Why did these Harvard MBAs guys make all of these bad loans?

Et Tu, E*Trade? By Daniel Carroll




Nov. 15, 2007 1:22 PM ET  |  About: E*TRADE Financial Corporation (ETFC)


Or: Why did these guys make all of these bad loans?

Billions of dollars in write-downs on bad mortgages. It was not difficult to find news reports in the last three years warning of the risk posed by easy mortgage lending. So why did these rocket scientist---Harvard MBAs do it? Why did they dive blindly and stupidly into their very own mortgage abyss?

Not only banks, but Wall Street titans like Merrill Lynch and Citigroup. And, of course, E*Trade.

Why do turkeys gobble? Why do sheep bleat?

Not to add salt to the wound, but this is not the first time this has happened. It happens at least once or twice per decade. It will probably happen again many more times in our lifetime. It will happen here in the US and it will happen in other countries. Big banks and financial institutions making stupid loans or otherwise doing stupid things with their capital. It's part of their DNA.

Just as a disclosure, I'm not really a financials guy - I have generally avoided financial stocks since I find that I can make money elsewhere. This might be a good time to look at them, though.

I've worked at big banks, and I've worked around stocks for a long time. So I know enough about them to be dangerous.

By the way, I do not own E*Trade stock. I have my accounts with them, though fortunately not my bank accounts. I do own stocks that have been affected tangentially by this mess, however. And it's not fun.

I would like to cite Warren Buffett. He coined a phrase called the "Institutional Imperative." Put simply, this is the inherent propensity of any company (especially large companies) to do really dumb things. Companies are hardwired to squander capital. Banks have a lot of capital, so they have more opportunity to squander it.

A few years ago, the hot market was real estate. Everybody was buying a new house, TV stations and shows on real estate proliferated, Home Depot and Lowes were enjoying big gains, lenders were tripping over themselves to extend mortgages, and investors were tripping over themselves to buy mortgages. Sound familiar?

The details are different, but theme is the same. Bubble. Then bust. Then, whoa, banks were in on it, too. Who woulda thunk?

You see, organizations are inevitably structured to reward activity by its employees that create value for the employee, but only sometimes create value for shareholders - and often destroy value for shareholders. The more powerful the employee, the more value he can create for himself.

For example, the people who originate loans make money when the loan is originated (remember those fees when you took out your mortgage?). They have quotas to meet, market share goals to attain. If they don't meet their quota, they either get fired or they don't make much money. Management, of course, also makes money off of the originations. And they don't make money when they refuse to make loans.

What about the risk? Don't these loans carry risks? Won't they lose money if the loan goes bad? Of course. But the originators and their bosses don't bear all of the risk. Investors are not going to dip into the employee's bank accounts and ask for the money back that gets lost. The worst that can happen to the employee is that he gets fired. And the top brass at the company will walk away with millions, so what does he care if he gets fired? And he was going to get fired anyway if he didn't make enough loans. There are other jobs out there. Remember, he has a Harvard MBA.

The employees who were concerned about risk got weeded out years ago.

Who carries the risk? The people who hold onto the loans carry the risk, and they are called "shareholders."

Of course, in the latest debacle, loan origination and ownership was separated, adding more room for mischief.

But don't companies put risk controls in place to make sure this doesn't happen? Sure. But people are creative - they find ways around the risk controls (hence the separation of origination and ownership). Beta and VAR ("value-at-risk") are popular forms of risk control, and they work well ... except when they are needed most. And when the boss as well as the employee aren't really interested in controlling risk, then it is a pretty safe bet that the risk will not be controlled.

Besides, everybody's doing it... safety in numbers ... who knew this would happen?

Humans run in herds. The herd was chasing real estate and bad mortgages.

Maybe the government should step in and fix things! Well, maybe not. You see, I'm a shareholder in the government - not because I want to be, but because I am required to be. As a taxpayer, I don't want to clean up somebody else's mess, and Uncle Sam will just make it worse. If you really enjoy watching the Institutional Imperative at work, then following our tax dollars will be great entertainment.

Except, of course, the government is stepping in. It's called a bailout. And bailouts perpetuate the cycle.

These aren't bad people. At least most aren't. They just have zero (actually negative) incentive to look at the big picture.

So why do banks make bad loans? Why do turkeys gobble? Why do sheep bleat?

Because it is the way of the world.

The best way to approach this as investors is to assume that companies will do stupid things. Most of these behaviors are very predictable - they've happened before, and they will happen again. Thus, they can be built into a valuation estimate for the company, if your time horizon is long enough... It's not risk if you expect it. It's only qualifies as risk if it is unexpected. If one buys into something that is expected, that's called a mistake (we all make them, so don't feel bad). Bad loans are not unexpected.

However, when these things do happen, stocks in unrelated industries get hit. But, if the fundamentals are still sound, then the intrinsic value will not be affected. That doesn't make the volatility any less painful, though.

Type in "Institutional Imperative" and "Buffett" into your favorite search engine, and you will find many a fine article on the subject.