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Former Treasury Secretary Henry Paulson has written a book entitled “On The Brink”. There’s an article about it in the February 15th issue of Business Week. This is an excerpt: “Henry Paulson recalls dining with some of Wall Street’s most powerful bankers on June 26, 2007, not long before the credit bubble burst. ‘All were concerned with excessive risk taking in the markets and appalled by the erosion of underwriting standards,’ … Yet they felt forced by competitive pressure to make loans they didn’t like… ‘Isn’t there something you can do to order us not to take all these risks?’ was the gist of a question posed by Chuck Prince, who was still running Citigroup as the bank bumbled toward disaster.”

The article, and apparently the book, paints a picture of Wall Street titans unable to stop themselves from barreling toward destruction. In an earlier article I made the point that we, the common people, knew a bad ending was inevitable, and now we know those responsible knew it, as well. Ever wonder how such a thing happens? Let me shed some light.

The problem with bank lending is that all banks have the same product to sell – money. There’s no product differentiation upon which one bank can outcompete another, so they’re forced to find other ways. There are only three ways to do this. A bank can offer money (loans) with superior service which generally means greater cost and correspondingly higher interest charges. Alternatively, banks can capture market share by offering low rates. Lastly, banks can compete by offering loans with greater risk. Disaster occurs when all three come into play simultaneously. This happens frequently.

Let’s take a hypothetical example. Suppose Bank A offers a new loan product to help consumers finance purchases of widgets. Bank A offers a high level of service; charging interest rates that provide an attractive profit. Bank A does a booming business.

Bank B, a competitor, learns how well A is doing and decides to compete by offering a lower rate. A responds by lowering its rate. As competition stiffens, interest rates fall. This is a process I affectionately refer to as “a race to the bottom”. Profit margins decline as loans are made with lower rates, but, since these loans are added to the earlier, more profitable loans, overall profitability appears acceptable. A and B aggressively pursue more loans and the race intensifies.

About this time, Bank C, who is late to the party, decides to gain a competitive edge by offering to finance widgets of lesser quality. Because C assumes higher risk, it charges a higher rate. C is very successful with this approach. Being intoxicated by this success, C, who is not as risk averse as A and B, starts offering loans to borrowers whose credit standing is a little tarnished. Business is good.

A and B, jealous of C’s success and having been lulled into believing that credit scores adequately assess risk, decide to join C and lower their standards. They convince themselves that they can offset the additional risk by charging higher rates. Higher rates are, at least in the short run, accompanied by higher profits. A and B feel very smart.

All three banks enjoy explosive growth in their widget loan programs. Six months or so into this process profits are good and widget lending appears to be doing well. Intuitively, they realize they’re making loans they shouldn’t, but greater profit means happier paydays and more promotions. To soothe their concern, they look to the Community Reinvestment Act (CRA), which they interpret as requiring loans for less valuable widgets to borrowers with questionable credit. This wasn’t what the CRA intended, but it’s a convenient excuse. Additionally, they examine studies of past trends showing that widgets have never fallen in value since the beginning of time. They fail to recognize that there has never been a time when so many widget loans were made, and never a time when credit standards were so low. They find comfort in the studies.

This is where problems start to surface. Banks assess the success or failure of loan products based not just on profitability, but also on loss ratios. Loss ratios are calculated by dividing losses experienced through borrower default by the value of the total portfolio of similar loans. A certain amount of delinquency, or slow payment, is expected, but as long as delinquency remains below certain pre-established levels, loan products are deemed successful.

Loss ratios are not very effective measures for two reasons. First, ratios evaulate past performance, not the present. Second, people are not statistics or credit scores. As time passes, people experience things that affect their ability to honor obligations. This happens to some extent to everybody, but it seems to happen more often to people with poor credit. Furthermore, these people seldomly have savings to help them through tough times. In other words, it takes time for loan portfolios to deteriorate. As this happens, loans continue to be made, rates continue to fall and credit quality declines.

Recognizing that loan portfolios deteriorate slowly is only part of the explanation. You see, the employees originating the loans are often paid a commission on the volume of loans they produce. Those in management get paid bonuses. Senior management, who should be the ones to halt the process, are afraid that if they stop, and it turns out to be the wrong decision, they’ll look bad. Besides, their bonuses are the largest of all. So, the process continues until the very disaster they fear becomes reality.

This leads us to the inescapable conclusion that the people dining with Henry Paulson on that June evening in 2007 should be standing in an unemployment line today. At a minimum, they should be repentant. As it turns out, neither is true. In fairness to Chuck Prince, I should point out that he did lose his job and has expressed regret. The others collected multi-million dollar retention bonuses.