The Failure of Impersonal Finance

Over the past 3 months, a small financial storm that kicked off in October 2007—with a spike in subprime mortgage foreclosures and the evaporation of $800 million in assets in two Bear Stearns hedge funds—gradually mushroomed into a Class 5 hurricane. A free-fall in home prices, and an avalanche of foreclosures on homes worth less than the outstanding amount of the mortgage, cost investors hundreds of billions of dollars and began piling dead weight onto the entire economy. Then, Lehman Brothers, a 158-year-old firm that had survived the Great Depression, declared bankruptcy and its $600 billion debt now trades for 3 cents on the dollar. The government nationalized the world’s largest insurance company, AIG, and the nation’s two largest mortgage companies, Fannie Mae and Freddie Mac, just to prevent a catastrophic collapse. As banks refused to lend even to each other, a wave of failures prompted the Federal Reserve to take the unprecedented step of actually investing directly in the America’s 8 largest banks. The stock market lost half of its total value and the credit markets seized up like an engine without oil. The $700 billion Troubled Asset Relief Program has provided just enough liquidity to get markets moving again – but not enough to rescue investors or homeowners. As of now, the entire world is heading into recession. In the continuing fallout of this financial meltdown, one of the most asked questions is not merely “Why?” but “Who (or what) is to blame?” Fingers have been pointed in every direction, some more credible than others: government meddling in mortgages, lack of government oversight, a failure on behalf of debt rating agencies, the invention of and then the resulting boom in credit default swaps, the excessive indebtedness of American consumers, or plain old greed. The government has been blamed for doing too much and for not doing enough, investors for being too greedy and then for being too conservative, and borrowers have been portrayed as both villains and victims. All of these approaches have their merits, yet miss the real root of the problem. I call it “the failure of impersonal finance.” Once upon a time – and sometimes still today – a person wanting a loan went to a local bank. He described his need to the banker and layed out his financial situation. The banker listened, analyzed the numbers, then went and looked at the house or business. He looked the borrower in the eye and decided whether or not he was trustworthy. He looked around the neighborhood and judged whether the house would hold its value. He visited the business and rated its prospects in his own mind. And if he made the loan, the borrower sat in front of him and signed a promise to repay it, knowing that both the job of the banker (whose kids attended the same school) and the viability of the bank (upon which many in the community depended) were predicated upon his ability to repay. And if he didn’t, it would be the banker himself who came for a visit. It wasn’t merely a transaction between autonomous self-interested parties. It was the beginning of a relationship based upon mutual interdependence, a relationship entered into with personal knowledge of the risks and rewards. Fast forward to the first decade of the 21st century. A young couple with a credit score below 500 picks out a 3000-square-foot house, which they intend to buy with no down payment, and are directed to a mortgage broker. The broker doesn’t know how much they make—although it’s almost certainly not the $200,000 a year they claimed—or where they work. He drives past the house once, in a newly-built suburb, but has little knowledge of the area – or concern if it later goes bust. Their poor credit history is not his problem. The mortgage broker makes a fee from putting the transaction together, then walks away with his money. A finance company bundles this mortgage together with thousands of others – once loans made to individuals, but now nameless and faceless numbers in a bond prospectus. An investment bank 1,500 miles away (such as Lehman Brothers) issues a security backed by the mass mortgages, then chops it up into slices of varying risk called “tranches,” each insured via credit default swaps to a different degree by an insurance company (such as AIG) based upon the risk judged by a debt-rating agency (such as S&P, Moody’s, or Fitch), which are then sold to all manner of institutional and individual investors – none of whom have ever met any of the borrowers or seen any of the houses. Most of these players make their money either from fees or from trading various derivatives – such as the credit default swaps. While dependent upon the overall market going up, none have any direct attachment to the borrowers. The net result is that the lenders – i.e. the investors – are loaning money to complete strangers. Most Americans would not loan $10,000 to a stranger on the street, for a project they know nothing about, regardless of the interest rate. But package it in enough of a sophisticated manner and put some big Wall Street firms behind it, and people will loan their money to people they’ve never met to buy houses they have never seen in places they have never been. Even in banking, the picture these days is only slightly better. Consider the case of a small-town banker whom I know. He formerly made all loan decisions himself, or in consultation with the other officers of the bank. His personal knowledge of customers and local markets, and his first-hand evaluation of businesses such as farming operations, enabled him to make profitable loans that others may have judged too risky while avoiding untrustworthy borrowers with whom others would have dealt. In over 20 years he lost less than 1/10,000th of all the money he loaned, while his bank generated a return on assets greater than that of its peers. But when his locally-owned bank was bought out by a large regional bank, nearly all actual loan decisions were shifted to a committee in a city several hours away. The loan committee members may have graduate degrees in finance and years of experience in number-crunching. But they have never met the loan applicants in question. Their knowledge—if any—of regional markets is limited to their own urban area. Their analysis is based entirely upon a small set of numbers – numbers generated by someone else. They are ultimately making or denying loans to strangers in strange places, for purposes which they learn only second hand. The result is that a bank that was once among the most profitable in the nation is now average, despite a vastly greater workload for the loan officers. Customers who once obtained loans – and would have repaid them – are often turned away. At least this particular regional bank is known for being conservative, so they err on the side of caution (and denial of credit). But everybody—the less-profitable regional bank, the demoralized local employee, and the rejected customer in the community—is worse off because of the depersonalization. Some may argue that this analysis fails, by pointing to the success (in general) of the stock market as a financing mechanism. After all, why would anyone who believes in free markets, and even invests in them when equities are concerned, disparage their use in debt financing? There is nothing personal about the stock market, is there? But there is a huge difference between a stock and a mortgage-backed security. Every share of a particular stock is exactly the same as any other share. All represent equal ownership in a company whose financial statements are made public and must be transparent, whose leadership is visible, and whose products are available in the marketplace. Investors know exactly what they are buying and whom they are trusting. Although not “personal,” there is a public relationship of trust and accountability, similar to that between any political or institutional leader and his or her constituents (except that in this case “citizens,” i.e. shareholders, can vote with their feet at any time by selling their shares). But every mortgage-backed security is different. Each securitizes mortgages to different people, collateralized by different houses, in different places. A mortgage in San Diego is not the same as a mortgage in Riverside, CA: the former housing market is stable whereas the latter has completely crashed. A loan made to a nurse making $50,000 a year is far less risky than one to a GM autoworker making $50,000 a year, because the former is a more stable profession. Every borrower is an individual, and while numbers are very helpful in categorizing borrowers and providing a general estimate of risk, they cannot tell the whole story. It’s true that the financial sector is bloated right now and jobs will continue to be shed. But while we need fewer people in mortgage companies and investment firms, we need a lot more working locally and meeting the financial needs of real human beings, making loans to people who live where they do on the basis of personal knowledge. Whether those loan officers work for locally-owned banks or nationwide banking giants is of little consequence. Nor does is matter if the community in question is a small town or an urban neighborhood. What matters is what the actual business relationships are based upon. We need to get back to an economy based upon personal relationships, upon mutual trust and respect between individuals and families, in the context of communities. People are not just consumers or producers, assets or liabilities. They are made in the image of God, and created to know Him personally and relate personally to one another. They have intrinsic worth and value. They make moral choices, for good or bad, which affect not only themselves but others as well. We are more than what we buy or earn, we are human. Our current financial system – at least in the credit markets – has dehumanized us and cut us off from one another in the name of profit. But the profits are gone. Now firms are hemorraghing red ink, asset values are in free-fall, and we are all winding up poorer. It’s time to rehumanize our financial system. It’s time to get personal.