Coverage and Collateral
I thought that I must be just woefully old fashioned.
In my mind the real reason for the financial crisis was that bankers lost sight of what it takes to operating a lending business.
There are really only two simple factors that MUST be the first level of screen of borrowers:
And banks stopped looking at both. No surprise that their loan books are going sour. There is no theory on earth that will change those two fundamentals of lending.
The amount of coverage, which means the amount of income available to make the loan payments, is the primary factor in creditworthiness. Someone must have the ability to make the loan payments.
The amount of collateral, which means the assets that the lender can take to offset any loan loss upon failure to repay, is a risk management technique that insulates the lender from “expected” losses.
Thinking has changed over the last 10 – 15 years with the idea that there was no need for collateral, instead the lender could securitize the loan, atomize the risk, thereby spreading the specific risk to many, many parties, thereby making it inconsequential to each party. Instead of collateral, the borrower would be charged for the cost of that securitization process.
Funny thing about accounting. If the lender does something very conservative (in terms of current standards) and requires collateral that would take up the first layer of loss then there will be no impact on P&L of this prudence.
If the lender does not require collateral, then this charge that the borrower pays will be reported as profits! The Banks has taken on more risk and therefore can show more profit!
EXCEPT, in the year(s) when the losses hit!
What this shows is that there is a HUGE problem with how accounting systems treat risks that have a frequency that is longer than the accounting period! In all cases of such risks, the accounting system allows this up and down accounting. Profits are recorded for all periods except when the loss actually hits. This account treatment actually STRONGLY ENCOURAGES taking on risks with a longer frequency.
What I mean by longer frequency risks, is risks that expect to show a loss, say once every 5 years. These risks will all show profits in four years and a loss in the others. Let’s say that the loss every 5 years is expected to be 10% of the loan, then the charge might be 3% per year in place of collateral. So the banks collect the 3% and show results of 3%, 3%, 3%, 3%, (7%). The bank pays out bonuses of about 50% of gains, so they pay 1.5%, 1.5%, 1.5%, 1.5%, 0. The net result to the bank is 1.5%, 1.5%, 1.5%, 1.5%, (7%) for a cumulative result of (1%). And that is when everything goes exactly as planned!
Who is looking out for the shareholders here? Clearly the deck is stacked very well in favor of the employees!
What it took to make this look o.k. was an assumption of independence for the loans. If the losses are atomized and spread around eliminating specific risk, then there would be a small amount of these losses every year, the negative net result that is shown above would NOT happen because every year, the losses would be netted against the gains and the cumulative result would be positive.
Note however, that twice above it says that the SPECIFIC risk is eliminated. That leaves the systematic risk. And the systematic risk has exactly the characteristic shown by the example above. Systematic risk is the underlying correlation of the loans in an adverse economy.
So at the very least, collateral should be resurected and required to the tune of the systematic losses.
Coverage… well that seems so obvious it doed not need discussion. But if you need some, try this.
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