Escrow Scam Redux

In the early 80’s, mortgage lenders had a very sweet deal when it came to servicing the loans.

They would require that (most) borrowers pay enough in the monthly payment to cover the mortgage, and to cover real estate taxes and fire insurance.

Fair enough.  After all, they were protecting the value of the mortgage loan, which was roughly 80% of the purchase price.  So why call it a “scam?”

What was more than a little sleazy was the way the lenders calculated the amount owed (they frequently made “errors,” nearly always in their favor rather than the borrower).

Reminds me of my post-college years when it didn’t matter how well I took care of a place I rented or how clean I left it, the landlord always kept the security deposit.

Another dirty little secret back then was that the escrow account got topped up every month so that it stayed funded a full year in advance, giving the servicer tons of cash to use or invest if they weren’t 100% scrupulous about whose money it really was.  The lenders looked at it as if was a “no harm, no foul” situation as long as the real estate taxes and insurance got paid on time.  A number of “business friendly” jurisdictions didn’t even require that escrows be segregated or that interest be paid on the money.

Of course, the early 80’s were also the era of double-digit interest rates, so having millions of dollars lying around was a profit center all by itself.  Some lenders I knew whispered that the earnings on their escrows more than covered the actual cost of servicing, making the service charges pure profit.

Why am telling telling this ancient history?

Because there is nothing new in the world, of course.

An article on the Bloomberg today spells out how Goldman uses their strong negotiating position as a market maker with a strong credit rating to require their swap counterparties to put up more collateral on the same deals than Goldman itself would post if the roles were reversed.

In other words, by simply running a balanced book of long and short positions, Goldman can create a huge source of free/cheap funding for its operations.

[Note:  I would be remiss if I didn’t point out that a number of my hedge fund manager buddies (yes, they don’t all shun me) would say that they are a better credit than most financial institutions because their business tends to be cash and carry with no long-term debt.]

The numbers are staggering.  According to the article,

“demanding unequal arrangements with hedge-fund firms, forcing them to post more cash collateral to offset risks on trades while putting up less on their own wagers. At the end of December this imbalance furnished Goldman Sachs with $110 billion, according to a filing. That’s money it can reinvest in higher-yielding assets.”

The article goes on to say that when derivatives are traded on an exchange, each participant will post the same collateral as any other participant for a given contract.

How much money will you bet me that Goldman’s support for setting up an exchange for derivatives draws a line that doesn’t include CDS, leaving those defined as “exotic” so the collateral arrangements and disclosure stays just as hidden as it is today?

Never mind that CDS are the exact type of derivatives that took down AIG and cost the taxpayer hundreds of billions.  Where the money is, that’s where the owners of the game will do their best to avoid regulation, while complaining very publicly about how much they’ve given into “socialist” demands by agreeing to new regulations that only apply to the “plain vanilla” stuff that didn’t have a huge arbitrage in it, anway.

No takers on my bet?  Can’t fault a guy for trying!



2 Responses to Escrow Scam Redux

  1. GeorgeR says:

    No wonder Buffet is so confident of his investment in GS, but how does Uncle Warren maintain his moralistic tone knowing this type of thing? Heads they win, tails you lose at GS.

    • hhill51 says:

      He had plenty of practice keeping his face straight while delivering the “derivatives as WMD” line at his Woodstock for investors rallies, all the while having many times his equity exposed in currency, interest rate, and even catastrophe derivatives and swaps via his insurance companies.

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