A Crisis in Trust
I apologize in advance for the following post, because, firstly, I am an apologist by nature, and secondly, it is a bit less well thought out than most posts, but the topic compels me to write about anyway.
I have a theory that what underlies and led up to the current credit crisis is really a crisis in trust. Trust is the fundamental thing that allows us to enter a transaction with another person (or with a corporation), and if we do not trust our counterparties, then there is no way that capitalism may work. What the financial industry has done in the name of innovation over the past couple decades is to bet far more than they should have on the premise that trust is unnecessary; basically, if you don’t trust someone, you just charge more interest, and extract more of a profit from a larger segment of people to make up for those who default. As long as we were in a boom economy, the relative numbers of parties that would be in default were low, and real, honest-to-goodness counterparty integrity and trust (like getting a loan from a banker you knew in high school) was quietly replaced by complex financial modeling.
What has occurred in the lending market (probably best described by This American Life recently) may the effect of the sudden failure of decades of financial modeling to compensate for the gradual deterioration of real trust between individuals on Wall St. Trust was just a limitation on the levels of profit that could be gained through financial innovation; the real geniuses found out that you could give a loan to basically anyone as long as you could include their probability of default as a number in your financial calculation. The lack of information or faith about the balance sheets of counterparties seemed to become a problem so suddenly because the innovations obfuscated the real cost of the debts that were being incurred (think option ARMs or balloon payments), until finally it all came due and nobody could be counted on to fulfill the terms of the mortgages (or, for that matter, credit default swaps) that they had agreed to. The boom market can not be described as the result of complete trust in all counterparties; it was the hubris of believing that trust could be outsourced to third parties (the ratings agencies), and as such, not being particularly important, instead of being an absolutely essential component of deciding to do business with someone else.
It seems like I’m being a bit hysterical about the importance of integrity and trust in a free market system where capitalists are incentivized only to maximize short term profit, long term implications be damned. To trust recent corporate philosophy, preserving your real trustworthiness is a matter best left to those in branding or P.R., and that your actual actions can be painted over or hidden by name changes or evasive legal maneuvering. However, the culture of a company or even the reputation of a business leader with integrity can visibly affect the way that all people interact with your company. To make my point, i’ll invoke the image of Warren Buffett, whose every word the American public seems to look to as if messages from a mystic oracle.
It may be true the reason the credit market seized up is solely because of the sudden extreme value of cash on hand to protect against strategic competitive moves, such as that alleged by some against J.P. Morgan. It also may be true that trust has no place in a free market; that all decisions should be based upon rational evaluation of the creditor’s ability to pay. However, in this type of an economic storm, I am going to make a prediction that the value of integrity and ability to honor promises, regardless of the cost, is going to be a determining factor in which businesses are able to survive and make it through the recession/depression. Those who are able to cultivate a supernatural track record and reputation for trustworthiness and integrity will survive where the sharp business of the past will fail without trusting counterparties. In fact, I believe it will likely be a successful tactic for small businesses to overtake their failing large competitors caught up in this mess over the next decade. Although I sincerely hope that the country recovers from this crisis quickly, it could very well prove to be a good time to be in business and change the way that business is done in America.
Trust,integrity, and honesty used to be the hallmarks of men and women in whom we identified as our heroes. As any value system or commodity has its shining pinnacle of highest purpose or newness, it must swing like a pendulum to it’s antithesis before reaching equilibrium once more. A small business can have a great marketing plan, capital, capable business acumen , and still fail if it fails to recognize some critical success factors. You must be selling a product that is considered of value to your customers at a fair price and you must give great service . Repeat customers and word of mouth referrals always win over marketing plans. I would consider several issues in addition to trust to pull us out of this morass. 1. What about a stock market holiday so everyone can catch their breath. I mean across the world for a 24 hour period unilaterally. 2.Then, I would consider what solutions that do not involve money might help the situation. One suggestion I heard of involved bartering properties between two sellers. How about banks bartering properties between two potential foreclosures? Many empty nest families are trying to downsize and many expanding families are trying to get more/less room and end up with two mortgages and get into trouble. How about a lottery where households that could handle a smaller mortgage on one house could bid on another house based on their equity or pre-approval rating? When Baltimore mayor Shaefer in the 70’s was trying to develop old property downtown, he sold abandoned houses for $1 with the stipulation that they had to be lived in by the buyer within one year and had to be rehabbed and lived in for , say, 5 years before buyer received title to the property. We need creative people to start thinking instead of throwing money at problems to get us out of this. I know you are out there! Put on your thinking caps!