Banking has suffered a not-sufficiently-acknowledged loss of know-how on the lending side. Back in the stone ages when I got an MBA, there were a few fellow students from big commercial banks like Chase (and no former investment banking analysts, the two year posts for college graduates) and they had all gone through credit training. But by the mid 1980s, the big end of town was fascinated with automated models and expert systems. American Express was considered the sophisticate of the crowd, allegedly with the most finely tuned program.
Fast forward 20 plus years, and the credit card issuers formerly seen as most savvy, Amex and Capital One, now are sporting credit losses not markedly different than their peers. FICO based mortgage lending has proven to be a train wreck.
The problem is that there isn’t a good substitute for knowledge of the borrower and his community. Does he understand what he is getting into? How stable is his employer? What are the prospects for the local economy? Those are important considerations, and they require judgment. That may still in the end be used as an input to a more structured decision process. but overly automating borrower assessment has resulted in information loss. It’s hardly a surprise that the quality of decisions deteriorated.
Meredith Whitney has pointed to this issue, but it has received surprisingly little attention:
Since the early 1990s, key bank products, mortgages and credit card lending were rapidly consolidated nationally. Banking went from “knowing your customer” or local lending, to relying on what have proven to be unreliable FICO credit scores and centralised underwriting. The government should now motivate local lenders (many of which have clean balance sheets) to re-widen their product offering to include credit cards and encourage the mega banks to provide servicing and processing facilities to banks that sold off these capabilities years ago.
Getting better customer input is crucial whether the powers that be are successful in putting in the reforms needed for private securitization to revive (the inaction on this front speaks volumes) or whether the end game is more on balance sheet lending by banks. The Financial Times’ John Dizard in April 2008 said that the Fed expected to see a considerable reversion to more credit intermediation by banks, but wasn”t taking the commensurate steps:
Think of the main US banks and dealers, along with their regulators, as the Iraqi government – though without the same unity, purpose or long-term planning. The cash positions and liquidity of both are better now. The Iraqi government is not squandering its money on food for the ration system, medicine, electric plant or water treatment.
The US banks and dealers are through the first quarter, and are backstopped by a Federal Reserve that has gone from vestal virgin to camp follower. Some of the accountants would have appended the above quote from Matthew’s gospel to their opinions on the banks’ and brokers’ quarterly earnings statement, but it did not fit the guidelines of SFAS 157, the accounting standard.
It is not fair to say the Fed does not have a plan. It does. The plan is for the banking system to recapitalise for a new on-balance sheet world by raising a minimum of $200bn in a short period of time, not longer than two quarters. That way, there is no credit crunch, according to the model.
We seem to be on to Plan B, which is to have the Fed step in to pretty much every credit market (adding commercial mortgage securities to the TALF is the latest wrinkle). If there ever is an exit, it would involve either a bigger role for traditional banks or considerable fixes to the securitization model, but we aren’t hearing any noise on either front.
I’d be curious if readers can point to milestones in this devolution. Some have suggested that the consumer lending skill loss took hold in the 2003 period onward, but Whitney pegs it as a 1990s phenomenon, and I saw some elements of behavior change even earlier than that. Any input here would be very useful.