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December 19, 2005
"A firm called Success Trust & Holding LLC has
offered, for $4500, to make my mortgage payments for 3 years, at which point my
mortgage will have been completely paid off. In addition, they will pay me an
amount equal to the value of my house at that time. Comments?"
It is a scam. Among the early mortgage payoff
scams I have looked at in recent years, this is perhaps the most outrageous.
The STH plan makes other early payoff plans look
benign in comparison. The others ask you to pay them for showing you how to
accelerate the repayment of your mortgage with your money. Their deceit is in
making you believe that you couldn�t do it without them.
In contrast, STH makes a promise they cannot
possibly meet. If you pay them $4500 upfront, have 20% equity in your house, and
add them to your deed as a co-owner, they will make your mortgage payments for 3
years. At the end of that period, they will deliver a paid-up mortgage to you,
remove their name from your deed, and cut a check to you for the current
appraised value of your house.
To illustrate the absurdity of this, assume I
have a $300,000 mortgage balance on a $400,000 house. If I believe them, my
investment of $4500 would grow to $700,000 in just 3 years! That�s a return of
438% a year, without any assumed appreciation, and without counting the interest
payments they made for you.
Because the appeal of the STH plan is the
out-sized return on investment, rather than an accelerated pay-down of the
mortgage balance, it should be classified as an investment scam. It is similar
in many respects to the mortgage loan warranty programs I have written about in
the past (see Is This
Mortgage Warranty on the Level?). However, STH promises returns three or
more times higher than the warranty programs.
Investment scams require a story. Even the most
gullible consumers, who secretly believe that some day a good fairy is going to
solve all their financial problems, need an explanation of how such a high
return is possible.
The STH story is based on an erroneous
interpretation of fractional reserve banking. Its interpretation is that any
commercial bank has the capacity to expand its deposits and assets by a multiple
of an increase in its cash reserves.
For example, if banks must hold reserves against
their deposits of 12.5%, a bank at which STH deposits $100,000 of home owner
equity convertible into cash could create $700,000 of additional deposits. In
the process, it would add the same amount of loans or investments, which will
fund the outsized returns STH promises its clients.
There are three fatal flaws in this story.
First, it is not possible for an individual bank to expand in the manner
described above. The bank receiving a cash deposit of $100,000, which is subject
to a reserve requirement of 12.5%, can increase its earning assets only by
$87,500, not by $700,000. This is what every banker will tell you, and they are
right. Anyone interested in the technical details will find them in the note
appended to this article.
The second flaw is that even if it were possible
for a bank to expand in the manner assumed by STH, the bank couldn�t possibly
earn enough to pay the returns that STH promises. If their deposits were
costless and they earned 9% on their assets, they would have to expand by a
factor of 20 (not 6 or 7) just to cover their cost.
The third flaw is that STH cannot deliver the
cash reserves that banks need to expand their loans and investments. There is no
legal way that partial ownership of a mortgaged home can be converted into cash
assets of use to a bank.
STH claims they are working with 250 banks, but
will not identify any of them.
While this is a scam without any question, I am
not sure how they intend to execute it. My guess is that they intend to borrow
as much as possible against clients� identity and property, and then disappear.
In response to my inquiry, STH said that it was
dropping its requirement that they be placed on the deed. However, they will
have your credit report, social security number and copies of your deed,
mortgage, note, and appraisal. In unscrupulous hands, these permit an enormous
amount of mischief.
If you have $4,500 and want to pay down your
mortgage, send it to the lender marked "apply to principal." This will work for
sure.
NOTE ON BANK CREDIT EXPANSION
Many scams use as a point of
departure the ability of commercial banks to expand their deposits and earning
assets by a multiple of any increase in their reserves. They ignore the warning
given in all money and banking textbooks that because a system of banks can do
this does not mean that any one bank can -- unless that bank is a monopolist.
Consider a monopoly bank that has a
reserve requirement of 10%, meaning that for every $100 of deposits it must hold
$10 of reserves, which I will assume is currency of the type you have in your
wallet. Suppose you find $100 of currency hidden in an old book and deposit it
in the bank. The bank can now make loans of $900, paying the borrowers with $900
of newly-created deposits.
At the end of the process, the
bank's balance sheet will show $1,000 of additional deposit liabilities, and
$1,000 of additional assets, of which $100 is the reserves you deposited with
them, and $900 is the additional loans they made. Of course, this assumes a lot
of things, including that the recipients of loans did not want to hold any
currency. But never mind that, the principle that a monopoly bank can expand
loans and deposits by a multiple of any increase in reserves is well
established.
If the bank that receives your
currency is only one of many, however, it can only expand its loans and deposits
by $90 rather than $900. The reason is that any borrower will use the deposit it
receives from the bank to make payments to a third party, who in all probability
uses a different bank. This means that as the bank makes loans, it will lose an
equivalent amount of deposits and reserves.
If the bank lends $90, for example,
and the borrower uses the $90 to buy a gadget from a customer of another bank,
the lending bank will see $90 of deposits shifted to the other bank, and will
have to send that bank $90 of the $100 of currency that you deposited. The other
bank will now have excess reserves that it can use to expand loans and deposits,
so the process will continue. The banking system can expand loans in the same
manner as a monopoly bank, but no one bank can.
Copyright Jack Guttentag 2006
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