By Edward T. O’Leary, veteran banker. A full biography of O’Leary appears at the end of this article
Industry veteran asks where bankers’ judgment has gone
My banking career began in the mid-1960s at The Bank of New York’s commercial loan officer development program.
I was one of about 20 young men (we were almost exclusively men in the
training program in those days) who were put through a more or less
open-ended process of writing credit reviews in support of commercial
lending applications. Our “clients” were the lenders, nominally, but
the real client was the bank itself. The bank had its standards, and
the occasionally adversarial role of the lending officers was
understood and acknowledged.
In those days, such programs didn’t have a set term. You did it until
you “got it.” One finished when one was finished. In my case, I got
through it in just under 15 months, probably less because of my MBA
than due to the bank’s need to get another credit man onto the lending
line upon the completion of the bank’s merger with the Empire Trust
Company.
That program served me very well for the next 40 years.
It gave me a very clear idea of what the bank expected in its loan
portfolio in terms of risk. The training also taught very specifically
what was expected of me: thoroughness, no bad credit, adherence to
standards, no surprises.
Mind you, this was before there was such a thing as a formal loan
review process or a credit policy that extended for dozens of
pages.
I had the idea in those days that all “big” banks did things pretty
much the same way with the same degree of formality. I think that was
accurate, based on my conversations with other bankers from different
institutions.
Signs of changed times
Forty years later I have come to wonder about how standards are taught
and inculcated at the big banks. Does the same degree of thoroughness
exist that I recall from my formative training? How do banks today
maintain a sound credit culture? How are lenders trained, and then
nurtured, in the practice and application of their skills?
What we witnessed during 2007, and on into this year, has not been very encouraging.
Big banks and their stockholders are beginning to live with the
consequences of some incredibly poor credit decisions—stupid and
short-sighted, in my judgment, and on an epochal scale.
Who are the lenders making these underwriting decisions? Where were
they trained? What sense of standards did they acquire in their formal
training processes? Is anyone accountable?
The really curious thing to me today is how what I would call the “bad”
credit decisions were largely made by the very large banks—“megabanks”
in today’s parlance.
Yes, they are probably made by men and women much younger than I am
today. However, the appalling thing, at least to me, is that they
haven’t been trained very well. Sure, bad credit could slip through the
system even at the old Bank of New York. But today we as an industry
spend a huge proportion of our salary budgets on “risk management” and
“risk abatement.” We tell ourselves and each other confidently that our
systems can identify and track risk in our portfolios and that our loan
review process uses the latest mathematical modeling techniques. The
problems of the oil field in the 1980s, and the commercial real estate
or LBO excesses of the 1990s simply couldn’t happen today.
Tell me, then, how the major banking houses ended up with billions of
dollars of leveraged buyout debt on their balance sheets without
permanent takeouts? Unless I completely misread the situation, these
are largely credits by makers and on terms that would not be bankable
in the bank’s own permanent credit portfolio (rate, covenants, etc).
Does one side of the house leave its common sense in the vault when
underwriting credit? Are the depositors of these banks, with their
primary capital ratios of 7% or 8% of assets, the lenders of last
resort?
That seems to be happening right under our noses.
Where’s the “Old Maid”?
Then there’s the subprime mortgage credit business. To be fair to the
banking system, much of the subprime loan originations that are now
burdening our financial system were underwritten and placed by nonbank
lenders that do not receive the scrutiny that our industry receives
from the various regulating authorities. But what about the
portion originated by the mortgage underwriting subsidiaries and
affiliates of banks, and placed into the financial system to be
packaged and sold to third parties?
The more egregious violations of common sense were not committed by the
banks. Yet the banks were nonetheless originating and placing subprime
mortgage credit that they would not accept onto their own balance
sheets.
The child’s card game of Old Maid makes the point. When you got dealt
the Old Maid, you were out of the game. Today, the Old Maid is sliced,
diced, traded, packaged, and sold in such a way that no one knows where
the Old Maid is. The point is that she is feared to be everywhere. And
this is seizing up a substantial portion of the markets. She is buried
within portfolios to be discovered in months or perhaps years to
come—and by holders who had no appetite for that risk to begin with.
A double-pronged lapse, and its lessons
We really have two categories of failures here.
First, there is the abdication of common sense. Credit was underwritten
with standards not appropriate to the originator and the ultimate
source of takeout (i.e., the depositor).
Second, we actively participated and profited handsomely through
elaborate structures of fees in originating paper we knew to be
problematic at underwriting. The fact that “low doc” loans or loans
made under excessively limber credit standards were not meant for our
own portfolios is hardly sufficient to excuse the banks for assuming a
decent share of the blame for the problems we see today.
Here’s my short list of what we’ve learned.
First, as an industry, we don’t seem to know, or appear capable of learning, what we don’t know.
Second, commonsense was left at the door, whether bankers were
originating LBO credit or subprime mortgages for the national market.
Third, loan review systems failed miserably and probably systemically.
Fourth, we are destined to learn these lessons all over again. Sure,
the faces will be different (and the practitioners are probably not yet
in senior high school), but we as an industry will relearn these
lessons with little if any experience residue of today’s pain and cost
to the shareholders. Why am I so pessimistic? Because our experience in
credit underwriting seems to be unfailingly consistent.
A major concern in my mind is not just the abdication of common sense
in the area of credit. It is also just how concentrated the banking
system has become. For example, Bank of America’s deposit liabilities
alone contain nearly 10% of our financial system’s money supply, as
conservatively defined. The top institutions are approaching 50% of the
total. There never has been much room for error on a bank’s balance
sheet, with our historically low equity-to-assets ratios, compared to
the industries representing our borrowing customers. Today, though, the
whole system seems to be placed at a level of risk that is historical
in its size and complexity. Remember, too, that it is official
government policy that no bank is “too big to fail.”
I am reminded of an old saying that is probably as figuratively true to
today as it has ever been: “A bank has to be right 99% of the time, as
the remaining 1% is the loan loss reserve.” ABABJ online
 About the author
Ed O’Leary, now a banking consultant based in Albuquerque, N. M., is an
industry veteran, having worked in banks large and small in both credit
and managerial ranks. He served as president and CEO of First National
Bank in Albuquerque and its successor, First Security Bank of New
Mexico, from 1991 until 2001, when First Security was acquired. Since
that time until September 2005, he served First National Bank of Santa
Fe as Senior Managing Director in its Albuquerque office. Until his
recent retirement, he was also a member of the bank’s board.
As an experienced commercial lender, loan workout professional, and
executive bank manager, he brings 40 years of commercial banking
experience to this viewpoint article. He began his banking career at
The Bank of New York and held positions of successively increasing
responsibilities at Southeast Banking Corp., Miami, Fla.; First
National Bank of Midland, Texas; and Liberty National Bank of Oklahoma
City, Okla.
O’Leary holds a Bachelor of Science from Boston College and a Master of
Business Administration from Columbia University. He is a graduate of
ABA’s Stonier Graduate School of Banking.
Among his published writings is his occasional series in ABA Banking
Journal, “Would you make this loan?”. O’Leary also speaks frequently on
banking. This includes participation in several ABA Community Bankers
Council telephone briefings for community bank directors and other ABA
telephone briefings.
You can e-mail him at
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. O'Leary's website can be found at www.etoleary.com.
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