Lending's Blind Spot

Global stocks have experienced wild fluctuations this week in the wake of the U.S. government's seizure of insurance giant American International Group, the failure of Lehman Brothers, the disappearance of Merrill Lynch as an independent company and reports the U.S. government will set up a government entity to take on bad debts from financial institutions.
By Peter R. Fisher
Saturday, September 20, 2008

How can a financial system that was thought to be so well capitalized just 18 months ago have proved to be so much more highly leveraged, and so much more poorly capitalized, than we thought? How did this leverage so abruptly and persistently translate into a lack of liquidity in the banking system and falling credit asset values?

The answers are likely to be found in the degradation of our credit markets caused by the prevalence of asset-based -- or "repo-based" -- secured financing.

Much analysis of "what went wrong" has focused on "agency problems" -- the misalignment of incentives -- in the underwriting of home mortgages; those who wrote an individual mortgage failed to examine the borrower's ability to repay because of their own intention to sell that mortgage to other investors. In our highly evolved financial system, there is a daisy chain of agency problems both in the creation of credit (from asset originators to asset distributors to asset managers) and in the investment process (from beneficial owners of assets, to boards of directors, to staffs, to consultants and again to asset managers). These problems are not new. In fact, they could have been cited just as easily in 1978, 1988 and 1998 as today.

Yet while there are significant differences between the events of 2008 and 1998, there is a haunting parallel in the mechanics that repo-based financing played in the story of Long-Term Capital Management and in the system-wide dynamics that began to unfold more than a year ago.

The degradation of our credit process comes about when lenders stop paying attention to borrowers' ability to repay out of cash flow and make decisions solely on the basis of the expected value of the collateral, and whatever loan down payment or equivalent securities "haircut" the lender can secure, whether the borrowers be households or hedge funds.

With all the discussion about underwriting standards for home mortgages, it is more than a little odd that we have been analyzing the crisis in our financial system for more than a year and nobody has spoken about underwriting standards for lending to hedge funds, or structured investment vehicles, or real estate investment trusts, or collateralized debt obligations, or broker-dealers or even to banks themselves. This glaring omission is a reflection of how deeply we are immersed in a culture of asset-based finance, in which lenders lend against the expected momentum in asset values.

Perhaps after a quarter-century of a bull market in credit asset values -- brought on by the persistent decline in nominal interest rates caused, in sequence, by disinflation, productivity gains and an extended period of abnormally low real rates -- we should not be surprised that "credit" has come to mean secured financing that presumes, rather than inquires into, the cash flows of borrowers. But as we have discovered to our peril, if no one is looking at the borrowers' ability to repay their loans, the value of the assets composed of those loans is not very good security.

In this system of transaction-based leverage, the haircut becomes the loss absorber of first recourse. But the haircut is only a slice of the asset itself and, thus, the "capital" available to absorb losses on the asset is perfectly correlated with the asset. As the asset rises in value, this correlation creates an additional cushion and appears to justify the wisdom of the loan; but when the asset's value falls, the cushion decays at the same rate. As lenders seek to protect themselves by increasing their implicit capital cushion through increasing haircuts (as commonly occurred in the first half of this year) their actions both confess their failure to look to the borrowers' cash flow as the first recourse and demonstrate the inherent weakness of asset-based financing as the impact of rising haircuts on asset values becomes self-defeating.

This cycle explains how our financial system became so much more highly leveraged than we thought it was and why there is such an extraordinary divergence between the value of credit as priced in the market and the value of the underlying cash flows that reflect borrowers' ability to repay their loans.

In reconsidering the Basel capital rules, maybe regulators should begin by looking at the treatment of secured lending. In reflecting on the lessons learned, maybe bankers need look no further than their own underwriting standards.

Peter R. Fisher, who was Treasury undersecretary for domestic finance from August 2001 to October 2003, is co-head of fixed-income portfolio management at BlackRock. This article is based on comments he presented last month at the Federal Reserve Bank of Kansas City's symposium at Jackson Hole, Wyo.

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