New ways to make old mistakes

It's fun to see the big names of economic punditry (such as Anatole Kaletsky and Gavyn Davies) profferring their opinions on the current rout in global debt markets. Their take on the situation can be summarised as (a) this was all very predictable (though off the top of my head, I can't remember either of these gents actually predicting it) and (b) it doesn't spell the end of the bull market, because the world economy is in good shape and corporate balance sheets are healthy.

The most dangerous words in investing are "it's different this time". Even so, for now I think the optimistic Kaletsky/Davies view is probably more or less right. However, I am worried about the extent to which the long bull market is the product of cheap (and loose) credit rather than sound fundamentals. Years of cheap money have produced a boost in asset values, rather than the historically more normal rise in goods prices. Asset price rises (houses, stocks) have persuaded individuals, particularly in the US, to leverage themselves up in order to consume beyond their current incomes.

It's hard to predict how people will react if asset prices stagnate for a little while and banks turn off the credit spigot. And the situation is complicated by the fact that inflation has begun to perk up a little, which makes it more problematic for central banks to try to ease the pressures by cutting interest rates.

When I was involved in the lending business, we were always very conscious of the fact that banks always find new ways to lose money. What strikes me right now is that the problems facing the banks are very little different from those they faced in the credit crunches of the '70s and '80s. This suggests that the "institutional memory" that helps to keep up lending standards may have been eroded by the long spell of benign business conditions that we have enjoyed in recent years.

Take the mortgage market, for example. There is certainly one new element in the equation this time: the existence of the securitisation market means that banks can (or at least could until very recently) package up their mortgage assets and sell them on to end investors. However, it's arguable that the ability to do this, and the profits it can generate, encourages banks to pile up mortgage assets without fully assessing the underlying risks.

A long bull market in any commodity always causes lenders to relax their guard. During the oil price surges of the 1970s, Canadian banks were giving mortgages in Alberta based on the assumed future value of properties -- and were even ignoring the fact that mortgage security was almost unenforceable in that Province. Until recently in the UK, we have seen interest-only mortgages for more than 100% of the property value -- well, people have to be able to buy a fridge and sofa, don't they? These kinds of practices always cause problems in the end, and it would be reasonable to assume that demand from the securitisation market has exaggerated them this time. But underlying the problems is the same old mistake that banks have always made.

Or take corporate lending. The big game in town, with the really large, prestigious deals, has always been M&A. Again, there is a new element this time, in the shape of the private equity industry. To compete for deals, banks have offered what has become known as "covenant lite" loans, with few of the traditional conditions that bank loans carry in less expansive times. This is not new, however: harking back to my lending days, I can clearly remember one genius coming up with the concept of "slippage", whereby covenants in the loan agreement could not be enforced by the bank the first time the borrower breached them.

This makes no sense at all. Banks never want to call in a loan, but it's imperative that they should be able to do so in certain circumstances. With "slippage", whether a covenant breach was the result of a temporary market downturn or outright management incompetence made no difference: the bank could not ask for its money back. Needless to say, that was a recipe for trouble then, just as "covenant lite" is proving to be a recipe for trouble now.

If Messrs Kaletsky and Davies are missing anything, it's probably this: when banks start to lose money on bad old loans, they stop making good new ones for a while. In an economy as credit-driven as today's, markets won't be able to withstand the withdrawal of credit for long. It's too soon to say whether that will happen, but it's certainly much too soon to be sure that it won't.