Asset Backed Securities (ABS) - Stable?

November 5, 2016

Have you taken a loan any time or used Credit Cards? Then, you may give this a read.

Have you ever wondered what happens to the loan you take or from where the banks give you the money? It's really wonderful how they do it. I didn't know it until recently. I think it's worth sharing.

So, bank gives you different kinds of loans like Car loan, Personal loan, Education loan. Essentially, credit card expenditure is also some kind of a loan because you don't pay the expenses upfront. You pay monthly or later. I am not taking the Home loans into account. That's a little different ballgame.

Now, a bank gives you these different kinds of loans and consolidate them into single entity. What it means, is that Person A might take $10,000 personal loan from Bank X. Person B might take $20,000 education loan from Bank X. Bank X consolidates the loan into a single $30,000 entity.

After consolidation of loans, irrespective of their types, the banks go to their investors to ask for the money. These investors are generally very very rich people (like top 1-5%). The banks *sell* these loans to the investors, promising them 2-5 or higher percentage of return. These are generally sold as Bonds or Certificates. These bonds are called Asset Backed Securities (ABS). Didn't the name sound fancy? Wait, there's more story behind it.

Now, let's say you take an education loan. You generally give 12-14% interest to the banks, against your loan. Banks keep some of the percentage of the interest, for their own administrative charges, some percentage for their profits and the rest for their investors' return for investments. So, all in all, the investor is actually giving you the money directly, in exchange of some profit. The middleman is the bank, which keeps some of its own profit.

Let's say investor I gives you $20,000 education loan. The investor I gets some percentage of profit from the banks for this $20,000. Now, you get the $20,000 and pay your university fees. Most of today's students go to the private universities, as we have limited infrastructure for public universities these days. Now, it can happen that the private university you attend, was developed by the same investor I. The investor I might have some share in your private university. Obviously, private universities are not charitable organisations, and they make money. So, investor I makes another round of profit from $20,000 through your private university. Therefore, the investor I makes money in two ways. One, by providing you the money (from the interest through the bank). Second, by taking university fees from you. I don't know how to fathom this two-way rip-off, without any trouble!

Now, think about out current situation. Students take loans to study but they can't find a job after graduating. I know most of my friends in Facebook are exceptionally good students from elite colleges but look around you. Most students, these days, find it very hard to get a job. Therefore, they might not be able to pay back their loan. One of my friends, working in an Indian bank, says that the recovering rate for student loans is approximately 50%.

Therefore, loans are taken by the students but they can't pay back because of the scarcity of jobs. However, the investor or the provider of the loan do want to get back the money with interest. Therefore the investors ask the banks for their money back, after some years. Now, banks have no money. Sometime, they declare themselves bankrupt, and the government comes to rescue. They bail out the banks and pay back investors. How does the government pay? From your taxes. So, you pay back with your tax-money to the investors. I don't know what other ways can working people be [any curse word] off!

I have checked that the amount of students loans have increased dramatically from the 1990s. It's due to increment in the number of private educational institutions and decrements in the public ones. That seems to be a well thought-out plan. Think how fragile a system, we are sitting on! Now, let me get into the home loans. If you apply the same concepts from the above, to the home loan category, and look at (God-blessed) America in 2008. This is what briefly happened in 2008 Financial Crash. Banks gave home loans like crazy. But the people couldn't pay back. Banks declared themselves bankrupt, and the government bailed them out. The same thing may happen with Asset Backed Securities.

If you call this stable, I doubt your definition of stability!

Follow up on Nov 17: After I wrote it on Nov 5, the Indian government demonitised Rs. 500 and 1000 notes from its curency. Therefore, people heavily deposited their old currency into the bank. You don't have to be an expert to understand that the banks have liquidity crunch these days and the reason behind this, if you have read the above piece. Now, banks have loads of money from the people.