Banking runs on margins and interest, not trust

A Smartmoney article goes a bit more in depth into how the mortgage market works, and some of the potential moral consequences. It also mentions Islamic banking. At its worst, Islamic banking is just a pro-forma workaround to enable the same result. However, the author also points out how some of its principles make good ethical sense in finance. Related to this, there's an Islamic mutual fund which has performed quite well; Islamic finance prohibits gambling and frowns upon debt, so the fund has loaded up on financially-strong companies, and avoids trading rapidly, both of which make very good sense in mutual funds.


But this isn't about ABN Amro, or its boss's rather pathetic-sounding claim that his global finance whale has become a "toy for hedge funds." This is about the realities of modern banking, which is in turn about collecting interest and fees from all-but-anonymous strangers. It's a business that runs not on trust and confidence, but on margins and volume.

In a world of commoditized credit, it's hard to know who's on the other end of a contract. Often, it pays not to ask. The brokers who arranged all those liar loans got paid long ago, as did the bankers who approved them. The investors who bought the riskiest securities backed by those no-documentation mortgages will be the ones to take a bath.

So now there are plans afoot in Congress to do away with "predatory lending" and subject mortgage brokers to more paperwork. The problem is that commoditized credit is predatory by its very nature, because the issuer of tradable debt cares about the creditworthiness of the debtor only one time — in the present. The future becomes someone else's problem.

The market seems to be responding to the subprime failures just fine without help from Congress by cutting off credit to the most reckless brokers and lenders and by leaving some of them broke. But yield spreads remain narrow, suggesting that the money that once flowed into risky mortgages has moved on to junk bonds and the like without the missing a beat. And as long as money remains plentiful, the people arranging deals retain a perverse incentive to care as little as possible about the arrangements' long-term risks.

Where will the mismatch between future risks and present-day rewards cause trouble next? It could be in commercial real estate, or perhaps in the syndicated lending for the leveraged buyouts currently propelling the stock market. Sam Zell and Larry Fink don't strike me as Chicken Littles.

Without question, the commoditization of credit has democratized access to financing and stimulated growth. But at some point the pension plans and insurance companies lining up to buy all that debt will have to ask whether the long chain of intermediaries has undermined the traditional bond of trust between lender and borrower.

I have accounts with several national lenders, and none of them really know me beyond my credit score, or see our relationship as anything more than an opportunity to market expensive credit monitoring. Of course, I view them as interchangeable suppliers of interest-free credit and charge-card rebates. I'm not at all profitable for most of them now, and the only way that would change is if I were to suffer a financial reversal. Beyond the rote expressions of gratitude by South Asian customer service reps, our relationship is adversarial in its economics.

And while there's no need to go overboard and adopt the Shariah, the main precepts of Islamic banking could have proven pretty useful at curbing some of the mortgage market's worst abuses. Since Islam forbids interest charges, Islamic mortgage contracts are essentially rent-to-own arrangements. The basic principle of Islamic finance — the long-term pooling of risk between the supplier of funds and their investor — would also have allowed banks and homeowners to share the housing downturn's pain through a mechanism less wasteful than foreclosure. The entire system depends crucially on sound collateral and full disclosure of benefits and costs — the very safeguards that so many subprime mortgage players failed to deliver in a rush to beat near-term volume quotas.

The more superficially the financial industry knows its customers and the more it views them as near-term profit catalysts, the more it spends to advertise the very opposite. I see these not-quite-white lies all the time in between snippets of business news: The investment advisor who's like a member of the family, the kindly loan officer next door.

If only someone were still willing to pay these people to care. In reality, many of them have been replaced with software models. It's called progress. On ABN Amro's personal banking page, the bank presents itself as "the partner that can help clients take charge of their financial future by planning in the present." And then there's Preferred Banking, "a relationship-banking approach for mass-affluent customers" who desire "individual recognition." That luxury costs extra.