July 16, 2008

Why do Banks lend poorly in the sub-prime market? Because they are not in Banking!

In a response to yesterday's post on the fall of the US dollar, Gunnar points out that incentives being out of alignment is no stranger to the banking world:

Interestingly enough Charlie Munger identified much the same themes (not all the particulars) way back in Wesco Financial's 1990 letter:
Granting the presence of perverse incentives, what are the operating mechanics that cause widespread bad loans (where the higher interest rates do not adequately cover increased risk of loss) under our present system? After all, the bad lending, while it has a surface plausibility to bankers under cost pressure, is, by definition, not rational, at least for the lending banks and the wider civilization. How then does bad lending occur so often?

It occurs (partly) because there are predictable irrationalities among people as social animals. It is now pretty clear (in experimental social psychology) that people on the horns of a dilemma, which is where our system has placed our bankers, are extra likely to react unwisely to the example of other peoples' conduct, now widely called "social proof". So, once some banker has apparently (but not really) solved his cost-pressure problem by unwise lending, a considerable amount of imitative "crowd folly", relying on the "social proof", is the natural consequence. Additional massive irrational lending is caused by "reinforcement" of foolish behavior, caused by unwise accounting convention in a manner discussed later in this letter. It is hard to be wise when the messages which drive you are wrong messages provided by a mal-designed system.

In order to understand what is going on in the market for banks, I think there is something that is extremely important to bear in mind. And this is:

banks are no longer in banking

In other words, it is more or less a myth these days that banks engage in banking, so whatever we think about banking, we shouldn't apply it to banks. How can this be? Well, let's get the theory straight: The concept of banking is this:

A market in which intermediaries borrow from the public on demand and lend to the public at term.

So, these intermediaries take on a risk between "demand deposits" and "term loans" that is captured in the interest rates and is protected by security. Etc etc. "Term" here means a long time, long enough such that there is no easy way to predict the economic future. This is a highly significant risk, and what causes banking to be different.

However, with the invention of securitization in the 1970s or so, while the intermediaries (sometimes known as banks) still borrowed from the public on demand, and created loans at term, they then went on to sell those term loans to the public. Banks are no longer lending at term, or more precisely are no longer exposed to the ramifications of term, themselves. They therefore enter into these term loans at little risk to themselves. Hence, although they are still styled as banks, and are regulated as "in banking", they are not actually engaging in the trade of banking. To be doing banking, you must engage in both sides of the equation; that special risk by being on both sides is the reason for the special subsidy and regulation of banking. Securitization removes that risk.

Hence, banks are now encouraged to do as many loans as possible, without worrying about the term risks. That is someone else's problem. Do I hear subprime ?

So while Charlie Menger's comment that there is a herd effect and a sociological effect that drives bad lending, the answer is much simpler. There is no dilemma, as banks don't need to lend wisely, they simply aren't at risk.

Having said that, it is going to take another decade or so for regulators and the public to wake up to this state of affairs. The banking subsidy is a licence to make money, and no bank wants to lose such a franchise, especially now that they've got out of the risky business of banking. It'd be a crime to let the easy money go!

Mystified by how 'sub-prime' debt engulfed Wall Street's smartest and now threatens the wider global economy? The Telegraph's comic strip may help explain how the story started.
Posted by iang at July 16, 2008 12:16 PM | TrackBack

there are several issues

1) CDOs were used two decades ago during the savings and loan crisis to obfuscate underlying value

2) long-winded, decade old post discussing (many of the current) problems with securitized instruments obfuscating the underlying value

3) depository institutions have been regulated ... and their deposits had been major source of funds for loans and mortgages. with securitized instruments ... almost anybody could get into the lending business, and then unload the loans as CDOs ... continually repeating the process for constant flow of money (no longer dependent on deposits)

4) being able to obfuscate loans values as triple-A rated CDOs ... provided a constant flow of money ... to nearly anybody that wanted to get into the business ... and decoupled actual loan quality from being able to unload the loans as triple-A rated CDOs (i.e. loan originators previously had to pay attention to loan quality to stay in the business, the use of triple-A rated CDOs allowed that whole feedback control mechanism based on loan qaulity to be bybassed ... business success now only was coupled to how many & how fast mortgages could be originated and unloaded).

5) lots of institutions bought up these triple-A rated CDOs ... including regulated financial institutions ... however, the underlying mortgages were no longer being considered based on quality ... the triple-A rated CDOs sort of creating a situation analogous to the "emperor's new clothes" parable.

6) subprime loans are interesting from a couple of perspectives. supposedly they were to go to first time home buyers with no credit history. They turned out to also be "subprime" in the sense that many of them had introductory teaser rates way below prime ... and supposedly at least 2/3rds went to entities with credit history (some significant portion possibly speculators, effectively planning on flipping the property before the rate adjusted).

7) the whole house of cards eventually came down ... and/or the bubble burst. The problems with the toxic CDOs created a confidence problem for all triple-A instruments ... somewhat akin to food contamination problems ... since nobody was able to tell which were contaminated and which weren't (i.e. CDOs designed to obfuscate underlying value did what they were designed to do).

8) There are projections that there will eventually be $1 trillion in write downs related to these (overvalued, formally) triple-A rated CDOs (less than half of the projected write-downs have happened so far).

9) One may conclude that if there was an excess valuation of $1 trillion in toxic CDOs ... there was an excess $1 trillion valuation pumped into the real estate market bubble ... which will now have a corresponding deflation

10) Recent articles are claiming one million unit excess inventory in the real estate market. The excess $1 trillion pumped into the real estate market and the related speculation created appearance of significant more demand than actually existed. With the bursting of the bubble ... not only does $1 trillion have to leak out of the real estate market bubble ... but the excess 1 million inventory is going to create additional significant downward pressure on real estate values ... i.e. what happens in traditional supply and demand ... with significant oversupply. It is possibly going to take a couple more years to reach equilibrium.

11) nominally, there would have been limited customers for such subprime loans (number of first time owners with no credit history) ... as well as limited market for being able to unload such low quality loans. Being able leverage (triple-A) CDOs to obfuscate the underlying values ... enormously increased the market and the corresponding money supply. With the enormous money supply (created by the use of CDOs), resulted in significant more money available for subprime loans than the original intended customers (opening things up for significant amount of speculation, resulting in the appearance of significantly larger demand and overbuilding).

having done a lot of work in dynamic adaptive feedback systems as undergraduate in the 60s (code actually shipping in large mainframe vendor products) ... i have tendency to look for what are the feedback control mechanisms that operate in any kind of infrastructure. i've claimed that the use of CDOs (to obfuscate underlying values) allowed normal financial market operations to be short circuited.

One question that might be asked is everybody was aware that a large number of subprime loans were being written ... and a large number of triple-A rated CDOs were magically appearing .... but (the "emperor's new clothes" scenario), but nobody seemed to realize the large disconnect.

Posted by: Lynn Wheeler at July 16, 2008 04:38 PM

Your comments are mostly true, especially for large banks, bot not all banks (even large ones) are the same


Posted by: Gunnar at July 17, 2008 02:09 PM

To put about $1 trillion worth of CDOs in perspective, Jason Hommel put some totals together in February of 2006 here:


Back then, the BIS had their total of otc derivatives at around $400 trillion. It seems like yesterday when they had just made it above $200 trillion. Now they are around $600 trillion.

The rating companies were, are still, in on the scam.

Monty Guild:


We at Guild Investment Management have mentioned the problems with derivatives 31 times in the five years between 2003 and the present in our market commentaries, yet people did not listen. Now, many people call us who own bank stocks and banking related instruments wondering what to do. Our opinion is to sell into rallies U.S. banking related stocks. There is no reason to own banking stocks in this environment as the problems will continue for years. In the end, many equity shareholders will be wiped out.

If the U.S. Fed, U.K. central bank, and other central banks continue to protect all of the institutions, all of the shareholders, and all the depositors, the crisis will actually be more prolonged and more difficult to come out of than if they let a lot of the smaller institutions go broke.

Thus far, it is obvious that the Fed and the U.S. and U.K. administrations want to make the government the lender of last resort and make it a world where mistakes are not punished. We go on record saying that this is a mistake...the example of Japan comes to mind.

The Japanese market peaked in 1990 at about 40,000 on the Nikkei 225 just as their banking crisis began. Japan did not confront their banking crisis. They kept a lot of 'zombie' banks alive and did not write off the bad loans. The banking system languished and the Japanese stock market bottomed down over 75% from its highs when it got to about 9,000 in 2003. Today it is still only at 13,000.

Is that what you would like to see in the U.S. and Europe? If so, then go ahead and continue with what looks to be the current Federal Reserve and U.S. Treasury strategy of keeping weak institutions operating 'as if' they were healthy and able to lend.


As we all know, these two institutions were in effect taken over by the U.S. Federal Government, which will supply their equity and guarantee their debt for the time being. The government intervened because much of the two agencies' $5 trillion of endangered debt is held by foreign central banks. This is a bailout and it will create a lot of liquidity which will be thrown into the system. An end result of the bailout is that it pumps massive liquidity into the system. This new liquidity is on top of all the other liquidity, foreign and domestic, that is piling into the system...thereby further fueling inflation in commodities, raw materials, foods, energy, transportation and services, and of course precious metals.

In our opinion, inflation will be the game, not deflation...unless they are unable to flood the economy and banking system with enough money to rebuild liquidity. They will continue to try, but if they cannot do this within three or four years, then we expect deflation can take hold. In the meantime, we are planning on inflation for the next few years and higher gold and food prices...and a lower dollar."


Monty has to speak conservatively so as not to scare his customers.


I think real estate in the US is down and out for years and years similar to Japan. For about 2/3s in the US, it's a leveraged game. After 18 years or so it's still way the heck down in Japan.

I can't see it bottoming out anytime soon when we are looking at a hyperinflationary (initially) great depression.

Posted by: Bob at July 18, 2008 07:43 AM

WaMu Shows Paulson Mortgage Rescue Plan Is Perilous

from above:

Paulson wants to create a version of Europe's market for covered bonds in the U.S. just as sales of the debt have fallen to a six-month low and prices have dropped 2.5 percent this year. While the securities are backed by loans and bank assets to get AAA ratings, most are valued, on average, as if they were three levels lower.

... snip ...

somewhat related recent post
http://www.garlic.com/~lynn/2008k.html#36 dollar coins

Posted by: Lynn Wheeler at July 22, 2008 11:29 AM
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