A continuation from Part 1.
“You are not paid to think,” is what my father said. “You are paid to sit there and do what you’re told.”
He was imparting his wisdom when I told him about the troubles I was having working in banking.
“Even if they tell you, you are paid to think, you are not paid to think. You are just paid to sit there and to do what you’re told. Don’t offer any insights. Don’t offer any opinions. And whatever you do, don’t come up with any ideas. Just shut up and do what you’re told.”
And he was right.
As far as my experience in banking told me management, supervisors and employers have two goals; self-preservation and maintaining the status quo. Thinking, inevitably leads to ideas. And ideas lead to better ways of doing things. And better ways of doing things usually results in streamlining operations. And streamlining operations leads to eliminating redundant positions, most likely theirs. Basically, thinking leads to change and change is bad because it disturbs the status quo. But most disconcerting, especially for the person doing the thinking, is that it is dangerous for it usually ends up in the thinker ramming heads with management and ultimately losing his job.
Thus with that short fount of knowledge my dad explained to me single-handedly more about the working world and how it operates than any human resource class or seminar ever did. And with this newfound knowledge I started to find a bit of solace in my job. I stopped bothering asking why. I stopped thinking or worrying about the ramifications of the decisions passed down to us by management. I stopped caring about the viability of loans. I altogether stopped caring. If management in its subtler ways was telling me to approve a loan, I approved it. If I was getting questioned on the wording I chose or a sentence I had written, I’d revise it verbatim to their liking. And if the numbers didn’t come out the way management wanted, I’d massage them into what they wanted. In essence I forfeited sentient and independent thought and just became another cog in the machine. I plugged myself into the Matrix, surrendered to blissful ignorance and did whatever management told me.
But the same could not be said for Jimmy.
Jimmy was a banker and in spite of that he was a buddy of mine. One of the few that didn’t have his head in the sand and instead of just trying to push loans through to get the commission, he actually cared about the likelihood of repayment. He was a brand new banker, and in being such was crippled by his idealism and integrity. One day, obviously frustrated he pulled me into his office, closed the doors and asked me, “Look, I need your help. What the heck is going on here?”
I said, “What do you mean?”
“Well, this business, these loans. They’re all garbage. The other bankers are bringing deals to the table that are worthless. Condo deals, town homes, and I’m not the economist you are, but I read your reports and I at least understand the market’s oversupplied. There’s no way those developments are going to sell. But their loans get approved anyway, meanwhile I’m getting yelled at because I’m not meeting my quota. It’s almost like they want us to bring in bad loans. It just doesn’t make sense.”
And then I realized what was happening. Jimmy was new. And in being new he foolishly held onto some romantic notions of running a good business, making good loans and doing what was in the best, long term interests of the bank. He, like I did before, somehow thought that efficiency and profitability were the primary goals of the bank. That the bank existed to make a profit. And that because of this, management would presumably prefer to avoid bad loans. In other words he didn’t understand the true business the bank was in. That it was not there to make a profit, serve the shareholders or conduct good business, but that it was there first and foremost as an employment vehicle for castes of senior managers and bankers. That profit and efficiency were truly secondary, if not a complete ruse. Nothing more than sweet nothings to be whispered into the shareholder’s ear. And so to help him out I decided to share my father’s wisdom with him, but in my own special way;
“You see, Jimmy, here’s how it works. Everything’s a 4.”
“A wha?” he asked.
“A 4.” I said.
Confused he asked, “What do you mean a 4?”
And so I explained.
4 was the magic number. Every bank in the banking world has a rating system by which they rate loans, somewhat similar to the bond ratings put out by Moody’s or Standard and Poor’s. There’s no standard rating system, each bank internally develops their own, but all of them have a numerical rating assigned to each loan to score it in terms of its quality and risk. An ideal loan would have a risk rating of 1, a bad loan might have a risk rating of 8. The particular rating system being used by this bank was a scale of 1-8, 1 being ideal and 8 being bankrupt with no hope of recovering any of our money.
But what made this bank’s particular risk rating system unique is that the method by which the loans were rated was completely mathematical. Meaning all the sub-scores that culminated into the final risk rating were based on numerical measures. Things like debt ratios, cash flow ratios, numbers that were exact and precise and could be mathematically measured, leaving no room for misinterpretation. Therefore if the loan’s “debt service coverage ratio” fell between 1.2 and 1.5, then you would apply a sub score of 5. And if the “loan to value ratio” was between 50%-70% then you would apply a sub score of 3. The point being that there was no room for error as there were no “gray” areas, and therefore no subjective judgments.
I personally liked this particular risk rating system because the ultimate risk rating was not debatable. Once you plugged in the numbers, the loan would have a mathematically calculated risk rating, and that was that. Also because of its mathematical nature its calculation could be automated. So gleefully I programmed a model that would automatically calculate the risk rating of every loan and imbed this information into the report. Thinking management would be impressed with this minor little streamlining, I proudly presented the first loan rated by this new model, which happened to have a score of 2.
“No, no. This isn’t a 2, it’s more of a 4” my boss said.
Which seemed odd to me because the formula, the finite, non-subjective, literal and mathematical formula had it at a 2. It was no different than me presenting him with the formula “1+1=2” and him saying, “Nope, that’s really more of a 4.”
I submitted a new report for a new loan. The risk rating literally was a 7.
“No, no. This isn’t a 7. This is more of a 4.”
Formula said 6.
“No, no. This is a 4.”
And soon I realized that it didn’t matter what the actual risk rating of the loan was, everything was a 4. If it was a great loan, with a great borrower, lots of collateral and excess cash flow;
If it was a former drug dealer, convicted of bribery, extortion and fraud currently under investigation and in the middle of filing for bankruptcy who wanted a loan to help transport some “flour” from Colombia;
And not only would the actual risk rating of the loan largely be ignored, but if any of the risk ratings deviated too far from 4 then the higher ups would lecture us about not paying close enough attention to the loan and the risk rating.
Thus, to play ball and keep our jobs, not to mention just get the loan through, we would manipulate the figures to make them all 4’s. If the loan was particularly good, we’d maybe rate it a 3. Or if it was particularly bad, we’d maybe rate it a 5. But we’d never deviate too far from 4 even if the loan was indeed an 8.
Once we started manipulating the figures the results were amazing. We spent less time explaining our risk ratings to the higher ups. We spent little time substantiating and defending our risk ratings. We spent significantly less time “revising” the figures to get the loan to be a 4. And just like a husband realizes that “yes dear” is the single most powerful phrase in all of marriage, we too learned that “4” is the most powerful number in all of banking.
So I explained to Jimmy, “You see Jimmy, everything is a 4. Every loan we do is risk rated a 4. Doesn’t matter if the guy is blatantly trying to steal money from the bank. Doesn’t matter that the guy asking to borrow money is Alan Greenspan himself. Doesn’t matter if the mathematical formula says it’s an 8, because everything is a 4. The key to succeeding at this bank is to worship, bow down to and name your children after the number 4.
For you see Jimmy, you’re not here to make good loans. You’re here to make loans period. I too was foolish enough to think that somehow logic or wisdom or some kind of credit control would be desired on the part of the bank. That somehow the bank would like to be profitable. But that was my first mistake; I thought. But like me, you have got to quit thinking. You don’t think. You just do what you’re told. If they want condo deals, you bring them condo deals. If they want twin home developments, you bring them twin home developments. If they want theme parks in the middle of nowhere, you bring them theme parks in the middle of nowhere. You just worship the number 4. And even though every ounce of your body is telling you it’s wrong. Even though every ounce of your body is telling you we’ll never see the money again. And even though your intellectual soul is screaming “9!” that’s not your concern. Your concern is the number 4.”
And then Jimmy, like me, had the epiphany.
“So in essence I’m not paid to think. I’m just paid to do bring in deals?”
Regardless, while we all did worship the number 4, 4 wasn’t the only number that was important in the banking world. 16 was another important one. Specifically 16%. For 16% was the rate of return the bank demanded on its loans.
Some banks do it, some don’t, but banks only have a certain amount of money to loan out. Ideally they want to get as high of a return as possible on that money so instead of loaning money out to anybody, they loan money out only to those people who are going to be most profitable. And to ensure this they write it into their policy that a loan must provide an “X” percent rate of return. In this bank’s case the hurdle was set at 16%.
However, banks don’t just look at the interest rate when calculating their rate of return. They look at the “total or “overall” rate of return on the loan which includes closing costs, various fees, and commissions. And just like they had a formula to calculate the risk ratings of loans, they also had a formula that would calculate the “overall” expected rate of return. So if a proposed loan didn’t provide a 16% rate of return it was declined.
This provided bankers and analysts a great incentive to make sure every loan had a rate of return in excess of 16% and resulted in the same sort of “number fudging” done with the risk ratings of the loans. If the formula showed “14%” then the closing cost or management fee was bumped up. If the formula showed “13%” then the interest rate might have been increased. Regardless the loan was structured in a way to provide at least a 16% rate of return.
This in itself wasn’t misleading or necessarily bad. If the closing costs or interest rates were increased, then naturally the expected rate of return would go up. All it did was increase the costs to the borrower, not misrepresent the expected rate of return. However, fees and interest rates were not the variables in the formula that were most susceptible to being abused. “Administrative costs” was where the manipulation occurred.
“Administrative costs” are the costs to the bank for managing the loan. In other words all the labor, time and resources the bank would have to expend processing, maintaining and administering the loan until it matured. And as administrative costs went up, then naturally the expected rate of return of a loan went down. However, whereas interest rates, closing costs and various fees were regulated by market forces and competition (meaning we couldn’t just charge 25% interest and a $400,000 closing fee because then the customer would just go to another bank), administrative costs could largely be whatever we wanted them to be.
The assumed amount of labor, resources and other expenses required to administer a loan was roughly $500. And in the ideal world, this may have been true. Bob the Carpenter would come in, completed application in hand, sign the documents, dutifully and religiously make his payments, pay off his loan and then we’d never see him again. Total costs to the bank; $500. But the housing market at the time was anything but “ideal.”
Because of all the troubles in housing market the majority of the bank’s loans required much more baby sitting than $500 in administrative costs. A typical and recurring story would be where a real estate development had not sold as many properties as was expected and was therefore unable to pay off its loan. This would require that the entire deal be refinanced essentially doubling the amount of work the bank had to do for this one loan, and therefore doubling the administrative costs. And, as was frequently the case, the development was in such dire straits that the developer was completely tapped of cash and was not even able to make interest payments. This required that the bank extend a less profitable loan called a “bridge loan” where we’d not only refinance the original loan, but lend the developer the money he would use to pay the interest expense and any new fees on the loan. In other words, while the interest rate may have been stated at 10%, in reality the bank was making 0%.
But the ever increasing administrative costs did not stop there. During the earlier months of the housing crash management believed there would be a “quick turn around” in the housing market. That this was merely a temporary slump that would only last a few months. Thus when they’d make bridge loans, they only made them for three or six months expecting the housing market to recover and all the developments to sell by that time. Sadly when the three or six months came and went with no more properties sold, the entire deal would have to be refinanced again, sometimes three times in one year, further multiplying the administrative costs of the loan.
However, even if it wasn’t a troubled real estate development loan, but a regular loan rarely would administrative costs be as low as $500. Again, in the ideal world Bob the Carpenter would come in, completed application in hand, he would have gotten approved and then dutifully paid off his loan on time. However, only in my wildest dreams where a young Sophia Loren was giving me a massage while I worked, feeding me martinis along the way, would such efficiency occur.
Typically what would happen would be a long and drawn out process that would consume vast amounts of the bank’s resources. First was the tooth-pulling process of getting all the necessary documentation and paper work from the borrower who was usually insulted that we’d have the audacity to request proof that he could back the loan. This alone took at least five hours of cajoling customers that they did indeed have to furnish us with tax returns, personal financial statements and other documentation in order to get approved for a loan. Second, upon receipt of all the necessary information, would come the underwriting process where analysts would easily spend up to 20 hours researching, analyzing and writing up the loan. This process was hampered along the way as management would constantly question every figure the analysts would come up with, request reports and data be revised to their liking and beleaguer them with other petty changes and revisions. Should the loan make it through that stage, then came the long and arduous process of approving the loan. Most banks approve loans by committee, causing administrative costs to skyrocket for it is no longer underlings or lowly ranked, lowly paid employees expending their labor, but managers and executives…in a meeting…all trying to agree on one loan…which on a good day would take 20 hours.
While there were certainly other costs associated with processing a loan, when it was all said and done the true costs of administering the loan were most definitely in excess of $500. A rough, back-of-napkin calculation puts the true cost between $1,500 and $2,000 and in the frequent case of problem loans, these costs could easily exceed $10,000. The end result was that the majority of loans would never produce the rate of return they were suppose to, and in many cases provided a negative return.
One would think the issue of administrative costs exceeding expectations or a risk rating inaccurately reflecting the true risk of a loan would largely be the problem of the bank. If a bank wants to lie to itself, who cares? It will find out soon enough the loan is much more risky and not as profitable. In the end the bank is only hurting itself. But by misrepresenting the true risk and return of these loans the banks claimed yet another innocent victim in the housing market scandal; secondary market investors.
As a means to lower their risk banks may not necessarily hold onto the loans they issue, hoping the borrower pays it off and on time. They might sell the loans on the “secondary market” as a means by getting their cash now and letting somebody else worry about the likelihood of repayment. They do this by either selling the loans directly to another bank or can do it indirectly via converting a group of their loans into a portfolio of “asset backed securities” which are then put up for sale much like stocks or bonds. Though the concept may be foreign to the everyday person, chances are the majority of us have experienced this when our mortgage has been transferred from one bank to another. But two major problems arise from this practice.
One, if a bank tweaks the risk rating and the expected return and plans on holding the loan, it’s only lying to itself. But if they plan on selling their loans on the secondary market, then they are lying to other people. And not only are they lying to other people, they’re lying about the two most important variables when it comes to deciding whether or not you should invest in a particular investment; risk and return. If a loan has a true expected rate of return of -5% and a true risk rating of 7, then no investor in their right mind would want to purchase it. But if the banks through desperation massaged or manipulated the figures to make that loan look like it was risk rated a 3 and had an expected rate of return of 20%, then not only could they lead unsuspecting investors to buy a bad loan off their books, but probably get a higher price for it as well.
Two, another problem is that by selling their loans on the secondary market it eliminated any risk to the originators of the loans. If a bank or mortgage company was not going to hold onto the loan then what did they care about the probability it would be paid back? They would get their commission and closing costs, turn around and sell it on the secondary market, approve a new loan and do it all over again. Unfortunately this effectively made the banks and mortgage companies brokers and provided them with a great incentive to focus on volume and not quality or risk. It was no longer about making good solid loans that were very likely to be repaid, but to go for volume, rake in the commission and fees, and then jettison the risk to an unsuspecting investor. It boiled down to a game of hot potato.
The consequences for this misrepresentation were severe. Though good and thorough investors should have conducted their own analysis and research, and drawn their own conclusions, apparently not enough did. Between 2004 and 2006 over $1.7 trillion in sub prime mortgages were sold as asset back securities on the secondary market, the majority of which held misleadingly high credit ratings. When the housing market started to tank and short term interest rates on various ARM mortgages reset higher, the true risk and return of these loans became apparent. Defaults in sub prime mortgages started to sky rocket, delinquencies increased as well, housing prices dropped impairing the value of collateral, and those left holding these soon-to-be-worthless mortgages suffered severe losses. Scores of mortgage lenders filed for bankruptcy or otherwise went out of business. Reputable firms such as Lehman Brothers and Citigroup either posted losses, laid off employees or otherwise scaled back operations in their sub prime divisions. And hedge funds such as those managed by Bear Sterns and UBS ended up going bankrupt and having to shut down due to overexposure in the sub prime market.
But because of the largesse of sub prime loans that had been purchased on the secondary market, sub prime problems were no longer quarantined to the banking and mortgage industries. Employee pensions were now under threat as hedge funds had become a popular investment destination for pensions, bankrupt hedge funds such as those managed by Bear Stearns, UBS and others. The stock market tanked in fear credit problems would spill over into the larger economy affecting people’s 401k’s and IRA’s. And though still unfolding, estimates range that sub prime investors themselves stand to lose between $200-$500 billion. But the largest cost was the dramatically increased chance of a recession. So severe were the sub prime woes that it forced the Federal Reserve to take action on a scale that it had not taken since 9-11. In just one month the Federal Reserve pumped over $200 billion into the mortgage industry in the hopes of staving off a recession. Again, no longer was it the soon-to-be-unemployed bankers, or the greedy mortgage companies that would pay, but your innocent, everyday average American.
What is truly sad though is not so much the current situation of the US housing market or economy, but rather the cause of all this. For it wasn’t a devious underground conspiracy that brought down over 100 mortgage companies and bankrupted a dozen hedge funds. It wasn’t a James-Bond-level criminal mastermind that forced the potential loss of half a trillion dollars. It wasn’t a terrorist attack that forced the Federal Reserve to take action on par with September 11th. Nor was it the most unexpected and powerful macro-economic shock that brought the world’s largest and most powerful economy to the brink of recession. All it was, was just one simple thing;
The number 4.