John Gapper (FT "There is no such thing as the banking profession" Feb 13, 2014) argues that the credit crisis may have been made worse by the introduction of mass reliance on credit scores like the FICO instead of the wisdom of traditional bankers' measures of borrowers ability to pay. This does not seem to be born out by recent studies. The Federal Reserve Board study of credit scores and their effects on borrowers ability to pay reported to Congress in August of 2007 found that the credit scores were effective predictors. Yuliya Demyanyk's article for the Federal Reserve Bank of St. Louis published in October of 2008, "Did Credit Scores Predict the Subprime Crisis?" argues that the credit scores did not promote bad loans, rather they appear to have been largely ignored by bank employees and loan origination contractors hired by real estate firms and banks to process applicants. Had bankers applied traditional guidelines
the crisis might not have happened. In a study of loan brokers by Anje Berndt, Burton Hollifield and Patrik Sandas, ("The Role of Mortgage Brokers in the Subprime Crisis" can be downloaded from the Insead website at http://www.insead.edu/facultyresearch/areas/finance/activities/documents/paper_Nov1.pdf) found that, " A probit model for loan performance shows that the increased broker profits lead to worse loan performance suggesting that brokers earned high profits on loans that turned out to be riskier ex post."
I don't believe credit scores caused the crisis. Perhaps, the lenders did a poor job of assessing the borrower's ability to repay. Another element was a large number of borrowers lost their jobs, hampering their ability to pay. The government played a large role in the mortgage area with the push to allow everyone to own a home.
So what then caused the job loss that you believe was the underlying force behind the collapse? Did banks panic due to low liquidity and then what caused the fall in liquidity, too many bonds with too little value in the assets backing them?
The job loss was caused by the economic downturn that caused companies to reduce workforce or go out of business. Liquidity in 2008 and through today remains strong in commercial banks.
When then caused the "downturn"? Paulson, Larry Summers and Martin Wolf all point to a collapse of liquidity in their books beginning in 2007, perhaps you mean something else by the term, "liquidity?"
There was a lack of liquidity in the investment houses, but not the commercial banks. In the case of Paulson, Summers, and Wolf, the real issue was the inability to fund their "straw house" investments due to a lack of credit quality. The media and politicians group all financial firms in the category of banks--which does not meet the legal definition of a bank. When I was on the Dallas Federal Bank board, we examined the many conduits of the investment houses tied to unfunded, conditional letters of credit.
Dear James:
What do you think of the unfunded conduits of credit that are apparently tied to the losses in the oil prices drop, especially in New Zealand. Also, at the same time the Swiss bank franc support is having a negative effect on dark pools investments that are just as opaque.
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