Thursday, April 29, 2010

BAD LOANS

I have been following the financial reform bill and the debate via the media as best I can. The shape of the bill appears to be quite comprehensive, with one very fundamentally large exception. The bill appears to focus on absorbing the losses resulting from another financial panic or meltdown so the whole economy is not imperiled to the same degree. Things like "too big to fail", enhanced capital requirements, lower leverage limits, regulation of derivatives, executive compensation, and even the bank tax, are all well and good (perhaps), but they don't address the issue of actually preventing a future crisis.

In fact the one thing that's not covered is the prevention of making bad loans, or least an attempt to so. If the loans were good loans, no amount of leverage, securitization, derivatives, out sized compensation, or other opaque complexities or side bets, would have been a problem.

Why hasn't the emphasis been, as far as reasonably possible, to prevent lenders from making bad loans.

There is a lot of talk about a Consumer Protection Agency when what we really need is a Lender's Protection Agency. I know the optics don't look very good, but that's what's really needed. We need to protect lenders from making bad loans.

You say that sounds silly, well it's not so silly and here is why. I'll start with a story about a piece I saw on 60 Minutes. They interviewed a subprime lender in California (he seemed like a pretty smart guy) and asked how could he make loans to people who not only put no money down, but didn't even go through a credit check (income , job, assets etc-NINJA loans.) These were also known as liars loans. He said that he knew that he should have required all of the basic underwriting stuff , but that if he did so, his customers would just go down the street to another lender who won't require it, and in a few months he would be out of business. He was caught in a trap, even if one of his own doing, and he couldn't stop unless his competitors did as well. The only way to have put a stop to this insanity would be for the government to stop everyone from making these bad loans. That's what they do in Canada; no home loans without putting 20% down and customary credit underwriting.

Not so long ago our banks were "required" under banking regulations to use "safe and sound lending practices" to properly underwrite loans. Clearly the so called NINJA loans won't qualify. Implementing such a rule again would protect the banks from themselves and as a result protect all of us. I don't know when that all went away , but at the very least we should bring it back and apply it to all lenders of any kind. These shaky, some say shady, loans not only hurt the borrowers but in the end hurt the lenders as well; as we have so painfully seen.

So let's add a Lender's Protection Provision to the financial reform bill to protect lenders against making bad loans. Of course, you can't eliminate all bad loans, but we could go a long way in that direction and then we wouldn't have to worry so much about all that other stuff everybody talks about, but was not the root cause of the financial crisis. The root cause was BAD LOANS.

I'll discuss why lenders were allowed to make these bad loans in a subsequent post.

Eric

2 comments:

  1. 1. For any bill today, a Senator's and a Representative's name does not cut it anymore, legislation has to have a shameless name like The Patriot Act, regardless of the purpose of the legislation. So you need a name/evenlogo with the right optics.
    2. The first portion of this "sub-prime lender's excuse" touches on what needs to be a "level playing field" approach to lending. In any business, while certain aggressive people want the field tilted, most legitimate competitors need a level playing field, so as to avoid unscrupulous competition.
    3. In the field of lending, any sort of lending that is done by individuals who get incentive compensation is going to result in aggressive/substandard loans. In other types of businesses, there is a sales force with incentive/commision pay; but a credit department that is paid a fixed salary. The credit department, which must hold sway, is the control on the business's credit sales. In a bank/finance company/mortgage company, the credit departments often are subservient to the sales/originators.
    4. The default comparision with a business sales organization and a bank is also interesting, because in a business organization you generally know in 30 or 60 days if you made a bad credit decision. In a bank it may take a year or more to have credit problems, whereas incentives are not withheld until that takes place.

    A simple solution would be to have any lending person in a federally insured financial institution to be prohibited from incentive pay. Believe me...it would solve the problem...and it makes perfectly good sense for our banking system.

    Marc/Commercial banker

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  2. Marc's solution hits on a great point.

    Banks don't pay their loan officers to say "no". They only get bonuses for making loans. They don't get bonuses for not making loans that shouldn't be made.

    It's like the age old conflict between brokers and lawyers. Broker only get paid if the deal closes but if it does close they get paid way more than the time and effort they put in.

    Lawyers get paid whether the deal closes or not , but a more modest amount than what the broker would get.

    Guess where the incentive are in that scenario to close the deal, whether it's a good one or not.

    Marc's solution deals with that problem.

    Eric

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