Real Estate Lender Implosion

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Old fashioned banking is not the answer

Tuesday March 4 2008

-- James Saft is a Reuters columnist. The opinions expressed are his own --

By James Saft
LONDON, March 4 (Reuters) - A return to "good old-fashioned banking" sounds nice, but we may live to regret going back to a system that implies less credit available at a higher cost and lower overall economic growth.

The wreckage of the burst credit bubble has prompted a fair amount of talk about banks returning to basics, really getting to know their borrowers, doing plain old lending and hanging on to much of the risk themselves.

Notably Hector Sants, the head of Financial Services Authority, the British financial watchdog, last week said the fallout "will put some pressure on this originate and distribute model and force banks to behave, as it were, more like banks behaved in the past."

"I don't think markets are ever going to return to the way they were," Sants told BBC radio."

He may well be right, and it would certainly make life easier for regulators if so, but if he is, it will have some serious and not necessarily good implications for the cost of credit for everyone, from households to the largest corporations.

The "originate and distribute" model Sants is talking about grew up because the banks worked out it could make them a lot more profitable. Rather than holding on to the loans they made, they "originated" them and then "distributed" them on to someone else.

And this was more than just a "greater fool" theory of banking, at least in the beginning.

Banks made loans, for mortgages or leveraged buyouts, using their credit expertise and knowledge of the borrower, and then packaged them up into a securitisation, onto which the ratings agencies put their imprimatur. That allowed hedge funds and pension funds and whoever else to concentrate on other things and to buy loans or deals that best fit the risks and rewards they sought. In theory, at least.

In practice it went off the rails, which is not entirely surprising given banks were paid to get deals done, and ratings agencies were paid by issuers. As we've seen, many foolish loans were made, it all came unstuck and now very few loans indeed are coming through, and there are virtually no buyers for complex securitised products.

In sum, the system was characterised by a large amount of greed, miscalculation and perverse incentives, and there is plenty of blame to be shared round between the banks, ratings agencies, investors and regulators.

But I have a horrible feeling we are going to miss "originate and distribute".


THE 3-6-3 SOLUTION?
Its great virtue was efficiency.

A move away from it could work a number of ways but all of them would seem to carry with them permanently higher costs of borrowing. If it is just banks doing the lending, there will be a long period, as we are now seeing, of them charging higher rates to build back up their own capital.

If securitisation comes back, but is simpler and based on a "buyer beware" system, that too will have higher costs.

If faith in the role of the ratings agencies and banks can't be rebuilt, two things will happen. Some deep-pocketed investors will employ many more people to do credit research, which will be a cost borne by borrowers and investors. These investors would also likely paste a sizeable additional spread onto deals to compensate for what they don't know about the borrowers.

"The result of a longer term switch away from originate and distribute is that the banks will have to carry more stuff on their books and they will be able to lend less," said Richard Portes, a professor at London Business School and the president of think tank the Centre for Economic Policy Research.

"There is no rocket science here. The process of lending will on balance be less efficient."

And less efficient lending should lead to lower economic growth than would otherwise be the case, and higher volatility of growth, hardly a recipe for strong growth in asset prices. So what are the alternatives?

Portes was one of the authors of a report on international financial stability that suggested moving to a system whereby ratings houses were paid by investors, as well as taking steps to encourage originators to retain more of the loans they write, though by no means all.

But turning the clock back to old fashioned banking, once known as "3-6-3" for "borrow at three percent, lend at six percent and be on the golf course by 3 p.m.", is not what we should wish for.

That would imply not just more expensive loans and less economic growth, but more plaid trousers too.

-- At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.

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