Reply to post: Re: Plenty of outsiders predicted the crash

Re: Plenty of outsiders predicted the crash

There are some fairly big differences between the two. Here's my sophomoric take on them,:

Insurance consists of the risk of an event happening in a time frame, the cost of the event, and whatever margin is needed for safe operating and profit. So say there is a 1% chance of a fire destroying your property in a year, which will cost $100,000 to repair, and 20% is a "safe" margin. The premium will be $1200 a year, so that after 100 years the $100k cost is covered, $20k in admin and profit taken.

This can _only_ work with enough people paying in, if you only had say 100 people in the pool, the chance of 2 claims in a year might bankrupt the insurer. So you need a big pool, enough that it is an accurate sample of the population you base the risk calculation from. Hence why there is almost always state backing of certain types of insurance, otherwise most insurers business plans consist of "good times profit, bad times fold company". There are a variety of other ways the insurers make their dime, more accurate risk calculation, selection of clients, higher margins and spreading the risk to a third party.

Making an asset backed loan consists of the value of the asset, the interest rate, and what the creditor can do to get their money back. A normal ("prime") loan would be on something that the creditor is pretty sure will hold or gain value, to a debtor who is very likely to be capable of making the payments on the principal and the interest. Thus the risk is relatively low, thus the interest is relatively low. Typical mortgage would be that the debtor pays the creditor roughly twice the properties value over the course of 25 years, and the creditor owns the property until the final payments is made, and can sell it if the payment schedule is not met. No pooling required, works fine with small numbers as well as large numbers, just easier to predict the average risk with large numbers.

A sub-prime loan is when either the asset is less likely to hold value, or more often that the creditor is less likely to be able to make the payments, Thus the interest rate is higher, and the creditor has a higher exception of taking possession of the asset. A typical example would be a rent-to-own appliance store selling someone a $100 item (a washing machine for this example) for $2 per week for 2 years. The creditor expects to either collect the $200, or that the washing machine will be returned and re-sold for $100 plus money made from the rent. Again, no pooling required, you can do it as effectively with one client as you can a hundred.

Now, to make a prime loan from sub-prime loans, that's where the pooling comes in (the collective part of a CDO) put enough sub-prime loans together, and repay in tranches, the top tranche or two will function like a prime loan.

As for why would anyone make sub-prime loans, that's easy. They are very profitable in the short term, and if they are asset backed then also in the long term. Why anyone would take them is a classic poverty trap. You don't have any other way to get the loan, so either you do without or you pay more for the same service.

If property "always" goes up in price, and the expected price increase is close enough to the sub prime interest rate, then everyone is fine. If the asset is education then it may be a perfectly good investment to pay 10% above the base rate, since once you're qualified and have a job, you then move into the "prime" category, and can re-finance at a less punitive rate.

I still do not see how sub-prime requires pooling. It's the mildest form of loan sharking, and works on any scale. Insurance requires pooling.

I do see how for the specific case of US mortgages to dis-advantaged people being backed by Fannie and Freddie (and thus by the taxpayer) is a pooling of sorts. It's just a terrible idea, if we want taxpayer funded mortgages, then have them. Don't pretend it's something else.

But that's my view on insurance anyway, I've worked for a few insurance companies, and the issue is that they are just administrators of government policy. They make guaranteed profits (and get money to invest) until a payout is required, then they either stall, deny cover, or if enough claims are correct, declare they are going bankrupt without a bailout.