Reaping What You Sow
As a child I learned the expression “you reap what you sow.” Over time and through experience I have learned that it is absolutely true. From time to time people forget this simple lesson and, in the case of the banking, investment and financial institutions of the United States in this recent economic crisis, sometimes people and businesses are forced to learn this lesson the hard way.
Over the last 20 years, incentives were created by congress to incent banks and financial institutions to lend money to borrowers who were not creditworthy. In fact, astute bankers knew that these borrowers would never be able to repay the loans that the bankers were making. Because of the incentives, the bankers didn’t care if the loans were paid back or not. The bank was only concerned with the ability to submit the loan to a pool of loans and get the loan off the books of the bank. Programs similar to the widely known mortgage programs were created for auto loans, boat loans, office equipment loans, consumer loans and even loans to buy pets.
In less structured times, bankers were careful and, in a free-market society, bankers would lend money only in the event that the borrower was willing and able to repay the loan to the bank. The penalty to the bank for not collecting on the loan was motivation significant enough and carrying enough associated penalties to incent the banker to be extremely careful. The fear of the consequence governed the motivation for profit.
When congress passed laws and the financial markets moved to create vehicles to package loans into securitized, rated and transferrable units, bankers became disconnected from that natural, free-market incentive to take care when extending a loan. The banker became financially motivated to extend as many loans as possible and to sell those loans into the securitization conduits as fast as possible. Electronic systems were created to accelerate the process and improve profitability for the bank or financial institutions and from 2003 to 2007 hundreds of billions of dollars of these transactions occurred.
With the increasing profitability of these quick-turn loans, the banks began purchasing “investment-grade” assets from top financial institutions. Many of these assets were backed by mortgages, auto loans, boat loans, etc. Because the assets had been pooled, diversified and rated as a high-quality asset, the asset became a high-quality asset—insured, guaranteed or otherwise rated as investment grade—despite the fact that the core assets underlying these securities were the very same loans that the bank had originated without any care as to the borrowers willingness and ability to repay. And ultimately, the banks, insurance companies and financial institutions purchased these same securities that they had helped create—those securities containing the loans that would never be repaid.
As fate would have it, the banks and financial institutions are reaping what they have sown. The borrowers are showing significant indications of not being able to repay—for some reason this is still a surprise to some people. The ultimate lender to the borrower was, in fact, the banks and financial institutions that thought they were not going to be responsible for collecting on the loans. The bank thought that the free-market penalty for originating bad loans to bad borrowers was not going to be their problem. Unfortunately for them, they misunderstood the principle that you reap what you sow. In addition to the poor probability of repayment, the loan collection issues and the accounting rules requiring the financial institutions to mark the value of these assets to the last known market price will force many of these banks and financial institutions out of business. It appears that banks, financial institutions and Wall Street have learned again, you reap what you sow.
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