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You Must Know Your Customer, Not Just Your Customer’s Collateral

The blowup of Archegos shows once again that secured lending isn’t always secure.

There are two ways to make sure somebody who borrows from you is going to pay you back. One is to know and trust the borrower. The other is to know and trust the borrower’s collateral—the assets they post as security for the loan. In theory, if the collateral is good, the lender almost doesn’t care if the borrower defaults. The lender will just seize the borrower’s collateral and sell it to recover the sum it lent.

Except time and again, it doesn’t work that way. The collateral turns out to sell for less than the lenders counted on, and they suffer heavy losses. That’s a pretty good description of the global financial crisis that originated in an overinflated housing market, which generated mortgage-backed securities and derivatives that were worth a fraction of what lenders believed.