A Failure of First Principles

Yet another post to add to the posts about the credit crisis. Although I don't work for a bank, I think the current credit crisis shows all the symptoms of a failure to follow sane and conservative banking principles. The reasons for the crisis described in this post, although not exhaustive, are an attempt to examine the problem from the point of view of a banking institution/lender issuing credit in highly speculative markets.

What happened - A Look at the Balance Sheet

The events leading to the credit crunch are common knowledge now. But, how do these events pan out in a banking institution's financial statements? Consider that I'm a bank/lender who offers a long term loan to a creditor. On my bank's balance sheet, such a loan would appear as an investment on which I receive yearly interest and am liable to receive principal over the payment period. Considering this is a long term investment, the debtor assures me he will back up this loan in case of default with an asset - in this case, his house. Mortgage backed securities is a term being thrown around for this kind of an 'IOU'. Such assets appreciated in price disproportionately with their real value because of speculative buying and selling of such securities. When the asset prices drop drastically due to such reasons, the effect on the balance sheet is disastrous. An investment in a secured loan, say $ 1.5 million, is now defunct and the only way to retrieve this investment is by taking possession of the asset backing that loan. However, the asset is now only worth $ 1 million, resulting in a $0.5 million write-off (bad debts) for the bank. In the event that a bank has invested a large portion of its credit in such markets, the write-offs are a major portion of its investments and we'll see a Bear Stearns.

Where did they go wrong - What can we learn ?

a. Risk Profiling and Credit Structuring

Lending in highly speculative markets has the uncharacteristic effect of making some banking institutions relax. Banks that are suffering or likely to suffer are most likely the ones who :

• Did not intelligently profile the risk involved in lending major portions of their credit in a speculative environment. Asset prices have seen a sharp and unrealistic rise and such volatility does not last long term (more on speculation later) in which case banks underestimated their risks. Or overestimated their gains.
  
• Did not responsibly structure their lending portfolios to diversify into stable markets, prone to less speculation. One of the first rules of investment - even in mutual funds or stocks - is to have a broad and diverse portfolio. Financial analysts examining this issue point out to the irresponsibility with which banks which are liable to go down have invested in unstable markets. If such banks had a foundation of stable portfolios from markets such as pharma, infrastructure and health services where speculation is less likely to influence your investment, there would have been a better chance of living to fight another day. It's a sad case of poor structuring where your most risky investments make up a major fraction of your credit.

b. Know where your debtor is coming from

A bank that fails to examine the credit-worthiness of a prospective debtor fails to do its job. One does not need to elaborate on this, except for the fact that a highly 'positive' market tends to build on euphoria and kill rationale in decision making.

c. Know where your money goes

A lot of people talk about complex securities and inter-linked securities. People complain that banks that had mortgage backed securities ended up using such securities to cover their own from their own creditors. What I do know is that when a bank which first does not analyze its risk on an investment properly, then passes on the risk on such an investment to gullible creditors has only compounded the sin. Creditors who did not realistically analyze the risk behind such securities were partially to blame. The solution is to hold banks accountable for the securities they market and tie these to a specific asset - which when assessed independently - can be shown to be overpriced or volatile.

Judging from some of these decisions, I believe the current crisis is a result of poor financing decisions, the principles of which have been lost in the illusion of short-term gains. The answer to this crisis does not lie in drastic measures but in a return to the forgotten first principles in banking

And now to touch upon speculation :

Speculation - Is it really that bad ?

It has been pointed out that the root cause of all this mess is a highly speculative environment. Hence instead of just regulating banking institutions, regulate speculation as well. I tend to disagree with this line of thought for a couple of reasons:

Suppose a product is scarce in the market and yet reasonably in demand. The price for such a product is high but expected to go higher due to the scarcity value and demand. A speculator, seeing the future potential of profiting from the sale of this product, comes to town and buys large quantities of this product at existing prices. This speculative buying pushes the product price even higher to a point where some consumers forego the purchase of the product. In other words, demand/consumption reduces by way of speculative buying. Secondly, when prices are higher than speculators like, they sell. This reduces prices and encourages consumption.

The bottom line here is : The short-term volatility in prices ends up regulating prices faster.

Speculators also tend to invigorate markets which do not have enough liquidity. A product that is low in demand will have a big disparity between the price a new entrant to the market is willing to pay and the asking price. A speculator, in conjunction with competing speculators, tends to reduce this disparity and create a more efficient market.

Regulating speculation for fixed periods of time (due to the above reasons) can also have the undesirable effect of prices changing with a huge lag with respect to demand and supply. The time lag will create more inefficient markets.

I believe one needs to think of addressing a major malady in the system - the folly of predatory lending and abuse of banking principles - which will come with more financial regulation. Such efforts will ensure greater robustness against volatility in secured lending than shooting small birds.