Don’t Blame Loan Officers for Poor Loan Performance

The Obama Administration thinks loan officer pay should be tied to the quality of their loans. From the Wall Street Journal:

The Obama administration has begun serious talks about how it can change compensation practices across the financial-services industry, including at companies that did not receive federal bailout money, according to people familiar with the matter…Among ideas being discussed are Fed rules that would curb banks' ability to pay employees in a way that would threaten the "safety and soundness" of the bank -- such as paying loan officers for the volume of business they do, not the quality.

This idea reflects a fundamental misunderstanding of how loan origination works. Loan officers do not approve their own loans; there is always some kind of credit approval structure with people other than the originator signing off. I’m not saying that system doesn’t break down (for example, see my post, “Why Did WAMU Abandon Underwriting Standards?”). However, if a lender does a lot of bad loans, it means senior management made bad decisions and/or looked the other way.

VoxEU addresses the issue in their article, “Bonus Incensed”:

Until the 1970s, the predominant institutional form for risk taking in financial institutions specialising in speculative trading was partnerships, with partners’ unlimited liability a central element.

Employees were entitled to bonuses, but entirely at the discretion of the partnership. Employee traders producing significant profits were very well paid; those generating losses did not get bonuses, were often dismissed, and even blacklisted. The partners had a highly developed sense of risk and their asymmetric exposure to it, in no small part because failure could also mean personal bankruptcy.

Partnerships have disappeared over time, and the predominant institutional structure in the financial industry is now the limited liability corporation. This transformation is a key reason for the emergence of the bonus culture, because it substantially reduces the incentive of senior management to monitor risk taking. Any financial institution engaged in speculated trading faces the inherent danger of individual traders taking so much risk that it threatens the firm. It is the role of the senior management to prevent that.

Their solution:

Financial institutions should adapt elements of partnership structures to the limited liability financial institutions of today. Senior management (the partners of old) need to have a substantial part of their compensation deferred over a long period of time, with the amount of compensation directly related to the long run fortunes of the firm. Any senior manager in an institution receiving public assistance should lose all of their deferred compensation. By contrast, the supervisors should not mandate deferral of trader bonuses or regulate junior employee compensation. This provides management with an incentive to check for gaming.

When I’ve been in a credit position, I’ve always been impressed with how effectively experienced loan officers triage their loan applicants. Spending time on a loan application which is not going to be approved is a waste of time, and good loan officers can’t afford to waste time. In my experience, applications for bad loans are almost invariably taken by inexperienced loan officers who don’t know a good loan from a bad one and/or who are desperate to establish a client base. Changing their compensation structure is not going to solve that problem – you need good credit people willing to say no to bad deals and senior management willing to back them up.

To the extent bad loans are originated, the problem lies with the lender’s credit people and senior management, not the loan officer.

The Commercial Real Estate Risk Culture at Deutsche Bank

Zero Hedge has published a letter from a former risk manager at Deutsche Bank which speaks to the difficulties of being a risk manager in a lending institution. Some excerpts:

For more than two years, I have been working internally to improve the inadequate governance structures and lax internal controls within Deutsche Bank. I joined the firm in 2006 in one of its foreign subsidiaries, and my due diligence revealed management failures as well as inconsistencies between our internal actions and our external statements.
Beginning in late 2006, my conclusions were disseminated internally on a number of occasions, and while not always eloquently stated, my concerns were honest. Unfortunately, raising concerns internally is like trying to clap with one hand. The firm retaliated, and this raises the question: Is it possible to question management’s performance without being marginalized, even when this marginalization might be a violation of law? Two years later, our mounting losses are gaining attention, and I offer my experiences and my thoughts in the hopes of contributing to the shareholder and public policy debate…

I joined Deutsche Bank in 2006 to build an investment business within its commercial real estate lending operation, and I was generally surprised by the aggressive sales culture within our firm. While many people consider the banking sector’s problems to be caused by residential lending, I witnessed multibillion-dollar loan proposals for commercial property.
With funds provided at more than 90 percent loan-to-value, these loans were “priced to perfection” and assumed that property prices and rental rates would continue to rise. For perspective, a single billion-dollar commercial real estate loan is equivalent to 2,000 residential loans of $500,000.
In general, my colleagues are hard-working, decent people, but the system of incentives encourages people to take risks. I have seen honest, high-integrity people lose themselves in this cowboy culture, because more risk-taking generally means better pay. Bizarrely, this risk comes with virtually no liability, and this system of O.P.M. (Other People’s Money) insures that the firm absorbs any losses from bad trades…

There’s much more at this follow up Zero Hedge post.

Related Post: Fox Guarding the Henhouse?  Bear Stearns Risk Manager Now at the Federal Reserve

Why Fewer Reasons Are Better; Dead Cats and Cul de Sacs

When turning down a workout request or a loan application, you need to explain why. Borrowers expect a fair reason for being turned down, and loan officers and underwriters can learn from each experience and hopefully prevent reoccurrences in the future. You have a choice – you can try to provide a comprehensive understanding of your entire thought process, or you can relate just the factors which are the most important to your decision. In my experience, the latter approach is better, because what people remember won’t be your best reasons.

For example, back in the mid-1980’s I worked for Cambridge Capital originating multifamily loans (the company is long gone and not related to any of the Cambridge Capitals currently doing business). The principals were very hands-on, bright guys who personally inspected every deal we did, and I know I learned a lot about real estate from them. But, my only specific recollection is one deal which was turned down because, when the principal did his inspection of the property, there was a dead cat in the parking lot. I’m sure there were other things he didn’t like about that deal, but I don’t remember them.

I did something similar during a presentation sponsored by a chapter of the Earthquake Engineering Research Institute in Oakland. After the Northridge Earthquake I did consulting work for the Los Angeles Housing Department, and one of the things I did was a drive-by inspection of all the red and yellow tag structures damaged in the earthquake. This was an inductive approach to learning – after you look at a few thousands damaged buildings you start to see patterns. A lot of these patterns were obvious. For example, proximity to the epicenter, hillside or liquefaction zone locations, and brick construction are all know risk factors, and the audience didn’t react when I relayed that information. I did get a reaction, though, when I told them that cul de sac streets were a risk factor. On reflection, this isn’t surprising. Orientation of the structure to the ground motion wave is an important variable, and on a cul de sac one or more structures are guaranteed to be oriented for maximum damage. Also, in Los Angeles a cul de sac is usually related to e geographic risk factor (the cul de sac terminates at a drainage ditch prone to liquefaction or a hillside, for example). But, I didn’t explain this during the presentation, and I know there are people out there who remember me as the idiot who thinks earthquake damage is linked to cul de sac streets.

There is a neurological basis which explains why people lock in on unexpected reasons. From Jonah Lehrer’s “How We Decide”:

The brain is designed to amplify the shock of these mistaken predictions. Whenever it experiences something unexpected – like a radar blip that doesn’t fit the usual pattern, or a drop of juice that doesn’t arrive – the cortex immediately takes notice. Within milliseconds, the activity of the brain cells has been inflated into a powerful emotion. Nothing focuses the mind like surprise.

This is why if you tell a loan officer you’re turning down his loan because the borrower lacks liquidity, the building is poorly maintained, the income is trending down, and there’s a dead cat in the parking lot, you will forever be remembered as the guy who is fixated on dead cats. Unless that’s what you want, you’re better off keeping that reason to yourself.

Underperforming Assets, Workouts, and Management

Via Newmark's Door, Secretgeek on "The Deadly Cycle of Meetingitis." Here’s an excerpt:

 

1. Q:What do managers do when they're stressed?
   • A:They call a meeting.
2. Q:What gets managers stressed out?
   • A:When projects are not making progress.
3. Q:When do projects fail to make progress?
   • A:When people spend too much time in meetings.

Secretgeek is talking about programming code crises, but the cycle applies to any situation which creates manager stress. The important part of this cycle is the root cause – it’s not the status of the project, it’s the manager’s stress.

Underperforming assets and workouts are inherently stressful to management, and are particularly prone to meetingitis (and it’s nephew, reportitis). Some managers are not comfortable unless they know the status of every deal, all the time. Secretgeek’s solution:

Communicate more, in order to meet less. Be proactive in your communication. Don't wait for them to call a meeting. Tell them what's going on. Produce regular reports. Don't "promise" to produce regular reports -- just produce them. Let them listen in on some of your day to day chatter. If you have daily standups, bring the manager in. Stop baffling them with technical mumbo jumbo. Feed them edible slices of information. Walk them through it in bite-sized chunks. Give them documentation tasks to keep them feeling important. Give them communication tasks. Draw pictures for them to stick on the wall of their office.

This approach might work for coding, but I don’t think it works very well for special assets. In my experience managers only calm down when they develop confidence their workout people are on top of their deals and elevate issues when necessary. It takes time and positive experience for workout people to develop that kind of credibility with their management (more on that here). Unfortunately, that level of confidence may never develop if the manager believes progress is a result of their involvement and not their staff’s work.

Keep the Bonuses, Change the Criteria

Thomas Gehrig and Lukas Menkhoff at VOX survey the research on bonuses and suggest we keep them, with some changes. An excerpt:

In fact, banks themselves are trying to correct their internal incentive schemes in order to re-adjust incentives on longer horizons. They seem to largely agree that, prior to the crisis, their systems may have been excessively short-sighted, and they are now trying to base rewards on more sustainable performance criteria such as average growth rates and volumes across longer sampling periods.

My suggestion (posted here) is measuring shareholder equity over a five year period.

Management, Feedback, and US Air Flight 1549

Via The Big Picture, an amazing animation with audio of the US Air Flight 1549 takeoff and landing.

It’s striking how the flight controllers’ understanding of the situation lags actual conditions. I think there’s a parallel with management and regulator understanding of what’s happening on the ground (or in the air, in this case) during rapidly changing conditions.