Let it be clearly understood that I mean to say mortgage lending is a conspiracy only to the extent that the lending institutions do not provide full disclosure up front. It is not a conspiracy to the extent that there is deliberate cover-up and deceit and misdirection for the purpose of hoodwinking you. After all, mortgage lending is legal by suitably accredited lenders.
You no doubt think that when you apply for and receive a mortgage loan, the lender takes the relevant sum of money from his reserves and hands it over to you on your signed promise to repay the money over an agreed period with interest added so as to cover the lender’s losses from not having that sum at his disposal to invest or use as he sees fit.
The above, while it sounds reasonable and realistic, is not how it works at all. In terms of GAAP (= generally accepted accounting practice), it would mean that in order to cover the credit you get from your mortgage loan, there would need to appear a debit in the same amount somewhere on the lender’s books. Instead, all that you will find in those books is a credit in the amount of the mortgage loan agreement’s nominal value. That is, the current total value, including all interest, of your loan agreement over its contractual lifespan, as signed by you and the lender’s attorneys.
This sounds like a huge magic trick by the lender.
And it is.
Like all good magic tricks, it relies on the audience not knowing exactly how it works or what’s behind it.
What really happens is that the “money” to cover your loan effectively comes into existence from nothing the moment you sign that mortgage loan agreement. That’s because that agreement becomes contractually binding on you as soon as you sign it, and is a legally binding promise by you to pay X amount each month for Y years, i.e. you obligate yourself to be a revenue stream for a total amount Z spread over Y years. Your contractual payment promise has value to whoever owns that signed promise, even though you still need to earn every cent you have promised to pay. That is, you sacrifice a part of your future to cover a current desire.
Remember our banknotes? They used to carry the following message signed by the incumbent Reserve Bank governor: “I promise to pay the bearer on demand at Pretoria X Rand.” (What exactly will the Reserve Bank redeem the note with? Another X Rand note.) It’s the same basic idea: The bank note is a promise to pay that gets passed along, in turn accepted for value by each recipient. It’s not actual payment, just a symbol of it.
And the idea that the Reserve Bank is the ultimate source of the lent funds is equally mistaken. The Reserve Bank is nothing more than a short-term buffer to cover lenders’ fiscal needs.
But I digress, so back to our mortgage lending process. Once you’ve signed that all-important loan agreement, what the lender does next is where the real trickery hides. The lender takes your agreement and bundles it with several others of the same kind according to expected risk profile (typically in bundles of a hundred or so) and sells these bundles on to external investors at less than their nominal (or face) value. This step is called “securitisation” and is a non-reversible transaction in most countries, including SA.
To clarify with some actual figures: Suppose your mortgage loan is for R1,000,000.00 over 25 years at an annual interest rate of 10% with inflation running at 6% p.a. Your monthly repayment will be about R9012.00 over 300 months, which makes the nominal value of your loan agreement R2,703,600.00 over that period, and its net present value (i.e. in today’s money) would be about R1,402,000.00. The lender sells your signed agreement to the external investors for, say, R1,200,000.00 and so not only covers your R1,000,000.00 debt but also makes a cool R200,000.00 profit without having done a stitch of actual work besides shuffling a few papers around. The investors got a cool deal because they have a virtual guarantee that, having spent R1,200,000.00, they’ll receive over R2,700,000.00 spread over the next 25 years, the net present value of which is about R1,400,000.00.
And that, in a nutshell, is the scurrilous practice of mortgage lending where the only loser is the borrower. As a test, you can ask your mortgage lender to show you the original signed wet-ink documents. They will give you an endless run-around because they no longer possess them.