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Hidden Culprit in Financial Crisis

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6 Responses

  1. Deven says:

    Thank you. As always, the post is clear, educational, and delivers a knock-out conclusion.

  2. Bruce Boyden says:

    This strikes me as odd, since there seems to be a missing incentive to have reliable credit scores. Someone’s bearing more risk than they wanted to somewhere. Is it because of the way the secondary market works (again)?

  3. Lawrence Cunningham says:

    Bruce,

    My theory is more general: credit scores emphasizing debt reinforce a culture of debt that strengthens the importance and profitability of banks in the economy. Banks make money when corporations, consumers and governments finance activities using debt, not when those groups use current income, accumulated savings, retained earnings, net worth/equity, and annual tax receipts to do so. Banks pay credit reporting companies so the latter report what banks value and want to hear, and that is debt, and its repayment, not income, and especially not accumulated savings and other assets.

    America is excessively leveraged, and that factored in the crisis: the federal government’s budget deficit is massive; the individual savings rate was negative for many recent years and anemic before that and since the crisis; and corporate debt-to-equity ratios are large and activities funded far more by debt than by retained earnings (American Airlines yesterday borrowed billions of dollars to enable it repay billions of dollars in outstanding debt).

    Excessive leverage may be a problem for many corporations, people and governments in ordinary times, but in aggregate benefits banks then, and only becomes a problem for banks amid spectacular, rare crises like the present one.

    True, as you suggest, secondary market operations may partially explain, if banks transfer loan risk to pools rated highly by conflicted rating agencies insufficiently attuned to examining actual credit quality. But then why not lend to high-quality credits too or design a screening mechanism allowing them to the next step?

    Besides my bank-centrism theory, high-quality borrowers are not only more likely to repay debt, but also prepay it, sometimes costing banks profitability (say, if rates fall, and the bank must relend at lower rates). Banks certainly want to avoid absolute dead-beats, but their best target market are people who use debt a lot and are reasonably good at repaying it roughly on schedule, perhaps even a little late, but never early.

  4. I’m with Deven (and probably everyone else): important and very informative post and insights. Thanks so much, Danielle

  5. “The Commission should put credit scoring on its list of possible causes of the financial crisis.”

    Should it be listed before or after Barney Frank?

    Credit scoring is just a tool – it doesn’t “cause” anything. If banks et al use it incorrectly or over rely on it, then that is on them, not the product provider. Perhaps some innovative law professors, seeing a market need for a better credit-granting tool, can develop one.

    Of course, if the market doesn’t know it got burnt by its over-reliance on the credit score (maybe because the government bailed them out?), then perhaps the Commission should look at what parties are distorting messages to the market.

  6. C.L. says:

    I agree that the system discourages loans to people most likely to pay them off. Even now, banks still don’t want customers who pay off their loans.
    My husband and I in February tried to get a mortgage to buy our first house together. He has a middle-range salary and no debt, and I am in law school with no debt. We were planning to put %30 down on a mid-priced house that 25% of his salary per year would pay off in 7-8 years. We were unable to secure a loan for that amount; the highest we could get would allow 25% of his salary per year to pay off the home in about 5 years. The problem is that both of us have always paid credit cards down each month and he has always paid off loans and mortgages early.
    We are really a terrible investment for a bank, so no wonder we couldn’t get a good mortgage.