I had an interesting conversation with a seasoned real estate attorney the other day. I’ve recently been looking into investing in commercial real estate, and I took a look at a company that provides a particular type of health care service. It’s a national outfit, with hundreds of locations, but in doing my research I noticed that its credit rating was a step or two below what’s considered “investment grade.” This seemed relevant, not just because of the obvious i.e. that there’s a greater risk the company might default on rent payments, but that a bank might be less likely to give me financing because of that rating. When I discussed this with the attorney, his reply was along the lines of “you might think so, and and it should be a consideration, but I’ve never seen a bank consider that as a factor.” He went on to explain that the banks care that there’s a lease and a tenant that will pay that lease, and perhaps that the tenant is a big company, but that he hasn’t experienced a loan officer going that deeply into the tenant’s financial bona fides. As a clarification, we’re not discussing eight and nine figure property values with tenants paying millions a year in rent, where big-time bankers and big-money investors do their dance. Think, instead, of a parcel of property upon which sits a 7-11 or a McDonalds. Not trivial, certainly, but not Wall-Street-Finance either.
There are many possible reasons why a legitimate risk factor like a tenant’s credit rating might not be a first-level consideration to a lender.
First, there’s the “checklist” nature of the job, both internally and with respect to outside regulators and observers. The people higher up the food chain certainly want to exercise control over the process, but to do so case-by-case is inefficient and will lag in comparison to a formulaic approach. Sure, tenant credit rating could be folded into that, but the more variables you mix in, the more chances for a “no” answer, and lenders don’t make money saying no.
Then there’s the regulatory aspect. The government is deeply involved in banking, and that involvement further biases the process towards a “checklist” mentality. If government busybodies are looking for fault in lenders’ operations, the best thing the lender can do is depersonalize the lending process, and remove as much subjectivity as possible. As before, credit rating could be factored into the mix, and in some cases it may very well be, but if you want to make loans, and your boss wants you to make loans, and your company wants to make loans, adding too many mandatory check-boxes to the list doesn’t help matters.
There’s also the CYA element: if you reduce criteria to a basic checklist, if you remove subjectivity from the process, you’re less likely to be sued or accused of discrimination by some falsely aggrieved or agenda-driven outsider.
Another possibility is that the people who sign off on these loans aren’t the most motivated sorts with respect to real risk assessment. They have a job to do, the parameters of that job are defined, the goals of that job are to write loans. They’re probably not aggressive and hungry masters-of-the-universe types either, given the nature of the job. No aspersion intended, just measuring probability and reality.
Yet, aren’t we told that markets are supposed to be efficient? Isn’t the efficiency of the free market a cornerstone of advocacy for liberty? Well, yes, but definitions matter.
While “efficient” implies that things are as good as they can get, market forces do not deliver perfection. Nor, more importantly, do they promise to. What they promise and deliver is a better result than than central planning can achieve.
Consider the example of the lender who doesn’t sufficiently consider credit ratings of tenants. Some of the possibilities for that insufficiency are related to the individual, some are related to the company, and some are related to the government. This insufficiency and inefficiency can be countered in a couple different ways. The management at the lender can adjust its rules, or give greater discretion to loan officers who demonstrate skill and talent. The government can impose more regulations and metrics. But whence the feedback for these changes? How is it determined if the changes improve matters, if they result in “better” lending, lending that improves income while reducing risk?
An inefficient lender in a free market is ultimately judged by its competition. If it performs more poorly than its competitors, it’ll find its profits lagging those of its competitors. In contrast, efforts to root out inefficiency by government produce no Ôpassive’ feedback of that sort. Someone has to take the measure of the effectiveness of those efforts, and that measure is as subject to human frailty as the lender itself is. Worse, actually, because there is little down side to being wrong when you’re the government bureaucrat. And, worse again, because with government regulation there’s a tendency to one solution. Whereas competition vets different approaches to efficiency, rewards the best and punishes the worst, centralized control relies on the skill and wisdom of the regulators, with feedback, reward and punishment far removed.
The greater inefficiency of statism is rarely considered by those who see imperfection in capitalism and in free markets. They lament those imperfections and use them as justification for regulation and intervention. They compare the actual with a fictionalized ideal, a presumption that some dispassionate and benevolent people in government can make things better than they are. I recently read a study that suggested the human brain spends quite a bit of time fantasizing about idealized scenarios. This fantasizing seems the likely source of the statist impulse that infects so many, and it’s hard in casual conversation to challenge those who see imperfections in free markets and conclude that making those markets less free will diminish the imperfections.
Yet challenge, we must. It is neither honest nor intellectually rigorous nor fair to compare the reality of free markets with the idealized dream of benevolent, wise and all-knowing statism. There is little to nothing to suggest that central planning can do better than free markets other than wishful thinking, even when inefficiencies in those free markets are identified. There is no effective substitute for the inexorable and dispassionate ruthlessness of competition. The market’s winners aren’t ever going to be perfectly efficient. They will, however, be the most efficient.
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