Saturday, January 09, 2010

Overthinking the bad loan problem 

While I am neither an economist nor a Wall Streeter, regular readers know that in addition to being an erstwhile securities lawyer I am the chief financial officer of a reasonably large company. As such, I am a bit baffled by the complex explanations offered for the credit markets catastrophe that we have been surviving for the last couple of years. Megan McArdle circles around my confusion, but does not resolve it to my satisfaction (commentary below):

One of the most persistent narratives of the recent crisis portrays a nation of unsophisticated home buyers led astray by greedy bankers. Supposedly those bankers were willing to write risky loans because they intended to pass them on to some unwary investor. But this explanation falters in the face of a legion of failing commercial deals. Prospective landlords had all the expertise they should have needed to put a fair price on properties—and the majority of lenders who were originating loans for their own portfolios had ample incentive to perform careful due diligence.

The best explanation for the calamity that has overtaken us may simply be that cheap money makes us all stupid. The massive inflows of international capital, which Ben Bernanke has called the “global savings glut,” poured into our loan markets, driving interest rates lower—and, since most real estate is purchased with borrowed funds, pushing up the price of property in both the commercial and residential sectors. Rising prices, in turn, disguised any potential problems with the borrowers, because if they ran into cash-flow problems, they could always refinance, or sell. Everyone was getting bad signals from the market, and outlandish purchases looked almost rational.


The idea that "cheap money makes us all stupid" misses, with all due respect to Megan, the sharper explanation: Cheap and easy money makes for "too much" competition among lenders.

Start with this point, which I think would be obvious: No banker or bond investor lends money for a basis point less than he can get to a borrower who is less than rock solid unless competition from some other prospective creditor forces him to make concessions. As competition among lenders intensifies, interest rates decline and terms get more favorable for borrowers in a bidding war. At some point, competing for the same pool of strong borrowers becomes unprofitable, so some lenders -- not all, but some -- start making loans to riskier credits.

Now, you might say that "greed" drives lenders to make loans to risky credits, but the reality is much less exciting. Excess capital in the system (because the world's central banks have allowed credit to remain loose) has to be invested in something. Sure, a few rare institutions will make a specific decision to remain small because they do not want to compromise, but that choice comes at a heavy price. The bank or other lender that refuses to compromise standards in the face of competition will stop growing, start shrinking, and its stock price will suffer mightily. Chances are, disappointed owners will clamber to fire the management. Prudence in a bull market is often mistaken for folly. Most lenders, therefore, will take the dirt cheap capital coming their way and make loans with it, even if that means compromising credit quality or pricing because the competition among them is so fierce.

Now, some commentators have wondered why our antitrust laws allowed financial institutions to get so large that they were "too big to fail." By now the answer should be obvious: Our antitrust laws are designed to foster competition, and the problem was that we had too much of it.

CWCID: Glenn Reynolds.


By Blogger SR, at Sat Jan 09, 04:59:00 PM:

TH: Do you believe it to be that case that there was so much cheap capital available to invest that the presence of Freddie and Fannie as risk reducing backstops combined with CRA incentives and mandates to lenders didn't push the situation a little too far out of balance?  

By Anonymous ck, at Sat Jan 09, 05:00:00 PM:

I'm always amazed when smart people care about what Megan or Althouse think about anything. When your naughty adolescent fantasies of sex with a black man outweigh anything that comes out of his mouth.How can anyone take these women seriously? It's like me voting for Kristal Summers because she's my favorite porn star.  

By Blogger Bomber Girl, at Sat Jan 09, 05:17:00 PM:

"The bank or other lender that refuses to compromise standards in the face of competition will stop growing, start shrinking, and its stock price will suffer mightily." This just sounds like bad bank management, coupled with a short-term focus on stock prices. Making loans that shouldn't be made when dealing with a "public good" like money (who keeps printing those bills after all...) shouldn't be the same thing as making bad cars that no one wants to buy. Oh wait, the taxpayer bailed them out too.  

By Blogger John Sanzone, at Sat Jan 09, 05:34:00 PM:

Certainly your point that banks begin lending to risky borrowers when too much competition results from marketing to good borrowers rings true. For a long time, and even now, mortgages are being approached the same way a McDonald's hamburger is...making the basic product "accessible" to everyone, even when they can only afford $1.  

By Blogger bankerinrealife, at Sat Jan 09, 06:57:00 PM:

It is nice to read an opinion that rings true, especially to a banker in the field who watched the precise events you describe unfold. There was growing and enormous pressure to make credit concessions to stay in the market. Not to mention the impacts of the growth in under-regulated participants operating like cowboys in the frontier.

That said, you have only described the fuse. The bomb was pre-existing; it was the set of incentives created by government action (Fannie, Freddie, etc.), the incredible optimism on Wall Street that lead to excess leverage at the investment banks, the capitulation of ratings agencies, and others.

As always, there are more complications in the argument, but you have hit an important nail on the head.  

By Anonymous Anonymous, at Sat Jan 09, 07:12:00 PM:

The Bank Holding Company Act was not an antitrust law. Nor was Glass-Steagall. Their main thrust was to promote safety and soundness.

It has nothing to do with competition, if one compares to the world 20 years earlier. It has to do with the fact that large institutions are increasingly inefficient (like the government). Buffet and Munger make this point about companies.

I called a large financial institution this week to determine who set their interbank lending rates. They had trouble telling me. When I call Hills Bank and Trust in Iowa, the woman who answers the phone answers my question, deals with my account, and gets me off the phone in 2, maybe 3 minutes, not with a script; and as often as not will send me an email afterward with a follow-up on the question I had.

No CEO knows how to manage these large financial institutions. It's preposterous -- just as it's preposterous to suppose that Congressmen and Senators really know what is in that 1000 page healthcare bill they are enacting -- they are THE EXACT SAME THING....

Can't you see this???

The path to socialism in Marx occurs because corporations get larger and larger, and the petit bourgeois (small businesses) die, which is exactly what things like the repeal of the BHA and G-S accelerated....

Your last sense is confusing in other ways. Re-read it. It doesn't make sense (on its own terms; you're saying something that makes no sense, not just something that is a mistaken analysis).  

By Blogger Purple Avenger, at Sat Jan 09, 07:15:00 PM:

Seems like just a "produce a good next quarter" mentality versus long term outlook.

American business management has been guilty of this for quite a while.

A friend of mine like to say "its all good...until it goes bad"  

By Anonymous Anonymous, at Sun Jan 10, 01:05:00 AM:

The same dynamic infected the private equity and hedge fund market. Pension funds and endowments tripped over themselves in providing capital and banks tripped over themselves in lending money or providing prime brokerage services.

Hubris + leverage + ther people's money = lots of bad deals.  

By Anonymous Anonymous, at Sun Jan 10, 10:23:00 AM:

The environment simply allowed shrewd people to unlink risk and reward. It is exactly what happened to cause the S&L scandal in the '90s.
Had lenders been forced to take the risks associated with bad loans, easy money or no, they would not have made the loans. They made bad loans and sold the risk to others. Thus, the revenue came not from the repayment of the loans but from the sale of the risk.
To the extent that Rangel, Dodd and the other criminals permitted/encouraged this, they are to blame!  

By Blogger Jane, at Sun Jan 10, 01:05:00 PM:

I think you're right that this was a big part of it . . . and one of the ways that cheap money made us stupid. But they weren't competing to make loans they knew would go bad; the cheapness of money disguised the problems for quite some time, because of the asset appreciation.  

By Blogger TigerHawk, at Sun Jan 10, 08:18:00 PM:

Jane, agreed. And the Fed did not appreciate what the credit inflation was doing, because the usual signal -- consumer price inflation -- was obscured for 15 years by the movement of the world's manufacturing base in to China, which massively lowered the costs of stuff. The Fed did not, apparently, substitute asset price metrics as a means for measuring the damage done by loose money.  

By Blogger Gary Rosen, at Mon Jan 11, 03:26:00 AM:

TH, your last post hits on something that has been bothering me about all this (aside from the fact that I understand so little about it). Nearly everyone now blames the Fed for keeping interest rates too low in the 2000's. I'm willing to buy that, it makes sense. The only thing is that I hardly recall anyone complaining *at the time* that interest rates were too low. Were the Fed's actions a rational response to conditions that no longer existed, fighting the last war as it were?  

By Blogger Cardinalpark, at Mon Jan 11, 01:00:00 PM:

Gary and TH -

a few other bits:

1) the dramatic increase in lending capacity generally and mortgage market specifically afforded by securitization - that is loans were no longer held by banks, but sold to investors...this dynamic, and the non-capital, non risk nature of securitization for an originator was tremendous fuel for mortgage growth

2) yes, there were folks complaining at the time that rates were too low for too long - like the editorial board of the WSJ.

3) subprime, non-doc mortgage lending was a somewhat new phenomenon. historically, subprime auto lending or cc lending always ends badly. we should not be surprised it happened here too.

One bit - there is lots of blame and none to go around at the same time. Credit expansions boom and then bust. It's always been that way and always will be.  

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