How Centralized Finance Rips Off Ordinary Americans
This post is a tale of two stories. The first is a story about how antiquated technology and regulations give a small cabal of Wall Street hedge fund managers enormous wealth and power. The second is a story about the invisible taxes buried deep in the mortgage creation process that continue to centralize power and money in D.C. And both come at the expense of ordinary American borrowers.
Story #1: The Ellington Money Machine
Recently, Mike Vranos of Ellington Management Group appeared on the podcast Real Vision: Finance, Business & The Global Economy. In the 66th minute of the podcast, there is a fascinating dialog that highlights how wealth creation happens on Wall Street. The interviewer asks, “this kind of basket of private sector loans; what kind of yields are you seeing in that market or even spread and how did it change over the last 12 months?” Vranos replies:
…on the consumer side, it’s still LIBOR+600bp or something like that… but I can’t stress to you how dirty your hands get… very expensive, these are very small loans, there is a lot that goes into securitizing and leveraging prior to securitization. But that’s the answer. That number has sort of ratcheted down over time, but it’s making that money the hard way… it’s not accessible to a retail investor or even to a lot of institutional investors. The non-QM mortgage side, let’s say you have a 3-year spread duration, you’re still in the LIBOR+300bp at least, gross spread, pre-securitization. And then you saw the results of the securitization, where you’re basically securitizing at LIBOR+100bp where you’re taking out almost all your risk. That’s almost sort of a pseudo arbitrage than it is a cash-and-carry trade… but you’re buying them in loan form. You not buying them in CUSIP form.
There is a lot of jargon here. But Mike’s statement can be summarized as follows: “We at Ellington borrow money at ~1% per year and lend to consumers at 6% per year. So we make 5% net per year. But then we use securitization (the same stuff that blew up the economy in 2008 ) to monetize that 5% spread at a 3x multiple. So when American consumers borrow money at 6%, we’ve figured out how to extract a 15% profit margin. And we deserve this money because this opportunity isn’t available to ordinary investors”.
So how did we get here? The answer is basically a regulatory regime that creates opportunities for people like Mike. Here is a subset of all the complicated regulations involved in the process that Mike describes:
- Mortgage lending licensing requirements that are ever-so-slightly different from state to state and extremely costly to set up
- Mortgage servicing licensing requirements that are ever-so-slightly different from state to state and extremely costly to set up
- Mortgage lending compliance requirements that create significant litigation liability for originators and require massive legal resources to avoid
- Consumer privacy laws that only allow guys like Mike to see the loan data needed to bid on loans
- Securities laws that make the legal fees for securitization so expensive that only large institutions can participate in such markets
- Securitization “risk retention rules” that force issuers to hold 5% of securities that they issue and hence limit participation to investors with a lot of money
- Securities regulations that constrain investor participation in such assets to “sophisticated” investors like Mike and his team
And why does Mike actively talk about such things so openly? Because he’s marketing to wealthy hedge fund clients. He’s saying: “there is no way you could buy this stuff on your own, so you should pay me to manage it for you”. In essence, these regulations created a system where ordinary Americans borrow money at 6% and all but 1% of that goes to guys like Mike and his wealthy clients.
Story #2: The FHFA Power Machine
Last week, the Supreme Court ruled on the conservatorship of Fannie Mae and Freddie Mac. In short, the Court ruled that:
a) The FHFA director can be hired and fired by the president at will
b) The federal government has the legal authority to confiscate Fannie Mae’s and Freddie Mac’s profits
In essence, the Court ruled to strengthen the centralization of home financing in the federal government. But it’s actually a much bigger story.
Fannie Mae is a semi-private organization that has its origins in the Great Depression era. Its mission is “… to provide liquidity and promote stability and affordability in the U.S. housing finance industry.” Beyond Fannie Mae, there is a vast complex of D.C.-based institutions whose stated purpose is to help promote homeownership. And at the peak of this hierarchy is the FHFA, an institution that essentially dictates policy to Fannie Mae in the most opaque and centralized way.
The small group of people that run the FHFA set U.S. housing policy through Fannie Mae and other related agencies. Moreover, Fannie Mae buys ordinary mortgage loans and issues “government-sponsored mortgage-backed securities (MBS)”. This market, also known as “agency MBS”, finances the vast majority of homes in the United States.
But that’s not the end of the story. Since 2009, the Fed has been printing trillions of dollars every year to buy the aforementioned agency MBS, which of course immediately gives Fannie Mae uncompetitive pricing power. Finally, the Treasury does a “profit sweep” to grab Fannie Mae’s cash flow, which puts the final touch on this crazy system of centralized power and money.
In terms of economics, Fannie Mae and Freddie Mac charge a ~4% profit margin on the balance of every loan. At ~$4 trillion in U.S. mortgage volume in 2020, that equates to ~$150 billion in a single year.
Now, you would think that mortgage company executives would be protesting against the nationalization of an entire industry. However, the Fed implicitly or explicitly lets mortgage company executives also keep roughly 50% of the gross profits so they don’t actively lobby against this system.
Most mortgage companies are private, so until recently, mortgage company earnings were opaque. However, Rocket Companies Inc., one of the countries largest lenders, went public last year. In the latest 10-K, we learned that they made $9.4 billion in profits on $7.8 billion in equity in 2020. This is many multiples higher than what you’d expect in a mature and stable market. In the document, they don’t even attempt to hide the math:
That’s right. Rocket made a 4.46% average profit margin for the $320 billion worth of loans that they originated in 2020! So instead of efficient capital markets giving consumers a rate of 2%, FHFA sandwiches mortgage companies into the middle of this process and they offer borrowers a 3.25% interest rate instead. If you do the math, the mortgage industry collectively made ~$150 billion from inflated mortgage rates in 2020.
In other words, when a $250,000 mortgage loan is created, the federal government makes $10,000 (via the Fannie/Freddie profit sweep) and mortgage company owners make another $10,000. Combined, this equates to ~$300 billion dollars per year in costs to American consumers.