January 1, 2009

Banks Stopped Investing and Started Speculating

Over Christmas I have had a bit of a chance to catch up on some reading, one of the books I read through was Garrett Gunderson's Killing Sacred Cows: Overcoming the Financial Myths That Are Destroying Your Prosperity. In Gunderson's book he suggests individuals look at investing in the same way that banks do as they have been so extremely efficient. As Gunderson puts it banks mitigate investment risk in personal loans by doing the following:





  • Check your credit.
  • Secure their investments with collateral
  • Require a down payment
  • Determine the interest rate
  • Determine the payment
  • Determine the time period for each investment
  • Verify your work history and income
  • Have an exit strategy that allows them to be profitable, or to at least return their initial capital, in almost any scenario imaginable.
  • Transfer their risks to the borrower in any way possible.

The goal then from the bank is to remove risk, and securing the loan all by investing in the individual, knowing that individual, and creating firewalls to secure the investment.

This looks very similar to Benjamin Graham's discussion in the first chapter of his Intelligent Investor where Graham talks of the differences between investing and speculating:




An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.
P. 18, Benjamin Graham's The Intelligent Investor

In thinking about the current financial crisis it seems to me that what really lead to our current predicament is that banks stopped investing and started speculating. They lost track of what they were so good at and started making decisions based on limited information and partial data.

Let's look at the list again and reflect on the what banks have actually done over the last few years:
  • Check your credit.
    No limited credit checks were preformed and massive overstating of income occurred.
  • Secure their investments with collateral.
    No, sometime collateral was not required at all.
  • Require a down payment.
    No, sometimes another loan was made to create the down payment.
  • Determine the interest rate.
    No, some loans had interest rates that were set and then reset later so the consumer or lender never really knew what the rate was going to be.
  • Verify your work history and income.
    No, not at all.
  • Have an exit strategy that allows them to be profitable, or to at least return their initial capital, in almost any scenario imaginable.
    Obviously not.
  • Transfer their risks to the borrower in any way possible.
    Laughably no.

This lead to the crisis, now we are in essentially a credit freeze where gaining access to funds is difficult if not impossible. I would argue that it is not because banks are fearful to loan money, they simply do not have the tools they once had to assess the safety of the investments. Those tools were thrown out piece by piece over the last few years and installing them back again, or creating a new set of tools is difficult.
Understand, the industry went through a massive change to get to where it currently is and that getting back to what it was so efficient at in the past does not happen overnight.