On Market-Based Credit

Reader DS in on a roll. A couple of days ago, he sent us an e-mail which we posted, with a few comments of our own, as “Toothless Fed.”

DS focuses on another remark in New York Fed President Timothy Geithner’s speech last week, “Credit Markets Innovations and Their Implications,” which led him to consider the distinction between credit pricing and terms being set by “markets,” that is, markets for financial instruments, rather than other competitive processes.

In the early days of asset-backed securities, securitiztion did not have much impact on the lending process. You still had banks making loans backed by collateral (mortgages, or cars, or credit card receivables) that investment banks sliced, diced, packaged, and sold to investors.

But as this activity grew, the pricing of the paper in the secondary market began affecting first, credit decisions (even if you thought the loan was too risky, if Wall Street said they could sell it and you got an origination profit, why should you care?) and then even credit processes (Tanta of Calculated Risk described how the mortgage approval process has been so dumbed down as to be close to a charade).

DS elaborates:

Here’s another point that may or may not have been discussed by others. In his speech that you post, Geithner writes at the beginning of one of the paragraphs:

In systems where credit is more market-based

It’s a very telling phrase: ‘more market based’

Let’s unpeel it.

Market based instead of, ‘credit based’. I.e. in the ancient days of sound banking, credit was credit based. Indeed, even having to write that sounds dumb. Of course, ‘credit was credit based’ … what else could it be?

But, actually in the ancient days of sound banking, ‘credit was credit-market based’. That is, all banks participated in markets that offered credit. In local, housing markets, bank credit was ‘credit market based’ in the sense that there was a local market for credit and that market set the terms and approaches of competition — for competitors, for customers, for shareholders, etc.

Among those terms of competition were the now ancient idea that credit worthiness of a customer was something worth considering in whether to grant a credit. Yes, risk was also part of the equation. Folks took more or less risk as they liked. And, those folks making the choice to extend credit — the bank underwriters – had jobs that actually required them to evaluate the credit-worthiness of customers (in part, because as you point out, another aspect of ‘credit being credit-market based’ was that principal stayed on the banks’ books.)

But, Geithner’s phrase is speaking about a very different kind of market. He’s not referring to ‘local credit markets’, he’s referring to national and global financial markets. Now credit is ‘more market based’ in the sense that it is more based on these massive financial markets and HOW THEY PRICE AND BUY PAPER.

In these new, innovative massive financial markets, credit is offered according to very different rules of competition; including, credit scoring that is done not as a primary valuation of the borrower, but rather to ‘fit’ what the financial markets have appetite for.

In this new world, we don’t pay primary attention to the borrower — we pay primary attention to the buyer of our paper.

This, in turn, creates a new moral hazard. Geithner (Or maybe one of the others you’ve cited) speaks about the moral hazard of banks that are insured by the government. But that pales in insignificance compared to the moral hazard of granting credit based on ‘credit being ‘more market based’ in this new world of innovation.

Credit as ‘more market based’, then, means credit has become a trade-able financial instrument in capital markets that are beyond the reach of regulation and driven by people hell bent on getting theirs before the great Minsky moment bursts the bubble. Meanwhile, local credit that once drove sound development of local economies now drive people into unsustainable financial postures that, when joined by the forces of job insecurity, lower real wages and lessening real benefits, dual working households, way too much use of usurious credit cards and more, mean that local economies float on helium.

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