Who will be caught out by easy credit next?

published 28 March 2007

Bubbles in asset values are created by what we might term mindless lending practices'. At regular intervals, credit markets lose all idea of risk and embark upon a process of crazy lending, driven by competition and the overwhelming desire for market share. That process, as it develops, contains the seeds of its own destruction. The fact that this happens at regular intervals is extraordinary, the process doesn't ever change nor does the eventual outcome. The future that's coming towards us, whatever happens in the near term, is one of an unprecedented credit crunch the only likely consequence of the current long-in-the-tooth unprecedented credit expansion.

How credit expansion led to subprime problems

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It is the broadening availability of credit that is the trick. People for whom mortgage credit was previously not available become qualified to acquire assets such as housing. Before sub-prime was invented, it used to be the case that to borrow money to buy a house the first priority was a personal stake; the second was that you had a history of good credit behaviour and the third was that you would need to demonstrate that you had sufficient income to meet the liability of servicing and repaying the loan.

It's a process that starts slowly. The early ones nervously join the game and achieve the objective of buying a house they can't afford with money they haven't got. As the value of the property they couldn't afford to buy with money they didn't have goes up, the mortgage provider suddenly has a margin of security. As long as the value of the property increases at a greater rate than the payment of interest they cannot afford, then all the sub-prime borrower needs to do is periodically re-finance the mortgage. Their equity grows from nothing to something, it is a miracle of alchemy. Other potential buyers without money, good credit or adequate income see the success enjoyed by the early buyers and realise this seemingly hazardous financial enterprise can't fail. It's a gravy train so they jump on!

The process of easy credit becomes ever more creative, artificially low starting rates for mortgages are generated, the payments made do not cover the full interest due, causing the outstanding loan to grow. Nonetheless, that's not a problem if the property is growing in value at a faster rate. Early players, who fall by the wayside, do not create a problem for the mortgage provider because they can always recover their loans and expenses from the property sales which have appreciated in value as a direct consequence of the mortgage provider's lax lending a very un-virtuous circle.

Whilst it works, it continues to work but eventually it has to fail. When it does fail, which is where we are now, the lenders are driven by circumstance to make the matter worse. They become less accommodating, they withdraw facilities, they refuse loans that they would have previously agreed. A borrower from Lender A who needs to re-finance his debt to keep the game going, goes to Lender B and is refused now he will default. His default will exacerbate the situation and cause credit markets to contract further. House prices rose to a large extent because of the simple reason that more and more mindless credit was thrown at them but those same prices will collapse as the credit process reverses.

For the moment, the market is sanguine about the situation believing that it is containable. However, experience tells us that the lax lending spreads everywhere like a disease. If investigated carefully, it is certain to be the case that the prime mortgage market has been infiltrated by weak credit practices. A few questions asked in the right places in the UK today will tell you that major lenders will often grant loans without going through any meaningful enquiry process.

Loans are granted in the commercial world on not much better criteria and it is weakening all the time. Who would have ever thought that the private equity groups could raise loans with lenders rights removed - called "covenant-lite" loans. According to the FT, private equity groups can protect themselves from any future downturn in the credit cycle by raising loans that remove most lenders' rights.

We also know from information available to us that some of the biggest banks are willing to lend 100% to entrepreneurs to acquire a business, relying only on the business for their security, demanding no personal guarantees and at a competitive rate of interest. Take a situation such as this, the bank's appraisal of a business is that it should be valued at ten times earnings but the purchasers can acquire the business for seven time earnings; the bank's lending criteria is to lend 70% of the appraised value which means that they will lend 100% of the purchase price who do you think is right? Does the bank know better than the vendor; why would the vendor sell his business at a 30% discount? The answer is that the bank is probably wrong. For a bank to make such a loan, they abandon a fundamental principle which is that lending should be limited to a percentage of the purchase price or the valuation whichever be the lower.

There's a kind of witches' brew that happens with all of this type of stuff because everybody has a vested interest. The bank are desperate to make the loan and are looking for reasons to make the loan not to refuse it. The advisers who appraise the security know the bank wants to do the deal and know that they will not get many future instructions if they keep killing the deals with pessimistic valuations. So valuers, in such circumstances, tend to wear rose-tinted glasses. The entrepreneur has nothing to lose, he has provided little or no capital of his own and is not burdened by personal guarantees. If it goes well, he wins; if it goes badly, the bank loses. Worse still, the bank can't even charge a decent rate of interest because the market is just so damned competitive!

Now imagine you are a senior executive of a major bank. Firstly, you are not as stupid as your lending practices make you look! You have an innate sense of unease and then you see the sub-prime mortgage market in America go bad. Aren't you just for a little while going to look at your own lending practices and wonder about them and ask have I any reason to worry?' If the answer is yes', are you not going to think a little more conservatively about what you do? You will start to question your practices but nobody yet will wish to change them because of the negative impact it will have upon the bank's new business and for the fact that the new tighter attitude to credit provision might trigger deterioration in the value of the securities held for loans already made. It's very difficult.

Nonetheless, your finger is that much closer to the button to tighten your processes. Then the bad news hits the fan, some big deal by another bank goes wrong and it all becomes very obvious that the processes have been stupid and destructive. Like the scorpion that stings the frog to death that is carrying it across the river and so brings about its own death you can't help yourself. As a banker, you act to tighten your lending criteria and as a consequence, bring the roof down on your own head!

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