Saturday, May 1, 2010

Financial debacle ... systemic set of faults

Dear Colleagues

There are a lot of lessons that could be learned from the economic events of the past five years or so. They might not be visible in the mainstream media, but they are useful in informing the development of an initiative like Community Analytics (CA).

The people the work with the capital markets are creative, and this would normally be a good thing ... but the singular focus of the system on profit without also putting some value metrics into the computations is inherently unstable. A value metric would be a stabilizing influence and make it much more difficult to profit from bubbles.

It is difficult to identify a single root cause of the "financial crisis" because it was essentially a systemic failure, with fault at many stages of the value chain. The single word that can be applied throughout the system is excessive leverage starting at the lowest level of the value chain ... at the level of the individual family.

Loan origination was done for a very long time using parameters that were fatally flawed. A lot of people made money every time a real estate and mortgage contract was closed. Profit was reported ... fees earned ... commissions paid ... every transaction, no matter what the soundness of the transaction. Land owners that sold land were happy. Land developers were happy. Builders were happy. Community bankers were happy. Lawyers were happy. Appraisers were happy. Community leaders were happy (with the expanding tax roles!). The loan origination industry was making a lot of people happy. In the long run, everything depended, however, on the earning power of the borrowers and the realizable value of the property. In the short run everyone in the loan origination industry was profiting mightily.

All of this was facilitated by the idea that a mortgage contract could be sold by the loan originator to an institution that wanted to invest in these contracts and earn from this investment. In theory they had both cash flow and they had underlying security. For the creative community in the capital markets, these contracts had the characteristics to be the foundation of a securitization process that had almost unlimited potential. Better still, the government was engaged in encouraging home ownership with the Freddie Mac and Fannie Mae institutions that had a role in making it even easier to fund the paper associated with mortgage based securities.

And of course, the Federal Reserve also collaborated with a cheap money policy that made all sorts of mortgages very profitable relative to truly high grade investments.

The profit measures in the capital market were an incentive to grow and grow and grow. Risk is not "accounted for" in a rigorous way until risk changes to an event. Until an event, risk is a subjective and notional idea ... and easy to ignore until it is too late!

With CA there is a value dimension to everything ... and more consideration of changes in the balance sheets of the various actors in the value chain ... and the value adding associated with all the actors. Families that have low earning power in expensive houses with big mortgages is never going to work ... the key here is the earning power.

While the housing bubble was growing ... earning power for the people buying many of these houses was declining. Corporate profits were strong, but increasingly profits came from goods being manufactured overseas and services being outsourced internationally. It is remarkable that the loan origination segment of the financial system did not see this ... and of course they did, but chose to look the other way because the profits being made were substantial.

Value chain analysis suggests that it was the loan originating segment of the financial sector that had the biggest role in creating the financial debacle ... together with the Federal Reserve and Fannie Mae and Freddy Mac which made money really cheap. Wall Street and the big money center banks around the world made mistakes in doing securitization without doing adequate due diligence ... and the rating agencies fed into the debacle by not doing their work rigorously. To add insult to injury, the regulators went to sleep.

Eventually the system crashed ... and fast action by governments around the world kept the system afloat. Wall Street lost three institutions ... Bear Stearns, Lehman Brothers and Merrill Lynch ... and big commercial banks around the world would have gone under if governments had not funded their survival.

The crisis is not over ... and will not be over until there is a much improved earning power in the various national economies around the world. From the point of view of short term corporate profit, stockmarket prices and GDP growth, economists can argue that the recession is over ... but this is a false metric. The value balance sheet of families, communities, cities, states and countries are still in a catastrophic state.

The problem is that capital markets only know how to allocate capital based on profit ... they do not know how to allocate capital based on the value metric. This is a terrible flaw in the modern economic system ... a ridiculous state of affairs.

With CA value analysis it is obvious that there are huge value adding initiatives that need to be funded ... to improve health ... to improve education ... to improve transport infrastructure ... to improve energy efficiency and to innovate in energy ... to improve water and waste treatment ... and so on. There is ... we are told ... lots of money "sitting on the sidelines" ... but where are the creative structures to get investment into areas where the outcome is value adding for society.

The concept of CA is to get metrics that will help this to happen ... get metrics to help change the way the game is played!

Peter Burgess

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