Sunday, January 20, 2008 @ 10:32 PM

Desperately Seeking… Answers

From Daily Digest (Everyone) | Discuss | Print  

Both Trader Mike and Barry Ritholtz reported a big spike in traffic to their blogs over the past few days. We’ve experienced the same thing.

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What are people looking for? Answers? Well, if that is the case, then I have to invoke the Justin Mamis response: by the time you know the “why”, it’s too late. That’s why traders always shoot first and ask questions later.

The monoline insurer camel is about to be shoved through the eye of the needle. With these companies effectively belly up, the cards will finally be laid out face up on the table. There will be blood on the streets, but the potential is there for the event to mark some sort of milestone in the ongoing credit derivative saga that began last summer.

As the process of creative destruction continues to unwind the financial sector, it is becoming very obvious that there are limits to engineered returns, that is, the type of financial alchemy that has been practiced over the past ten years has proved to be exactly that: it only works when the market is going up.

Before I went into the securities industry, I spent six months in the banking business as a lending officer trainee at the Royal Bank of Canada. I learned about the Five Cs of Lending, namely:

  1. Capacity - Can the borrower repay the loan? Is he able to meet future obligations?
  2. Credit - Has the borrower repaid loans in the past? Has he met all past obligations?
  3. Collateral - In the event of default, can the bank liquidate the asset and recover the principal?
  4. Capital or Conditions - Is the borrower putting in enough of his own money? Are general business conditions good or bad?
  5. Character - In the event of tough times, will the borrower struggle to meet obligations or will he walk away?

In 1986, a lending officer lent out depositors’ money. We had to do a good job because we faced our depositors frequently. Mrs. Smith would stop by to say hello. Mr. Johnson would tell us about his grandchildren. We didn’t lend out their money willy nilly.

The stock market always sucked when real estate was booming. To make extra money, I did mortgage banking on the side. In 1988/89 there was a huge bubble in real estate in my area. It got to the point where mortgage applications from Hong Kong buyers were shooting out of the fax machine faster than I could staple them together. By that time, we had developed a no-questions-asked lending policy: if the buyer put 40% down on the property, we would look the other way.

I remember asking my boss how this would all resolve. He sort of shrugged his shoulders and said, “I just hope you and I are not here in 20 years’ time.”

By the mid-1990s, bank stocks had experienced a huge boom. The move was attributed to deregulation and the disinflationary economic environment, something like, “rates are dropping, and banks will be able to make tons of money.”

And then came securitization. All of a sudden, the critical failsafe, the thing that kept all of us lending officers honest was removed. You see, we were no longer lending out depositors’ money. The money we lent out belonged to no one. No wonder lending criteria went out the window; there was simply no incentive to enforce the Five Cs.

To make a long story short, I think the loan default data used by modern-day quants must have been based on numbers from past cycles when the Five Cs were in effect. Without accountability, the fear of get fired for making bad loans was gone. The only thing that mattered in this cycle (or bubble) was how much money a lender could push upon the borrower. The more the better. And someone forgot to factor in a big cushion for losses stemming from this fundamental change in lending practices. OOPSIE!

So where do we go from here? As luck would have it, Ben Inker, Director of Asset Allocation at GMO has just released Our Financial House of Cards [DOWNLOAD PDF]. The white paper “looks beyond the current credit crisis in the financial industry to surface broader questions about our financial system: What does it do? How big should it be? And, beyond the current crisis, what is its sustainable level of profitability?”

The key point Mr. Inker makes is this: U.S. financial company profits as a percentage of GDP was at historical highs. Big time. And with contraction in securitization, how will the companies keep up their earnings? If their earnings go back to historical levels, a lot of people currently working in financial services will no longer be required, and the outlook for stock prices is, well, not so good.

The Five Cs are back. They can’t make AAA bonds out of junk anymore. The game is over. It’s time to move on. Perhaps to export-related industries.

P.S. 2008.01.22 Bloomberg just published an excellent article: “Structured-finance adviser Adelson says analysts failed to see that the mortgage market was becoming riskier. They relied instead on models to predict the performance of CDOs based on historical defaults, recovery rates and correlation risks for various credit ratings. They didn’t consider how piggyback loans, which are loans used to borrow a down payment, would perform when extended to people with a history of not paying their bills…”

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