The Bankwatch

Tracking the consumer evolution of financial services

Sub-prime crisis | Back to basics, and the promise of social lending

The always clear and succint Economist sums up the current financial crisis in next weeks leader here. I say crisis advisedly, because the markets are carefully saying nothing, or alternatively, focussing on the sub-prime market in the US, while the reality could be broader, and in any event a signal of a need to get back to basics.

First this from the Economist leader; as you read this, think derivatives and securitisation. The least understood methods, yet that which have largely been credited for the efficiency of global capital markets over the last 20 years. Incidentally, the correction we are seeing is a good thing for those markets, a good thing for social lending, and open source banking, but more on that later.

Risk and the new financial order | Surviving the markets | Economist.com

But there is a price that is only now becoming apparent. Because lenders expected to be able to sell on the risk of default to someone else, they lent too easily. After all, they would not have to pick up the pieces. In theory, that risk should have been borne by the people best able to carry it. But with everybody having sold on the risk to everyone else—and the risk often being carved up, repackaged and sold again—nobody is sure where the losses are. The fear is that some risks ended up with those who least understood what they were getting into, and fear is a potent force in this disintermediated world. In the interbank market, every counterparty was potentially vulnerable. Even small amounts of bad credit can drive out good.

I posted the other day about ‘know your customer’. The world of derivatives and other financial vehicles take financial instruments, such as bonds, currencies, commodities, mortgages, and divide them into different components, then re-assemble them as financial contracts that are traded amongst Banks, and investment houses. The nature of that division, and re-assembly means that the original debtor, the final person who must pay that debt is lost in inter-bank transactions. Know your customer is lost.

In simple terms, thats what has happened with the example of sup-prime loans. BNP in France who froze three of their funds this week, own some component of mortgages in homes in the US. The fact that a Joe Homeowner, hypothetically, in Main Street, Witchita, Kansas, is three months overdue on their mortgage payment after their interest rate and monthly payments rose by 3% is transparent to BNP. All BNP know is that the debt instrument they purchased and rolled into their fund(s) is no longer worth what they expected it to be worth. Worse still, they do not know how many Joe Homeowners there are, to what extent they will default, to what extent the home value will cover the foreclosure, and how long that will take. BNP thought they purchased an income stream, but actually they purchased an overpriced bad debt.

Back to Basics

This will take some time to sort out. There will be short term improvements, but there will also be significant reluctance to purchase obscure instruments, where the underlying credit quality is not guaranteed, so that will result in tighter credit conditions that Banks impose on their mortgage and loan activities.

It is incumbent on all social lenders to watch this carefully, and appreciate there is an opportunity to provide a valid and financially sound alternative to borrowers and lenders. Social Lenders still use the common approach of credit ratings to signal likelihood of payback on a loan. But they have the added advantage of additional factors that can be brought into the mix, the secret sauce of social lending, that traditional Banks can never replicate. Social Lending is highly transparent, and hiding is much harder in the open. The quality of lending that can occur within a well run social lending operation can greatly transcend the ‘by the book’ transaction that occurs in a one on one application and approval process typical of Banks.

Incidentally, as as aside, recently Prosper have been having issues, bringing out phrases such as ‘lender revolt’ and Prosper need to get that under control, and eliminate the emotion. Their issues go back to problems embedded in their early offerring, of lending to people with poor credit. That have since been corrected, but long time Prosper lenders are bearing those costs associated with that lending. Such lending has been eliminated from Prosper since early 2007. They saw the problem, learned and eliminated it.

Social Lending by definition carries the promise of at least eliminating the problem that the financial markets experienced this week. A promise of a simpler financial process, one that is easily understood and explainable. It won’t replace the worlds capital markets, but if it can provide at least a small alternative to those who choose, then mission accomplished.

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Background:
It is such a powerful piece, here, is the full leader from The Economist. I strongly recommend you buy it, and read the other related articles:

Risk and the new financial order

Surviving the markets

Aug 16th 2007
From The Economist print edition

The new financial order is undergoing its harshest test. It will not be pretty, but it is necessary

Illustration by Jon Berkeley

THE lifeguards had been scanning the horizon for an oil-price shock,
a bankrupt buy-out or a terrorist attack. But when the big wave struck
last week it surprised them by coming from inside the financial system
and threatening to swamp an unlikely shore, the money markets where
banks lend to each other to help cover their daily operations.
Investors have been asking for years if the frantic innovation in
finance, especially the securitisation of just about every form of debt
into a tradable asset, was a way to spread risk efficiently, or whether
this left the financial system prone to rare—but cataclysmic—failures.
It looks as if investors are about to find out.

Over the past week central banks have lent tens of billions of dollars to restore confidence to the markets (see article).
But it is already clear that this mess is about more than a bit of rash
mortgage lending to Americans who were in the habit of falling behind
with their monthly payments. Hedge funds and private-equity firms,
kings of the boom, are nursing big losses. Debt markets that once
handed out cash to all comers are tight or closed altogether. In almost
every asset market, investors are scurrying to reprice risk—which
mostly means to reduce it.

The gravest and most immediate threat is to the banking system. For
the time being, banks no longer trust other banks enough to lend them
money except on onerous terms; equally worryingly, they lack confidence
that other banks will trust them if they want to borrow. It is alarming
when the very outfits that exist to supply the economy with credit
start to hoard it from each other. At best this tightens monetary
policy; at worst, a shortage of cash will cripple the payments system
and cause runs on otherwise solvent banks and businesses that cannot
rapidly raise funds.

Underneath all the new technology and the fancy derivatives with
strange acronyms is a dilemma as old as banking itself. Anyone who
thinks that lending has been too loose—and many bankers do—should
welcome a purge: better now than later when the imbalances would be
bigger and the economy probably weaker. But if good banks fail and
money for good companies dries up, the purge will wreak huge and
wasteful damage on healthy parts of the economy. How likely is that?

Fear of the deep

Financial crises are always about the way people do business, and
not just the deals they have struck. Yet this one goes deeper than
most. The spreading panic has shown up weaknesses in some of the
foundations of modern finance. The past 20 years have created untold
wealth. As securities and markets have steadily taken the place of
old-style bank managers, the number of potential investors has grown
and the cost of capital has fallen. Much good has come of that.

But there is a price that is only now becoming apparent. Because
lenders expected to be able to sell on the risk of default to someone
else, they lent too easily. After all, they would not have to pick up
the pieces. In theory, that risk should have been borne by the people
best able to carry it. But with everybody having sold on the risk to
everyone else—and the risk often being carved up, repackaged and sold
again—nobody is sure where the losses are. The fear is that some risks
ended up with those who least understood what they were getting into,
and fear is a potent force in this disintermediated world. In the
interbank market, every counterparty was potentially vulnerable. Even
small amounts of bad credit can drive out good.

In theory, ratings agencies and mathematical models help investors
price the risk they are taking on, even if the securities they are
buying are scarcely traded. Yet when some supposedly good-quality
assets proved to be worth little, people lost faith in the models and
the ratings. Across the board, investors had failed to take account of
how fast and how far asset prices fall when everyone wants to sell at
the same time. Hard-to-sell long-term securities had been bought with
short-lived debt, which left borrowers vulnerable to a change in
sentiment every time the debt fell due. It does nothing to restore
confidence when the biggest model-driven hedge funds had to get in new
money. The people at Goldman Sachs lost a packet when something
happened that their computers told them should occur only once every
100 millennia.

Reassess, reprice and then rebound

The retreat to a new level of risk was never going to be orderly or
free of casualties. Neither should it be. Bankers and investors need to
suffer precisely because the methods of modern finance have been found
wanting. It sounds Darwinian, but the brutal demonstration that you pay
for your sins is what leads the system to evolve. Markets learn from
their mistakes. Only fear will spur investors to price risks better and
get them to put more effort into monitoring their counterparties.

If these lessons are to sink in, central bankers must stand
back—as, by and large, they have done. Every intervention now will be
taken as a sign of what the regulators will do next time. If they bail
out banks that have mispriced risk, the mispricing will continue. And
when the central banks do step in, it should not be to save the
financiers. The cost of intervention is warranted only to save the rest
of the economy from the financiers’ folly. By that test, central banks
were right to lend money to the banks in recent days, because it
ensured that a liquidity crisis did not become a solvency crisis. They
may yet have to take over a failed bank, though only if that is needed
to stop a run. It is still far too soon to cut interest rates.

Because this crisis taps so deeply into the newly devised structures
of finance, anyone who says the worst is definitely over is either a
fool or someone with a position to protect. As risk has become
bewilderingly dispersed, so too has information. Nobody yet knows who
will bear what losses from mortgages—because nobody can be sure what
those loans are really worth. Nobody knows if tighter lending standards
will oblige borrowers to raise more capital, triggering more sales in
stockmarkets and more pain. Nobody knows how messy the inevitable
bankruptcies will turn out to be. What markets need now is time to
piece that information back together. Time before the next wave
strikes.

Written by Colin Henderson

August 17, 2007 at 11:27

4 Responses

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  1. […] November 13th, 2007 · No Comments The trends within Prosper are interesting since the sub-prime crisis hit.  Two things stand out that show promise to bear out earlier predictions: […]

  2. […] own take, that I have written about, is that the technical mechanics of interbank investments (Asset Backed Commercial Paper, […]

  3. […] CNN:  How to prevent the next Wall Street crisis The new “innovations” simply hid the extent of systemic leverage and made the risks less transparent; it is these innovations that have made this collapse so much more dramatic than earlier financial crises. But one needs to push further: Why did the Fed fail? He is referring to the distance between the ultimate borrower (sub prime mortgage in hometown America) and the ultimate lender (perhaps a Bank in Switzerland or UK).  More on that here. […]

  4. See also http://www.buzzlending.com in France where social lending start to take off.
    Best regards
    Chris

    Chris

    January 23, 2009 at 07:16


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