Knowing that I am interested in these kind of matters, friends and family have in the past questioned me about different aspects of the credit crunch. When struggling to explain the sub prime mortgage issue in America, one approach I have found effective is to contrast what actually happened with a more traditional local bank manager model of lending. This type of locally based, conservative, no frills lending model, is one which someone like Captain Mainwaring from the sitcom “Dad's Army” would recognise.
In this local branch model of mortgage lending, the circumstances and history of the mortgage borrower are firmly established to the representative of the organisation doing the lending. Often this relationship will have been initiated through a customer account at that branch, but if this is not the case, local knowledge combined with the information given can build up an effective picture of the customer's financial position. Most importantly the original lending organisation then retains this mortgage customer, creating a solid in-house connection between the person making the face to face decision about whether to lend, and the ownership of the assets and liabilities which derive from this decision.
In this more traditional model, the local branch of that organisation would at any one time hold a portfolio of mortgage accounts, containing a cross section of the local population, and all at different stages of maturity. It is useful to imagine being a local traditional bank manager and having a list of names, job titles, payment histories, balances, all available for you to study. I am by no means a financial whiz, but given a bit of time and maths, even I could with this information, work out the health or otherwise of the assets and liabilities of my bank branch. More importantly, if the wider economic conditions deteriorated, I would feel quite able to grasp how and where this change may impact upon my portfolio of accounts. For example I could skim through my list of customer names and highlight the few who may be at risk of having issues with their repayments, while feeling comfortable about the majority who were either in the later stages of repayment, or who still had comfortable income to payment ratios.
Contrast this with a trader in the sub prime episode holding “sliced and diced” mortgage derived assets, who began to receive negative signals about house prices and mortgage defaults. How could he gauge what his investments were actually worth? He may have a list of account holders attached to these investments, but these faceless names would mean nothing to him other than their mortgage payment history. Someone else from some distant organisation had filled in the application form with the customer and valued the property.
Furthermore, there is the problem of negative selection. If you are a trader receiving investments made up of mortgage customers whom you know little about, being sold to you by someone who knows more about the nature of these customers, chances are they will pass on the less desirable customers. The question of negative selection is less likely to be important for a local bank manager, as his or her mortgage holders are selected by virtue of being existing customers, or at least by the qualification of being local. This may be a weakness if the local area suffers an economic shock like a large employer closing. But this is a relative and regional issue from which risk can be pooled by the parent organisation, in contrast to an absolute negative selection issue, which is you being a patsy for your more informed competitors.
From a systems perspective, the local branch model of mortgage lending has many more characteristics which give it resilience and more importantly contribute resilience to the wider financial system. The diversity and richness of the home loans held by the bank branch contrasts favourably with the homogeneous lump of names held by the trader. A butcher's analogy could be that the bank branch is holding a variety of cuts of meat, right from rump steak through to the cheaper braising steak through to pigs trotters; whereas the trader is holding just big buckets full of unidentifiable mince!
“Alexander et al. noted 'Supervisors ignored or misunderstood the distinction between risk traders and risk absorbers, and the need for heterogeneity' Consequently regulators wrongly focused on 'search liquidity', which needs risk traders, rather than 'systemic liquidity', which needs risk absorbers – people who hold assets for the long run.” (p48 Michael Mainelli and Bob Giffords ”The Road to Long Finance”).
It is easy to argue that a local branch model of mortgage lending would more effectively “absorb” the risks of a housing market crash, as the actors involved have the information and the confidence in the substance of the assets and liabilities they hold to plan, write off and adjust their accounts accurately. In contrast the holders of mortgage derived sliced and diced products would be likely to wish to “trade” in their risky holdings as soon as trouble came on the horizon, even at a big loss. The downgrading of an AAA rating may even force them to sell, in order for them to maintain the AAA clause in their investment approach. The branch bank manager, when questioned in detail by her boss about her exposure to risk during a recession and house price crash, could with confidence analyse or rate customers in terms of varying degrees of exposure. In contrast the trader holding sliced and diced mortgage based investments would have very little to say to his or her boss to calm their nerves in choppy waters.
From a systems view, contrasting the two models by observing their effect on information flows and information hierarchies is useful. “Many of the interconnections in systems operate through the flow of information. Information holds systems together and plays a great role in determining how they operate” … “Hierarchies are brilliant systems inventions, not only because they give a system stability and resilience, but also because they reduce the amount of information that any part of the system has to keep track of. … No level is overwhelmed with information.” p14 & p 83 (Donella H Meadows “Thinking in Systems”).
We constantly hear that we live in a digital information age, but the sub prime practises managed to severely reduce the information and accountability chain between the lending process and the resulting financial asset / liability. The new practises turned mortgages, which are in fact very practical transparent financial relationships, into blocks of toxic opaque financial uncertainty. Many will have heard the word “toxic” being used in relation to these kind of assets. What makes these assets toxic? The answer is unmanageable uncertainty about what their eventual value will turn out to be. What caused this very high uncertainty? Lack of information about home owners situations, and lack of trustable accountability for the validity of the information that was present (e.g. inflated customer income statements).
The hierarchy structure in the bank manager model bestows upon the local manager a desirably comprehensive and yet manageable amount of information about the assets and liabilities he or she is responsible for. The trader on the other hand may find him or herself holding investments relating to many hundreds of home-owner’s which will be little more than a list of names. Further detailed investigation of all the names in this scenario would be virtually impossible. Easier for them to just sell on!
The weaknesses highlighted show that from a systems perspective, some well evolved information hierarchies and subsequently resilience were lost in this instance, by financial innovation in a wrong direction. A bank branch would be more willing to absorb the effects of a downturn by a managed, planned, write-off. The trader would be more likely to attempt trade away the risk as the uncertainty would be unmanageable. The fact that unwise lending not only exposed the weaknesses of this model, but was encouraged by this model is a further point which has been already widely made by others. Not only did this flaw in the system react badly to a housing price crash, but in enabling unwise purchases to escalate it helped to cause the bubble. The misled and ultimately counter productive attempts to create products to insure against these sliced and diced mortgage based investments is also another dimension to the story well covered by others.
Of course I am not proposing that we need to return to 1960s style banking, with a Captain Mainwaring in every branch, but I hope that making the contrast has been useful.