Demonizing the deadbeats

July 13, 2015 6:39 AM (UTC+8)

 

In response to my previous article on the Greek referendum, one of my esteemed readers on the chat forum wrote about my apparent predilection for demonizing a “proud people” who belonged to an “ancient civilization”. To which of course, my response is “balderdash”. Of course, that is not the entirety of it; and this little discussion gave me the impetus to explain something that may not be altogether obvious to people who do not work in the world of credit – or the act of giving loans to other people, companies and countries.

The latest deal between Euro zone and Greece   too fails to take into account the essential lack of character in the borrower
The latest deal between Eurozone and Greece too fails to take into account the essential lack of character in the borrower

The first principle of credit is to look at an applying borrower’s willingness to repay. The second principle is to look at their ability to repay. Please read that again – this IS the order in which you gauge the creditworthiness of your borrower; not, as the various automated credit machines and CDO engines will have you believe, by looking at the latter principle i.e. ability as a guide to the first principle i.e. willingness. That simply doesn’t work, and is almost always responsible for more losses in credit than mistakes in assessing the second principle.

Too much about banking these days focuses on a borrower’s ability to repay – the value of any collateral they are willing to provide, their income and expense analysis; and use of proceeds from the loan – and too little emphasis is placed on the actual willingness of anyone to repay. That’s because the latter is a subjective analysis, and these days it is quite dangerous to perform subjective analysis of anyone because of the political ramifications.

Imagine you are a loan officer at a large American bank and are approached by two deadbeats for loans. Both deadbeats are unemployed and have long histories of not repaying on their credit cards. Your job is easy – you reject both of them.

Now let’s change your picture. Instead of looking at their credit scores, you work in a bank that prides itself as a community lender and so you actually need to meet people. In this case, you meet both the applicants and find that one of them is white, and the other black. It turns out the white applicant is a cancer survivor who has struggled to pay his medical bills and is now recovering. Having gotten a college degree, he is now keen on a bank loan to help establish a new wellness center for other cancer patients. The second applicant is black – and let’s stay close to the stereotype now – didn’t pass college because he got in trouble trying to peddle drugs. He now wants to open a café that will serve pot smokers with legal marijuana. If it makes it any easier for you to decide, you can interchange the ethnic identity of the two people above – so the black one is the cancer survivor and the white one is the drug peddler.

Who do you lend to? Well, based on the above, and despite everything that your heart would tell you, it is simpler in America today to reject both applications due to their credit history. That’s because there is a host of anti-discrimination laws that will stop you from lending to the white borrower if you aren’t already going to lend to the black borrower. Community lender, you see. In the interest of fairness, you allow a machine to judge, and this machine looks at the history of credit card missed payments, and the lack of an employment history to decide that both borrowers cannot be trusted with a new loan. End of discussion; you as the loan officer get to blame the machine, mutter your apologies and run behind the branch to call your spouse and tell them what just happened.

In a different world, you would spend time with both borrowers, figure out what they need; set up a program to monitor progress and assist both with the process of rehabilitating their lives. That judgment still depends on the crucial variable of whether you think both are willing to repay their loans, or are they likely to fall back on the excuses of their past miseries – cancer or drug abuse – to avoid repaying the loans even when they have the money.

“Countries don’t go bust”

Back in the eighties, a former head of Citibank went public with one of the most asinine statements in the history of banking (yes, even the subsequent gems like “we’re still dancing” and “doing God’s work” pale to insignificance in front of this little gem), which was to declare “countries don’t go bust” when asked a question about the bank’s rising exposure to Latin American governments.

As subsequent experience was to prove, countries don’t go “bust” but can happily fail to repay loans from creditors all the time, declaring themselves bust, and getting more loans from the good people of the International Monetary Fund (IMF) or other useless multilateral institutions. There is an important distinction here – most times that countries declare themselves bust, it is to do with “external” debt obligations, for example borrowings in US Dollars for a Latin American country. Here, the question is do the people of the country sell their assets to repay foreign creditors, or simply shrug their shoulders and walk away saying they don’t have any US Dollars?

The IMF prescription for resolving this is to make some silly assumptions such as:

  1. Devalue the country’s currency (as in beggar thy neighbor policies, so very soon what was a national problem will become a regional problem as other countries around will need to devalue as well or face a loss of competitiveness)
  2. Impose structural reforms – fancy words that usually mean cuts in government spending*
  3. Allow exports to pick up
  4. Gather US dollars
  5. Repay foreign creditors

*There is also the general presumption of capitalism here – if a country cannot cut its spending, then it has to sell its government-owned assets; this is (if at all done properly) the only reason why any country getting into an IMF program ever achieves increased efficiency.

What is interesting when we look at all the sovereign debt crises since the eighties to now, is not that IMF programs work (they generally do not) but really what are the most successful cases of such turnarounds. There are basically very few that can be recounted

The UK entered into a IMF program in the 70s and achieved a return to competitiveness for no reason other than Margaret Thatcher’s stunning structural reforms in the late seventies and late eighties (well after the IMF program itself had ended)

  1. India, which after the 1991 payments crisis enacted some stinging structural reforms and put itself on the path of export competitiveness; the main reason for a turnaround was the removal of socialist intervention and the increased independence of the central bank
  2. Mexico, which post its 1994 crisis received explicit US government principal guarantee on its sovereign bonds (this was a singular achievement of Robert Rubin as Treasury Secretary under President Clinton); this along with NAFTA completely changed the country’s competitive position and paved the way for a broad based recovery
  3. South Korea in the late nineties, which really did export its way out of what was essentially a liquidity crisis (too many South Korean loans matured in December 1997 as the country’s corporates and banks awaited the boon of lower costs of funding from acceding to the OECD in that month). In other words, South Korea recovered from the “wrong” crisis
  4. Brazil, post the election of Lula wherein instead of following the promised socialist path, the new President followed a more centrist route that helped (along with rising commodity prices) the economy achieve escape velocity from its previous rounds of crisis
  5. Other countries like Thailand, Indonesia had a smattering of success from their IMF programs but these weren’t broad based enough. African and Latin American economies distinctly failed on most counts post IMF interventions

What stands out is that the countries which succeeded all had a strong sense of nationalism and in many ways, true pride in their history. Most of the other countries that failed either didn’t have a sense of national identity or the identity itself was forged out of continuing economic crises of the past, rendering the mood poisonous.

Greece, for example. Since the 1800s when the country exited its Ottoman domination of the previous 500 years, the nation has been in one form of economic, banking or currency crisis or other pretty much continuously. What is touted as an ancient democracy is, for all intent and purposes and particularly after the Second World War, a mere plutocracy – rule of a few rich men. Indeed, the surnames of various Prime Ministers since the Second World War show the repetitive, family nature of control.

Having pretty much lied their way through to euro accession in 2001, the Greeks instead of then setting about rebuilding their economy on sustainable lines as was afforded by low interest costs, went the complete opposite way

  • A welfare state to end all European welfare states, with generous doles and handouts
  • Pensions that were generous even by Northern European standards
  • Carve-outs for excess payments that soon covered large swathes of the population
  • Lowering the retirement age despite evidence that people lived longer
  • Reduced tax collection efficiency due to bureaucracy and corruption

Michael Lewis, in his seminal Vanity Fair article in 2010 entitled ‘Beware of Greeks bearing bonds’, covered many of these problems. Yet, the Europeans so taken in by their grand vision of a project to unite everyone, forgot the basics of credit management and ignored all these issues until it was too late.

So how does a creditor deal with a borrower like this?

  1. Accept that you will not get most of your money back
  2. Ask for hard assets as collateral for anything further you lend
  3. Take specific measures to monitor progress frequently
  4. Charge punitive rates of interest for every failure

As I write this, there is news of a new deal in Europe to keep the Greeks in; requiring more asset sales that are ring-fenced from the government budget, and various other austerity measures. As with all the previous plans, this one also fails to take into account the essential lack of character in the borrower – and hence, is another exercise in futile romanticism.

This plan will also fail, in the fullness of time – or a year, as it happens in the case of Greece.

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