One does not have to be a banker to realize the mistakes that created the 2003-2007 housing bubble. Bankers’ mistakes are emblematic of larger American business culture problems. We incent the wrong behaviors and eschew the hard work and emphasis on fundamentals necessary for long-term success.
You Get What You Incent
Banks were interested in generating upfront fees. Incentives were predicated on “making the deal.” The best way to make a deal was to ignore the creditworthiness of the borrower. The banker who made the bad loan suffered no personal financial penalty. There was no “skin in the game.” Why not write as many loans to poor credits as possible?
I heard a talk by Lynn Sharp Paine, who teaches business ethics at Harvard Business School. She discussed a case study about a change in the Sears Auto Center manager incentive plan. Instead of a heavily salary-based system, managers received bonuses based on volume of repairs. Repair volumes soared until state authorities sent testers who found that customers were overbilled and many unnecessary repairs performed. Sears got the behavior it incented. Charges and penalties ensued.
Bankers are no different than Sears Auto Center managers. Incent bankers to make as many loans as possible, expect an ocean of defaults.
Cheap Money Makes Everyone Stupid and Sloppy
To offset the internet bust, the Federal Reserve pursued a deliberate low interest rate policy. The Bush Administration pushed a home ownership imperative. This combustible mix made money readily available. And money never sleeps. It found its way into subprime, interest only, no document, Alt-A, teaser rates and a variety of other “innovative” products. “Innovative” lending was really semantic code for qualifying risky home buyers on the theory that inflation would bail out both borrower and banker. Then came the sea of red ink. See What are the Unintended Consequences of Low Interest Rates?
Sloppiness became so endemic that many mortgages were improperly documented. A Kansas court, in a recent decision, threw into question one such bank’s ability to foreclose on properties.
Know Your Borrower
A close friend was involved in community banking in a large mid-Western city. While many banks shied away from inner city loans, my friend embraced these loans, since he knew the borrowers personally. The borrowers were African-American businessmen and professionals. Over time, his branch had the lowest loan loss rate of all the bank’s branches. His strategy proved that computers and credit scores are no substitute for knowing one’s borrower.
My wife received a call to verify the salary of our three-day-a week lady. We reported her income each year and in her best year she made $13,300. We did not know her other income. Her husband was a laid off truck driver who worked part time. Their work history was less than ten years. My wife called in a panic because this couple was seeking a mortgage of over $500k. My wife verified her $13.3k salary and amazingly the bank made the loan.
Financial Innovation and De-Regulation Lead to Disaster
Every time financial publications trumpet the benefits of innovation and de-regulation prepare for economic destruction. When the airlines were de-regulated how many went bankrupt? National, Eastern, Ozark, Pan Am, Continental, People’s Express, NY Air and a host of others went into bankruptcy. With its aggressive, but flawed energy trading complex and new age accounting, why was Enron hailed as the new model? Why have we vilified, stodgy utilities that signed long-term deals and eschewed trading? The demise of Enron was all but foretold. Banks are no different as they moved from stodgy traditional banking to proprietary, trading, sub-prime lending, mortgage bundling, credit derivatives and other “innovations” which led to their near bankruptcy.
Inscrutable Investment? Don’t Buy It
Warren Buffett once described derivatives bought speculatively as “financial weapons of mass destruction.” Despite that warning, bankers embraced these products during the last decade.
At their best, credit default swaps, a bankers’ favorite, are fiendishly complex instruments, created by mathematicians with no readily discernible market value and no public exchange for price discovery.
A “Credit Default Swap” is a credit derivative or agreement between two counterparties, in which one makes periodic payments to the other and gets promise of a payoff if a third party defaults. The first party gets credit protection, a kind of insurance, and is called the “buyer.” The second party gives credit protection and is called the “seller.” The third party, the one that might go bankrupt or default, is known as the “reference entity.” CDS’s became staggeringly popular as credit risks exploded during the last seven years in the United States. Banks argued that with CDS they could spread risk around the globe.
Credit default swaps resemble an insurance policy, as they can be used by debt owners to hedge, or insure, against a default on a debt. However, because there is no requirement to actually hold assets in reserve, credit default swaps can also be used for speculative purposes.
Until the collapse of Lehman and Bear Stearns, few bankers understood the illiquidity of these instruments or the counter party risk, that is, the ability to receive payment from the person writing the derivative.
Non-Recourse Loans
A non-recourse loan prevents the lending banker from seeking recovery from the personal assets of the borrower. Certain states such as California and Arizona are non-recourse mortgage states. It is not surprising that these states lead the nation in foreclosures and “walk a ways” where borrowers abandon their properties. Non-recourse lending not only contaminated the housing industry but infected commercial real estate and even ship building.
Implications
It is not surprising that we have the current financial crisis. Bankers were incented to write as many loans as possible to generate fees and ultimately large bonuses. No one focused on the ability to collect on these loans. Over reliance on computer models demonstrating that lending was profitable based on historical default rates proved false. Knowing your borrower and having recourse against personal assets were old fashioned concepts and not very sexy in banking’s new age.
When we de-regulated the banking industry, provided bogus incentives, ignored creditworthiness, and created and invested in esoteric investment products that were little understood even by the CEOs of the banks that trafficked in them, why are we surprised that we have the ongoing credit crisis that never seems to end.
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