Let's say citizen borrowed $100,000 to use to buy a home with 100% financing, 30-years, 5% fixed. The borrower/buyer executes a promissory note ("Note") promising to pay a certain amount each month for 30 years. The loan is fully amortized so each monthly payment will be exactly the same, although earlier payments will go more to interest, later payments more to principal. The Note is secured by a deed of trust or mortgage on the home. If the borrower does not make the payments as promised, the lender can foreclose and take the home, sell it, use the proceeds to pay off the Note.

What is the present value of the Note? If the bank wants to sell the Note, they will take some amount less than the face amount. Let's say $60,000 is the present value of the Note. The lender accepts $60,000, puts it into a CD or other investment earning interest, and makes the payments to whoever loaned them the money when they come due. Let's say the lender borrowed the $100,000 from the fed at 1% interest. Obviously, they sit there for 30 years, earning money on the difference between the interest they pay, and the interest the borrower pays to them. Now the bank has what? $60,000. But the bank no longer has the security, because that went with the Note. The bank does not have the security and does not have the full amount borrowed to repay the loan. The bank has a financial risk, in other words, if they use that $60,000 for other lending purposes.

Let's say Wall Street calculated the present value of promissory notes secured by real estates on home loans made by banks. And to keep it simple, let's say they calculated $60,000 was the present value of a $100,000 loan due in 30 years with interest fixed at 5%. Did they include in their valuation process a discount for loans which represented 100% of the purchase price? Or some other discount for risk. If they did, doesn't that mean they should have told the public that they personally had discounted the Notes, or had questions about the likelihood of full repayment?

But more importantly, let's say Wall Street calculated these Notes with a present value of $60,000. When they turned around and mushed the loans together and sold fractional interests (CDOs), how did the value the Notes? Did they, for example, have one value for purposes of them purchasing Notes from lenders, but another much bigger value when they sold the Notes disguised as CDOs? Of course they did. How else could they make money? If the Note had a present value of $60,000, and they sold it to the public at $60,000, Wall Street makes nothing. So how did they value these Notes for purposes of selling them in CDOs? I'll bet that's where the fraud comes in. By mushing the loans together in CDOs, it would make it impossible for buyers/investors to examine the underlying conditions of the loan, because they are not buying a loan, they're buying a fraction of perhaps thousands of loans.

Valuation is an expert function, but the fact is there are calculators that do basic valuation to determine present value. The question is whether they applied a discount for the Notes which had a high risk of default -- which is pretty much any home loan if the borrower put down less than 20% of their own money. Wouldn't a substantial discount reflect their own belief the Notes had a low value? And if they did not disclose that to the buyers of CDOs, is that fraud?

## Monday, May 3, 2010

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