Debt for Profit

I have to say, after reading about CIT and Goldman Sachs over the past few days I have had many occasions to smile. I am forever fascinated by the amount of money made on "debt" in our financial markets. I am also forever fascinated by our government's willingness to allow the credit markets to continue along their corrosive path "creating" new "products" that allow layers of profit to be made or lost all based on some underlying "debt" somewhere.

This quote from Street Insider, has me baffled.

According to reports from the Wall Street Journal, Goldman Sachs (NYSE: GS) is in talks to amend the terms of a $3 billion loan to struggling lender CIT Group (NYSE: CIT).The loan, extended to CIT in June 2008, calls for CIT to pay Goldman $1 billion if it were to file for bankruptcy. Goldman could reduce the total loan amount, though other scenarios likely are being considered. The loan needs to be resolved as part of CIT's move to raise funds as part of its restructuring. Goldman spokesman Michael Duvally said Goldman "is working with CIT and its creditors to enable it to continue to use the facility, which we believe gives it its most attractive cost of funding." Duvally said the potential $1 billion payment is not a windfall payment, but reflects the "present value of the spread to be earned over the life of the facility."

I do not profess any clear understanding of the layers of products that allow "bets" on debt repayment, but to lend a firm $3 billion at a 2.85% interest rate with annual "interest" payments of $85 million as stated in this article on the Dow Jones News Wires ,

The investment bank extended $3 billion in funding to CIT in June 2008, according to regulatory filings. The 20-year contract, which was put in place as the credit markets froze, calls for CIT to pay Goldman 2.85% of the maximum amount lent, which would come to about $85.5 million annually for the first 10 years of the agreement. CIT would be required to pay $1 billion if it were to file for Chapter 11 bankruptcy.

then for Goldman to claim a Billion Dollar payout if the company goes bankrupt is amazing. In addition, Goldman claims to have bought "credit protection" on the original $3 billion which pays again if CIT fails, thus making the $1 billion CIT "penalty" (I would love to read this loan document to understand why CIT would have actually agreed knowing the dire straits they were in mid 2008) plus the credit protection on the original loan which may not cover the entire $3 billion but as long as it covers 70% of the original loan amount, Goldman makes a profit on the demise of CIT.

Wow, lending has become this profitable. Not is lending profitable, but those who buy / sell / trade the multitude of "instruments" linked to the debt have an opportunity to make a mint as well.

It seems like "debt" has become like "oil" in the sense that when a tanker of oil is loaded somewhere in the world it has already been sold forward to someone, options and futures are being traded on the oil and it may actually be "owned" ever so momentarily by many parties before actually being "delivered" to its final purchaser. In addition, there is insurance on the oil, the ship and I am sure a multitude of other products linked to the oil so that the firm moving the oil can also be "protected" in the unlikely event something goes wrong in transportation of the oil. In each of the "transactions" described above, a small "commission" or "cut" of the transaction is taken by someone for providing the "services" or "protection" or "securities" or "contracts" to buy and sell.

Now "debt" is similar. From the fees by those making the loan, processing the loan, brokering the loan etc. there are a myriad of "products" to allow the lender to "protect" themselves from default of the borrower. In fact what stops the borrower from buying protection from themselves in the form of some kind of "insurance" that pays if their business suffers financial hardships and losses ensue, thus causing them to default on the loan? The loan may be syndicated with other loans and sold as a "security", interest payments "stripped" from the loan, bets made on the likelihood of it being paid, the loan itself can be sold to another firm, the loan can be "owned" indirectly through credit protection "products" where someone may have "rights" to the loan or it's interest payments under certain circumstances.

Man, if you can think of it, it has been tried, is being tried or is in the works. This is the "financial industry" and the house of cards built on "debt". The markets for most of these derivative products are not regulated and many of the firms that create, buy and sell them are regulated which puts our entire "regulated" financial system at risk as we have seen over the past 24 months. Yet the game still goes on.

It has been said in some fashion in every religion, "one must not create an economy based on usury". We have done exactly this and are moving ever faster to a baseless debt based economy which will implode; it is a matter of time.