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By Dan, January 10, 2010 12:07 am

With great crisis comes great opportunity…may you live in interesting times…

When a system fails the first thing you need to do is damage control, the next thing you need to do is fix it and the last thing you need to do is to prevent it from happening again.  With the world banking system we may have gotten through the first stage, but we’re a long, long journey from the next two stages.  Hopefully, the scale of this disaster was such that people are willing to engage in some more creative thinking and question some of the “laws” of banking that have so ably gotten us where we are today.

It may be too late – the time for aggressive action was a year ago – but we can but hope.  Sales of the British game “Whack-a-Banker” (after all, what did a mole ever do to you?) remain brisk, indicating that national sentiment has not yet forgiven these people.  But rather than just beating them (satisfying though that may be), perhaps it’s time for some more constructive criticism?

Maybe constructive isn’t the right word.  What I propose for consideration is actually a bit of creative destruction.  In two words: eliminate collateral.  Get rid of it.  Don’t make it a part of lending decisions.

“What?” I hear you cry.  “Is he mad? Has his brain come unglued? Wipe the foam from his lips! If there’s no collateral backing a loan, doesn’t that make it even more certain it’ll be unsupportable and probably bad?” Though unintuitive, I think the answer is no.

I rest this conclusion on a bit of unattributed old wisdom.  What’s the best way to win a gun fight? Don’t get in a gun fight.

Collateral is the same way.  I don’t mean that a loan should have no security.  Far from it.  But the concept of collateral as practiced by today’s small business bankers is very industrial revolution in nature, not in keeping with our information society.  First of all, there’s a belief that collateral from a small business should be in the form of tangible, physical assets.  Those assets may be cars, computers, office real estate…wait – aren’t those all things that are illiquid and can lose value suddenly? Don’t cars and computers lose 30% of their value when they drive off the curb? Don’t computers lose practically all of their value within 3 years? Yes, it’s true.  Does the bank have a hope of getting 25 cents on the dollar for this kind of stuff in less than a year? Probably not.  If they resell the computers without some work, they may even be leaking confidential customer PII (personally identifying information such as credit card numbers) without even knowing it and opening themselves up to law suits.

And most information and services companies (including law firms and accounting firms as well as more tech oriented companies) don’t have a lot of these types of assets anyway.  Their products are intellectual, virtual or services.  But there are companies that do have these kinds of assets – restaurants, theaters, manufacturing companies – yes, the types of businesses that currently have the highest failure rate.

So while I can’t get a bank loan for an established web services company twice on the INC 500 list of fastest growing companies in America, in the time it takes to tell it the restaurant down the street got one, failed and the bank now owns its building and can’t sell it.

This is called an adverse selection bias.  In their desire to secure themselves, the banks require assets that are only possessed by companies that are greater credit risks to begin with.

So what’s the solution? Take a page from micro-lending.  The success of companies like Grameen is based in part on the fact that they don’t use collateral.  They use a very sophisticated form of relationship banking and revolving credit.  The pressure to repay the loan is primarily social at first, but the borrower gains credit and borrowing capacity as she borrows and successfully repays.  Each time she goes through the cycle she can borrow a bit more.  She meets her banker regularly to manage the loan and restructure it if circumstances require it.  No collateral, but a default rate so low it would make any Wall Street bank as green as a greenback with envy.

It comes down to the point about the gun fight.  The best way to secure a loan is not to have it default to begin with.  If banks could get over their preconceptions about collateral, develop long term relationships with entrepreneurs and aggressively invest in the businesses of the future, we’d all be better off.

Comments (2)

By Dan, January 8, 2010 3:41 am

Every CTO knows the old story – one moment you are in your office calmly reviewing the product backlog to prepare for yet another meeting and the next moment the schedule, the team and seemingly the world have been shattered and you are left feeling like Newton if his meditations had been interrupted by a concrete pylon rather than by an apple.  What has happened is that your star developer – your top producer – dropped by for a chat and told you that he’s getting a bit bored in his current role and would like to try something new – he’s thinking about becoming more of an architect.

It may seem innocent enough, but I call this problem the Siren of Scalability because, if wrongly handled, it will pull the organization, the developer and the product through the doldrums of non-productivity and onto the rocks of non-competitiveness.

This may seem like a gross overreaction, but think about it for a bit.  Everyone wants to grow, increase her skills, responsibilities and earning potential.  And it can usually be done in one of two ways – either becoming deeper in your chosen craft or by becoming a manager.  So each person thinks about what she could do to accomplish that.  In a startup there often isn’t a clear upward trajectory on the management track so that means your ambitious developer concentrates on perceived skills growth – the “hard” problems for which people get paid big bucks – scaling and architecture.

There are a few problems with this.  Only the very largest organizations really need more than one architect.  Imagine what your house would look like if was designed by a committee of architects.  Software can have the same problem.  It’s true that “architect” is actually a misnomer – what software architects due more resembled the tasks of a structural engineer that a true architect, but “software structural engineer” doesn’t have the same ring.  And you still don’t need more than one.

And if you believe the buzz about cloud computing – which in the long term is pretty hard to ignore – you actually may not need an architect at all.  If you build your system on a commercial or open source framework in the cloud, only the top few hundred websites are likely to hit scaling issues requiring this set of specialty skills.

What will always be useful, however, are top producers.  Alternative skills to hone are product and business-based since no one knows the product better than its developers and virtually every good developer is also a business analyst.  But that’s hard to explain when they come in with stars in their eyes and the Siren in their ears.

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By Dan, January 7, 2010 5:06 am

It is interesting that free market thinkers (often to the right politically) claim to be among the more fervent supporters of the institution of monogamous marriage whereas more leftist economic thinkers are more associated with free love.

While certainly not universal, to the extent this is true you’d expect the opposite.  Free market economics is about rewarding the efforts of society’s greatest contributors.  It accepts the idea of inequality as necessary for greater productivity.  Extending this to marriage, this would imply that the most successful people should be entitled to the most mates whereas the least successful should struggle to find a mate at all.  This bit of amateur eugenics or social Darwinism should result in a stronger, better human race.  Right?

Not so fast.  Those conservative thinkers really like the institution of family, right? (That is if you don’t count congress … in every possible sense of the term.)

But that’s leftist.  “To each according to his needs, from each according to his ability.”  Fundamental Marxism.  Distribute the wealth.  Make people as equal as possible while addressing their needs.  One mate for each person – it’s what you need and what society can provide.  It doesn’t take into account what you can support, your success in life or anything else, but it sounds a lot like monogamous marriage.

But are the lefties the free lovers? Maybe not so much there either.

This whole argument is admittedly trivial, but should be fun for annoying the doctrinaire among your friends (lefty or righty) at your next cocktail party.