In Defense Of Banks

(Note: This post deals mostly with the mortgage lending industry. I know much, much less about the investment banking industry, and so will touch on it much more gingerly.)

I'm going to have to do something I never wanted to do: defend the banking system in America. My defense? Banks aren't stupid. They aren't. Look, I know that is hard to believe, what with the current banking crisis and all, and yes they are a little bit stupid and a lot myopic and short-sighted and all that jazz. But they aren't completely idiotic. Which is what we'd almost have to believe if we are going to place a majority of the blame (or even a good deal of the blame) on the people who took out the mortgages instead of on the banking institutions themselves. I know what you're thinking. Why should I pay attention to the crazy rantings of a literature major who never took a finance class in her life? I'll tell you why. It is because a big part of why I'm jobless right now is that I worked in the mortgage industry. Also, my mother works in the mortgage industry. All of her friends work in the mortgage industry. And I've gotten to hear a lot about banking and the rules and regulations and such both growing up and while I spent my summers working there along with working there after college. Plus, I got passed around from department to department, so I have a pretty good idea of how the mortgage industry works. I also kind of feel like Marisa Tomei with rattling all of that off, but I think it is important to note that I actually do know a bit about what I'm talking about.

First things first: the idea that some of this mortgage crisis was brought about by people lying on their applications is untrue. The main problem with this idea is that even if mass amounts of people were lying on their mortgage applications and getting mortgages anyway, the bank would still be at fault. The reason is simple; if one person manipulates the system, the system is not necessarily compromised and that person is responsible. If a large amount of people are able to manipulate the system, to the point where the system breaks, then there has been a systemic failure. Those people who screwed the system are still responsible, but the system is also to blame because it failed to work properly. I would contend that the system would be more to blame, because it disregarded the holes in the system and allowed itself to be compromised. It would mean that a majority of people working on that side of the bank, in departments like closing, post closing, and quality control, were complete idiots - along with the people who designed the mortgage approval process as well. It would mean that not one person in the whole system recognized that a great number of people were lying. It would mean that Quality Control should get a new name. It would mean that Post Closing failed in all of its duties. It would mean that Closing was approving files without even a cursory glance. Banks do not get all of their mortgage information from the customer. Banks also get access to credit reports and look at pay stubs and generally do a pretty thorough job. There are always going to be a few people who manage to beat the system, but for the most part the system runs fairly smoothly in this regard.

Second up in the blame game in many conversations are the people who bought houses they could not afford. This is ignoring a couple of salient points. There are very few people who could not, in that moment, afford to buy a house that got a mortgage anyway. Those people are out there; but if nothing else, the banking industry generally does catch these applicants and denies them. If a person (or couple) absolutely could not afford the mortgage or the home upon walking into a banking institution, they generally did not get the loan. Banks do not approve loans they know will fail. If too many of those loans were getting through, again, it is a situation where the blame is inequitably divided. The customer is to blame in part for applying for a loan s/he knew s/he could not afford. But the bank is more to blame because they are the institution with the stamp. The applicant's job is to apply for the loan. The banking institution's job is to verify whether or not this applicant could afford the loan, or if they were going to default. It would be like someone under 21 attempting to get served at a bar. The greater fault lies with the bartender who serves the underage patron than with the patron.

But the most important thing to recognize is that both of those scenarios make up a limited portion of the mortgage industry. The majority of the mortgage industry is not nearly as black and white. It deals with risk. If Will Smith were to walk into a bank and wish to take out a mortgage on a cozy little two bedroom cottage, the bank is in a relatively low risk situation. If I walked into a bank and wished to take out a mortgage on a cozy little two bedroom cottage, the risk attached to such a loan would be significantly higher. The act the banking industry attempted (and failed) to perform was by approving more and more high risk loans. These loans generated a good deal of income while the economy was good, allowing those banks to venture further beyond the border of the safe risk amount. It was a gamble that just kept paying off, and in many instances it was a gamble the industry as a whole encouraged banks to make. During the period of economic expansion, banks faced considerable risk of a take over by another financial institution. Bigger, more successful, banks were buying out smaller banks and banks that had less of a profit margin. Investors, stock holders, and CEOs of these mortgage institutions wanted to see significant growth each quarter in an industry that almost demands a longer view. Most loans are written to be paid off in 15 years or 30 years; the stress to grow exponentially when one's product requires longevity increases risky practices. In an eat or be eaten world, banks were more apt to make what seemed to be good short term decisions; the only problem with that is that those decisions were bad for the long term.

Those decisions were bad long term ones for a variety of reasons, but I think it is important to note that every mortgage lending institution I know of has a Construction Department. The Construction Department is in charge of, obviously, construction loans - loans that pay for the building of new structures. And those structures, during the housing boom, were valued for more than their worth much like many houses were. There came a point in the industry where the supply of these constructed houses far exceeded the demand, and that partially explains the collapse. It also clearly demonstrates a version of tulip bulb mania in which at one point in time houses were worth a certain amount because there were more people clamoring to own (and capable of owning) homes than there were homes (McMansions, mostly) they desired, but over the years the market had been flooded with those homes and thus devalued themselves while still attempting to sell at the same price when those homes were in a competitive market. The system corrected itself by devaluing homes (creating a buyer's market, if anyone had money with which to buy), which in turn made those high risk loans all the more risky. An additional problem is the fact that Lines of Credit are tied directly to the value of a homeowner's abode, so a person could have had $300,000 available on his LOC one day and $120,000 on that same LOC the next (those numbers are, of course, entirely hypothetical).

Due to the nature of the loan game, in which many take adjustable mortgages in the idea that in a couple of years the mortgager can refinance at a lower adjustable rate if the market is fair, the downswing was a disaster for the high risk loans that were so profitable merely a year earlier. In this way, the market kind of screwed itself, because it depended upon banks to be able to perform like other institutions and create consistent and large profit margins. Thus, my own personal "Biggest Blame" for this whole mess is not the mortgage lenders or the customers themselves but a financial system that demands short term success at the expense of long term success. In order for banks to maintain their independence, they engaged in risky business practices. As long as the economy was good, Wall Street rewarded those risky business practices. Once the economy shifted, those risky practices were not nearly as profitable, and now the mortgage industry is in a fairly stupendously bad free fall. Obviously, there are many different solutions that need to be put in place over the next months and years, and there is the necessity of a bail out. But one thing we need to take heed of is what happens when short term profits come at the expense of long term stability, especially in an industry that supplies long term products. We need to come up with a different way of analyzing their success and failure on the global markets; we need to recognize that we should not expect large profit margins each quarter due to the nature of the product itself. If we hadn't focused so much on short term profit, then banks would not have had to engage so many high risk mortgages to ensure their survival from financial quarter to financial quarter when the market was good. And if banks had been more picky and less "eat or be eaten", then less of them would be in financial straits now.

Banking Blunders

As some of you know and some of you don't, my last job was in a bank. I worked on the mortgage-side of banking, doing things like quality control on recently approved loans and then later telling people that their check from their Line of Credit didn't go through because their signature didn't match the one on file -and then getting to tell some of those same people that their Line of Credit available was going to be decreasing because it was directly tied to the amount of equity available on their now rapidly depleting in value house. It was a fun job. And it explains why I'm not working now, as there is surprisingly little demand for someone whose main experience is in an industry experiencing a massive crisis and whose degree is in literature.

Because of this, I have an odd understanding of the mortgage market, and of the banking system. The first thing I know is that banks aren't evil. They weren't deliberately trying to screw over their customers. They weren't even really letting loans go through that they knew would never be repaid. What they were doing -and are still struggling to do- is succeeding in a system where success is based on growth, and large amounts of it. Banks consistently live with the fear that if they don't continually have their stocks rise, if they are not continually building up vast amounts of new business and opening new accounts and reaching out into new areas, that they will be taken over by a bank whose growth is rapid and who is doing all of those things. So, bigger banks take over smaller banks and more successful banks take over less successful banks. And we are taught -via capitalism- that this is a good and righteous process and that it will work out for the best. Except when it doesn't. And that is where we are right now. Banks are in a crisis because they were forced to play a game they are not built to sustain. They are in a crisis because their stockholders, their CEOs, and Wall Street value short term success over long term growth. Which is why banks need to be better regulated. Which is why we have to make it so that banks can't play that game. Which is why banks either need to recognize that for themselves across the board, or we need to recognize that for them.

About a month ago, a friend of mine wondered if the current housing and banking crisis was based on predatory lending or if it was more on the borrowers who were taking on more debt than they could afford and lying on their loan applications, and suspected that the answer was somewhere in the middle. My answer is that it is on neither. This crisis wasn't based at all on a malignant set of people trying desperately to screw the other set out of their hard-earned money. It wasn't about banks taking advantage of the disadvantaged, or about the disadvantaged lying in order to secure that loan. The banking process is infinitely more complicated than that. Banks, due to being a business, generally don't approve loans they know -or even suspect- will default or fail. Banks, due to being regulated, generally don't involve themselves in predatory practices. And the amount of people who lie on their applications and don't get caught doing so is negligible. If enough of them succeeded to bring down the banking industry, then the banks are really, really dumb and should overhaul their post closing departments, their quality control departments, and their closing departments -and there are enough banks that not every single bank could have this issue. Instead, the problem is one of short-sighted good faith. The bank assumed that the economy and housing market would continue its boon, even with all evidence to the contrary. The borrower assumed that his job would still be there, his house would still be worth X-amount, and that the economy would continue at a steady and good pace. For the borrower, many of them were not taking on too much debt at the time of the loan. It was only when the housing market bottomed out, when the economy slowly started to sink, that the loan that had been before possible now became impossible.

Banks are fairly well regulated now so that they cannot take advantage of their customers. The interest rates are federally regulated. The mortgage agreements are drawn up and every contingency -including how much it will cost to pay off the loan before the prescribed time and the amount the borrower incurs for a late payment- is clearly documented. There are very few actual surprises within the mortgage agreement itself. But what does need to be done is to reimagine the way we value banks' success. If we imagine success as being holding onto loans, not selling them to other banking institutions, not racing to open up as many loans as possible, and instead try to envision a company that will outperform over a longer period of time -decades, instead quarters- then we can help to revise and revive a flawed banking system. It isn't the only solution, nor an all-encompassing one. But I do think it will help.