How Bananas and Mortgages Can Explain the NFT Craze

If you’re baffled by the craze for non-fungible tokens (NFTs), those bespoke digital assets selling for millions of dollars, here’s one way to make sense of the phenomenon. 

First, keep in mind that a thing can be split into two things. Second, understand that the value of each thing, before and after the split, is in the eye of the beholder.

Now, picture a banana.

When picked from the plant, the elongated fruit is encased in its yellow skin. The skin can be peeled off.

The value of the fruit is obvious: It is edible. To some, the peel itself may have some value as well. 

You can use the peels as compost in your garden. Also, banana peels can be used for pranks, such as by leaving one on the floor for someone to slip on or for stuffing into a car’s tailpipe. These are mean tricks so don’t do them. 

In the 1960s, there was even a brief fad of smoking banana peels. According to Wikipedia, the “recipe” for extracting a fictional substance called bananadine from the peel was a hoax, but who’s to say those kids didn’t feel some kind of high? 

The point is that the value of a banana, and of its peel, is subjective. I throw banana peels into the garbage but there’s a saying: One man’s trash is another man’s treasure. 

To recap: One object can become two objects and, both before and after they are separated, the value of each object is in the eye of the beholder – as it is for anything else.

To further illustrate these ideas, let’s consider a much more serious example: the $11 trillion U.S. mortgage industry. 

Unfortunately, the mortgage market is as convoluted as anything in DeFi. I will break it down as simply as I can, and thank readers in advance for keeping up. 

If you financed a home with a mortgage, chances are the institution where you send your monthly payment is not the same one that holds the mortgage. It also may or may not be the same bank that loaned you the money in the first place. 

That’s because, like the banana, a mortgage is an asset that can be split into parts and sold separately to different entities. Think of the debt itself as the edible part of the banana. It typically gets packaged, with a whole bunch of other naked bananas, into those complex securities you heard about in "The Big Short." 

Too unglamorous for Hollywood dramatizations, the peel is known as the mortgage servicing rights (MSRs). This is a set of administrative duties your lender may or may not farm out after the loan closes. A servicer manages billing and payments, pays property taxes and hazard insurance on your behalf, writes a nasty letter if you pay late and does other scutwork. 

The MSR is part of the whole when the loan is written; it can remain so or be peeled off (mortgage pros even speak of a “servicing strip”). The difference is that while you can eat the banana and keep the skin, when a loan is paid off the MSR disappears. 

Like loans, MSRs routinely get aggregated into big packages and sold to the highest bidder. To be clear: The company that wins the peels doesn’t work for you, the borrower, it works for whomever has the bananas, the mortgage holder.

From that investor’s perspective, the debt has value because the holder is entitled to your monthly principal and interest payments over the life of the loan – and, if you fall behind and never catch up, after 90 days or so it can take your house. For the buyer of the peel, servicing rights have value because the servicer earns a fee (a cut of the interest) for its drudgery. 

How valuable are these two assets? The mortgage and the associated servicing rights both generate income for their respective owners. The question is how long the assets will do so. 

For both assets, the answer depends on how likely you are to stay in the home before:

All of that, in turn, depends on the outlook for interest rates, home prices, employment levels and probably lots of other things. Wall Street has long employed armies of highly paid propellerheads who crunch numbers to estimate the “prepayment speed” of mortgage assets. 

Notice that word, estimate. Forecasts are right or wrong in retrospect, but nobody knows what’s going to happen until it happens. And banks often get rekt when they underestimate how quickly loans pay off.

Once again: One asset can become two (banana/loan, peel/servicing), and the value of each is subjective. 

But “subjective” here does not mean “untethered from reality.” 

A couple years ago, someone taped an unpeeled banana to a Miami gallery wall, called it art and sold the work to three different buyers for more than $100,000 a pop. 

By “the work,” I don’t mean the banana itself, which was bound to rot. The banana was replaceable, in the artist’s instructions for recreating the work, according to an explanation in Vogue. The buyers got a certificate, which is how there could be three of them and only one banana. 

Why would anyone pay six figures for … the right to duct tape a banana to a wall and call it someone else’s creation? I can think of at least two reasons. 

One is, you really appreciate the work and want to patronize the artist, because you believe it makes an important statement about ... something. The other is so you can impress your friends (and one-up your rivals) at the next cocktail party. 

In other words, the bragging rights.

That may be part of the reason why non-fungible tokens (NFT) are blowing up in these strange times. Digital items can create bragging rights just like their canvas-based counterparts – and are arguably more liquid as an asset class. 

(By the way, the title of the banana masterpiece was “Comedian.” Read that however you want.)

For a definition of NFTs, I can’t improve upon this by my CoinDesk colleague Nikhilesh De in his “State of Crypto” newsletter:

“They can represent things (like tweets, real estate, real-world assets, etc.) or they can be the things (like art). ... [W]hile anyone can copy and download video clips or image files, an NFT has a record saying that it has only one owner.

“To be clear: You can still download the image file recorded in an NFT. If you sell a tweet, that tweet will still exist on Twitter, visible to all. ... Think of them as autographed football cards. You could print as many copies as you want but if the player signs only one, that’s the card that’ll likely have the most value. For example, an autographed Tom Brady card just sold for $1.32 million.”

You might think: $1 million for a piece of cardboard? Ha, that’s chump change. In this week’s biggest crypto story, someone won an auction at Christie’s by paying $69.5 million for an NFT by the artist known as Beeple. 

This mystery buyer outbid noted aesthete and Tron founder Justin Sun, who was ready to pay $60 million. But if either of them simply wanted to appreciate the work, known as “EVERYDAYS: THE FIRST 5000 DAYS,” they didn’t have to pay a dime. Beeple’s collage is viewable for free online. Because it’s a purely digital work, “owning” it doesn’t confer the same advantage as displaying a painting (or a banana) in your den. 

I’d suggest this is the core innovation of the NFT: It has separated the bragging rights (h/t to Bloomberg’s Tracy Alloway) of owning a rare object from possession of the object, much like Wall Street decades ago cleaved servicing rights from the underlying mortgages. Or, in the case of virtual “objects” that no one can solely possess, NFTs have preserved, or resurrected, the bragging rights.

Unlike servicing rights, though, bragging rights don’t have an income stream; their value is psychological (one art critic has called NFT collecting “posing”) and thus presumably even harder to model. 

But not impossible to finance! As CoinDesk’s Brady Dale reports, there are now decentralized finance markets where you can pledge NFTs as collateral for loans.

I don’t mean to sneer. For one thing, the NFT phenomenon has shown positive side effects. Beeple is likely set for life and can pursue his art without ever worrying about putting food on the table. Twitter CEO Jack Dorsey has pledged to charity the proceeds of an ongoing auction for the first-ever tweet, last bid at $2.5 million.   

And as with fruits or byzantine financial contracts, if you think these valuations are absurd, well, that’s just, like, your opinion, man. The buyers, though, should keep in mind that art markets, just like financial ones, are known to crash. It’s hard to imagine the same can’t happen for “art” you can’t even hang on a wall. So you’d best be ready to savor those bragging rights for a long time. Longer than many Americans stay in their homes.

Paying almost $70 million to “own” a picture anyone can look at for free may sound bananas. But, clearly, the time is ripe to sell NFTs.