The always clear and succint Economist sums up the current financial crisis in next weeks leader here. I say crisis advisedly, because the markets are carefully saying nothing, or alternatively, focussing on the sub-prime market in the US, while the reality could be broader, and in any event a signal of a need to get back to basics.

First this from the Economist leader; as you read this, think derivatives and securitisation. The least understood methods, yet that which have largely been credited for the efficiency of global capital markets over the last 20 years. Incidentally, the correction we are seeing is a good thing for those markets, a good thing for social lending, and open source banking, but more on that later.

Risk and the new financial order | Surviving the markets | Economist.com

But there is a price that is only now becoming apparent. Because lenders expected to be able to sell on the risk of default to someone else, they lent too easily. After all, they would not have to pick up the pieces. In theory, that risk should have been borne by the people best able to carry it. But with everybody having sold on the risk to everyone else—and the risk often being carved up, repackaged and sold again—nobody is sure where the losses are. The fear is that some risks ended up with those who least understood what they were getting into, and fear is a potent force in this disintermediated world. In the interbank market, every counterparty was potentially vulnerable. Even small amounts of bad credit can drive out good.

I posted the other day about ‘know your customer’. The world of derivatives and other financial vehicles take financial instruments, such as bonds, currencies, commodities, mortgages, and divide them into different components, then re-assemble them as financial contracts that are traded amongst Banks, and investment houses. The nature of that division, and re-assembly means that the original debtor, the final person who must pay that debt is lost in inter-bank transactions. Know your customer is lost.

In simple terms, thats what has happened with the example of sup-prime loans. BNP in France who froze three of their funds this week, own some component of mortgages in homes in the US. The fact that a Joe Homeowner, hypothetically, in Main Street, Witchita, Kansas, is three months overdue on their mortgage payment after their interest rate and monthly payments rose by 3% is transparent to BNP. All BNP know is that the debt instrument they purchased and rolled into their fund(s) is no longer worth what they expected it to be worth. Worse still, they do not know how many Joe Homeowners there are, to what extent they will default, to what extent the home value will cover the foreclosure, and how long that will take. BNP thought they purchased an income stream, but actually they purchased an overpriced bad debt.

Back to Basics

This will take some time to sort out. There will be short term improvements, but there will also be significant reluctance to purchase obscure instruments, where the underlying credit quality is not guaranteed, so that will result in tighter credit conditions that Banks impose on their mortgage and loan activities.

It is incumbent on all social lenders to watch this carefully, and appreciate there is an opportunity to provide a valid and financially sound alternative to borrowers and lenders. Social Lenders still use the common approach of credit ratings to signal likelihood of payback on a loan. But they have the added advantage of additional factors that can be brought into the mix, the secret sauce of social lending, that traditional Banks can never replicate. Social Lending is highly transparent, and hiding is much harder in the open. The quality of lending that can occur within a well run social lending operation can greatly transcend the ‘by the book’ transaction that occurs in a one on one application and approval process typical of Banks.

Incidentally, as as aside, recently Prosper have been having issues, bringing out phrases such as ‘lender revolt’ and Prosper need to get that under control, and eliminate the emotion. Their issues go back to problems embedded in their early offerring, of lending to people with poor credit. That have since been corrected, but long time Prosper lenders are bearing those costs associated with that lending. Such lending has been eliminated from Prosper since early 2007. They saw the problem, learned and eliminated it.

Social Lending by definition carries the promise of at least eliminating the problem that the financial markets experienced this week. A promise of a simpler financial process, one that is easily understood and explainable. It won’t replace the worlds capital markets, but if it can provide at least a small alternative to those who choose, then mission accomplished.

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Background:
It is such a powerful piece, here, is the full leader from The Economist. I strongly recommend you buy it, and read the other related articles:

Risk and the new financial order

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