to do a back of the napkin calculation of the type of loss an investor would have on a $100,000 mortgage that is to be repaid over 30 years. I don't claim to understand what has happened here, and I don't need to understand to have felt utterly ill that banks would have ever considered increasing leverage from 12.5 to 30 and that regulator would have allowed it to happen.

But, I am going to do some calculations on what I think has happened. The mortgages have been repackaged into bonds of sorts and from my understanding of bonds is that they don't sell at face value, but they tend to be priced to market rates. The average rate of these mortgages due for reset isn't the 1 and 2% teaser rates making the news, but 7% and they are resetting to 10 or 11%. I will use 10% for this analysis, but for ease of calculations I will assume after 5 years of interest only it goes to 10% where it has a 25 year amortization to pay it back.

From reading about the various state pool funds I've seen interest rates of somewhere between 5 and 6% so I will assume the mortgage bonds were repriced to give a 5.5% return to investors. The homeowner is paying 7%, but the investor has paid a premium for the bond so they are only getting 5.5%. The scam artist in the middle, aka the financial middle men who are to investors what psycho was to the woman in the shower (and the financial middlemen have about the same level of person ethics and humanity as psycho) have made a killing here.

Now, the homeowner would have borrowed $100k but the investor would have paid a premium for the bond because of repricing the mortgage to pay the investor 5.5% instead of the 7% and 10%. I am going to simplify the math here.

The income stream that the homeowner pays is $7k of interest for the first 5 years, or $35k of interest. When payments are priced at 10% that include reducing the principal the home owner pays about $909/month, or $10,908 for 25 years, or $272,700 plus the $35k for a total of $307,700. Here's where I simplify the math, I just assume 5.5% return over the life of the investment, so what would principal today be to get $307,700 paid out at 5% with a combination of principal and interest?

So, to pay out $307,700, easiest is to assume equal payments for 30 years, or about $855/month.

Omg, omg, omg, be still my heart, looking at this kind of thing amazes me. What I get is if you borrow $151,000 at 5.5% over thirty years with payments of about $855 you will have paid out a total of $307,700.

So, with these assumptions, the homeowner would have borrowed $100k at the various interest rates that reset to 10% after 5 years and the bondholder would have paid $151k for that debt, in order to get an extra what, and extra 1-2% of interest with enormous risk?

It doesn't take much to see here that if that $100k mortgage for the homeowner is $50k underwater and foreclosed on, the investor only gets $50k and seeing how they paid $150k, they lose 2/3rds of their investment.

If the homeowner instead pays 7% for the life, rather than jumping to 10% after the first 5 years they end up paying the $35k for the first five years, but then they paid $8472 per year, for $246,800. That reset reduces life time payments by $61k. They end up paying an average of $686 per month for the next 30 years. If I calculate what $246,800 would be worth at 5.5% you'd get $103k today, so the loss would be around 1/3rd, or alternatively, the rate of return over the 30 year is 3.6%, about 2% less than promised.

Ekkk, this is ugly. I am tired, not sure about the quality of my edit...

What experience and history teach is this -- that people and governments never have learned anything from history, or acted on principles deduced from it - Georg Wilhelm Hegel, 1770 - 1831