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Risk and the Recovery

Sunday, January 18, 2009  |  posted by Hugh Hewitt

Last week I devoted a couple of segments tothe news that GMAC was replacing its Board of Directors. I noted that most such boards across the U.S. are people with the same type of people –very successful corporate or government executives– and only rarely with pure salesmen. My lament was that selling is so often underrepresented in the world of finance and management, but it is ultimately the driver of the economy. Steve Jobs is many things, to use one example, but he is a salesman with few equals in the country. Find some skilled salesmen for the GMAC board, I suggested, and GMAC would do much better than it had.

This prompted an e-mail that I have read a few times and find fascinating. If you agree with GB or not, send me your thoughts about his take at


You were so very right today about what GMAC needs to do. But it’s the same with almost every bank and major corporation. The issue that all of your guests seem to miss is that most banks and really most corporations at the senior management level have very little idea what they do to make money. Management is about managing risk, not about making money. [# More #]

California Magazine ( long since gone the way the Boston Globe and Miami Herald are going) held a contest every year for the worst boss in California back when I used to work for that big bank from Charleston that was from San Francisco. The less than beloved president of that bank won several times including beating farm labor employer and mass murder Juan Corona one year. Those were “the days” you think of when you think of a “bank.” Back then banks used to access risk, establish value and have someone try to figure out what a business did to make money.

Those were also the days when we started the variable rate home loan. And YES, it was a good idea then because of the Nixon, Carter inflation and a general trend of increasing incomes. It was also when we started selling the loans in bundles to investors. That is the key here that you must understand. Banks are not what most people think a bank is. They are simply sales organizations now. Banks sell money on both ends, to the consumer and then bundled, to the investor.

Banks live on the “spread” and the fees for managing payments. If you think you understand banking, if you understand the almost unlimited ability of a bank to issue loans, this will sound incredulous to you. It’s just the truth, the bottom line about how banks maximize profit. And it is automatic at every major bank in the world. Banks keep a very small percentage of loans on their books long term because they make more by selling them than by keeping them.

To sell those loan bundles and to make loans banks have thru the magic of great science fiction become risk adverse and incapable of judgement. Chrysler, Cerberus, GMAC and General Motors big problems are a great example of this. Cerberus owns control of Chrysler and owned the controlling interest (51%) in GMAC until it became a “bank.” That, contrary to what the news has been reporting is the biggest source of GM’s problems. You and I both know auto dealers that have a stack of “deals” in their desk they can’t finance. GM dealers are by far the worst off because GMAC would not loan to anyone unless they had a FICO score over 700. We both saw the commercials where GM dealers would shop your loan to banks all over the country. Ask your friends how often a 700 FICO score walks in the door!

Here is where everything is broken a couple of times. FICO and all the other scores allow a lender like GMAC to not have to assess risk, keep risk or sell risk to investors. Because of the universal results of Fair Isaac and all the other scores the fine science of statistics can be used to write great science fiction about the value of loan bundles for sale. That increases the value of the product while skipping a risk assessment.

When Cerberus controlled GMAC it was able to sell loans ( auto, real estate, consumer) in bundles that were statistically averaged for near 0% risk to the investor. Cerberus, like every lender, helped insure the bundles with a third party insurer so risk was nonexistent. Every major loan and every bundle of loans sold were insured, with insurance that has proven to be another great work of fiction, so that the risk was seemingly eliminated. Today nobody believes the fiction anymore. What that means in real time terms today is that the cycle is broken and nobody knows what to do. Banks, all lenders, only assess scores which are as secret in nature as our nuclear weapons secrets. Lenders don’t know where the risk is because the statistics used to eliminate risk were wrong, are wrong. That means they don’t know who to sell money to anymore, hence needing a FICO score of 700 to buy through GMAC.

Investors won’t buy loan bundle investments because they can’t tell the value of them. The “banking crisis” started when big French and Dutch banks decided they could no longer tell the value of investments held in loan bundles stopping withdrawals from accounts based on them.

The “banking crisis” won’t end until banks decide they know how to assess, manage and accept risk again. The government can stuff them full of all the cash they can print and it won’t make a difference. In an industry that has made a fortune borrowing money from the Fed at 2.5% or with a cost of money at 3% and loaning twice as much of it at 5.5% then selling the loans at 3.5% with supposed absolute security, risk is the “new frontier.” Replace those numbers with credit card rates, figure out the return on credit card balances at those rates, realize that almost all of those loans are sold and risk averaged to see how great the problem is.

The 3 people at any major bank who decide who to sell money to don’t know how to make those decisions anymore. And the 10 people who resell the loans know that there are no buyers anymore. Banks don’t know who to sell to which is all 99.99% of bankers do. Every business sells for a living. Banks just eliminated the risk assessment section then got realistically scared when the other half of their sales pitches were no longer believable.

Sorry this is so long. I enjoy your show and appreciate that sometimes you can think like you’re not a lawyer.



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