5 ideas
Science and engineering accumulate knowledge, so each generation builds on the last. Finance does not: the lessons of a credit bust fade as the people who lived through it retire, and the next boom's lenders relearn the same mistakes. Rising sophistication in financial instruments does not produce wiser credit judgment, and often disguises its absence.
Credit quality is decided when a loan is written, and it deteriorates most during prosperity, when defaults are rare, collateral values are rising and competition for borrowers pushes lenders to loosen standards. The losses show up only in the downturn, so the real mistake is made years before it becomes visible. To judge a lender, look at the terms it accepted in the boom, not its current loss rate.
Federal deposit insurance and implicit too-big-to-fail backstops remove depositors' incentive to watch their banks. Insured institutions, especially thinly capitalized savings and loans, can then gather cheap funds and gamble on high-risk real estate and junk bonds. The gains stay private while the losses pass to taxpayers, so the guarantee meant to prevent crises ends up financing them.
Penn Square, a small Oklahoma City shopping-center bank, made aggressive oil-and-gas loans during the early-1980s energy boom and sold billions of dollars in loan participations to big banks, above all Continental Illinois. When energy prices fell, Penn Square failed in July 1982, and the bad participations helped trigger a run on Continental in 1984. That forced the largest federal bank rescue up to that time and gave rise to the 'too big to fail' doctrine.
Leverage and bad lending can be identified accurately long before they cause damage, because easy money, rising asset prices and fresh borrowing keep an overextended system afloat. A skeptic who calls the bust early can be right about the fragility and still lose money on the forecast for years. Read credit analysis for what it reveals about fragility, and treat its timing as far less reliable.