Usury

It’s there from The Code of Hammurabi to the Bible to Adam Smith: Usury. (You would think that is enough of a cultural tradition for conservatives to want to, ya know, conserve.) Tom Geoghegan has an interesting meme that the abandonment of usury laws in the late 1970s has lead to our current crisis. (h/t Freddie):

You know, if you are Mr. Potter in It’s a Wonderful Life and can only get six percent, seven percent on your loan, you want the loan to be repaid. Moral character is important. You want to scrutinize everybody very carefully. But if you’re able to charge 30 percent or, in a payday lender case, 200 or 300 percent, you don’t care so much if the loan—in fact, you actually want the loan not to be repaid. You want people to go into debt. You want to accumulate this interest. And this addicted the financial sector to very, very, very high rates of return compared to what investors were used to getting in the real economy, the manufacturing sector, General Motors, which would give piddling five, six, seven percent returns.
So the capital in this country began to shift in the financial sector. That’s why the financial sector began to bloat up. That’s why we ended up, by 2006, having a third of all profits going into the banks and the financial firms and not into the real economy.

When I first read this, I thought it was a small piece, but the more I think about it, the more I think he’s onto a big part. As he points out, not only do the absolute levels of debt change post usury, but the way we, and especially the creditors, think of debt changes. It’s not something to be paid off is an obvious first problem; the second is that it is something now profitable to trick people into.

But what is most disturbing is when the creditors get to the mindset that debt is something to be maximized and optimized before it defaults, you get all the effort, hard work and energy going into making it just that. I’ve seen pages of equations and computer code by quants dedicated to trying to figure out how to optimize a crack addict’s NINJA loan in a 360 dimensional hilbert space. Not to optimize it so that it gets paid off, increasing the joy and utility of all, but how to squeeze as much juice out of it before the expected default probability spins out of control, leaving the bank with the home it had started with (that was worth a fortune, because home prices keep rising!). I’d rather have all the brainpower shooting to get loans to people who deserve them or figuring out how to help distressed people wind down their loans instead of getting loans to those we can most roll before leaving them bankrupt, and if usury laws are the sharpest blunt tool in the shed, I’d be open to considering them.

Anyway, I couldn’t help but think of usury laws as I read this interest New York magazine piece about the guy who created the Mortgage Security software that helped blow up Wall Street. Notice this part:

I quickly learned how fishy this world could be. A client I knew who specialized in auto loans invited me up to his desk to show me how to structure subprime debt. Eager to please, I promised I could enhance my software to model his deals in less than a month. But when I glanced at the takeout in the deal, I couldn’t believe my eyes. Normally, in a prime-mortgage deal, an investment bank makes only a tiny margin. But this deal had two whole percentage points of juice! Looking at the underlying loans, I was shocked.

“Who’s paying 16 percent for a car loan?” I asked. The current loan rate was then around 8 percent.

“Oh, people who have defaulted on loans in the past. That’s why they’re called subprime,” he informed me. I had known this guy off and on for years. He was an intelligent, articulate, pleasant fellow. He and his wife came to my house for dinner. He had the comfortable manner of someone who had been to good schools—he was not one of the “dudes” trying to jam bonds into a Palm Beach widow’s account. (Those guys were also my clients.)

“But if they defaulted on loans at 8, how can they ever pay back a loan at 16 percent?” I asked.

“It doesn’t matter,” he confided. “As long as they pay for a while. With all that excess spread, we can make a ton. If they pay for three years, they will cure their credit and re-fi at a lower rate.”

That never happened.

We should be working hard now to make sure that “as long as they pay for a while” is no longer a guiding ideology for our nation’s consumer debt policy.

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6 Responses to Usury

  1. hmm says:

    so you are saying that someone who defaults on a car loan should not be able to get a car loan in any way that is potentially profitable to the people giving out the loan?

    if they can’t get a loan, how will they get to work?

  2. Mike says:

    I’ll turn it back to you – is it ethical to sell a loan you think has an 75% chance of not being repaid? What if that loan doubles the chance of the person going into bankruptcy?

    Would you call it ethical if that 75% chance of defaulting mortgage was sold to all the neighbors on your block, where each house goes into foreclosure 75% of the time, and you own your house?

    There are lots of ways to build up your credit if you’ve messed up your FICO scores that don’t look like playing the lottery. Paying your electric bill for a year, for instance. Getting poor people who are underbanked access to real financial markets, as opposed to one shot at the roulette table, is a better move, even if it is utility reducing in the short-or-long run.

    Again, having to show personal responsibility with the small things over the long haul, rather than with the one risky thing over the short run, in order to build one’s credit strikes me as an excellent conservative principle rather than going double-or-nothing at the subprime financing casino.

  3. hmm says:

    mike –

    i agree with you on some points and not on others.

    for most families in the US, there is no alternative to having access to a car, and there is no way to have access to a car without buying one. not having a car is a one way ticket down.

    why isn’t there a car rental market similar to a rental housing market? if you do the numbers you will see why.

    doubling down may make sense in some cases. investments in one’s own capital stock are often that way. education is one case.

    for housing i agree that not everyone can afford to buy a house, and that the advantages of doing so are overrated in general. i also agree that lending money to people for non-productive purposes (vacations and christmas presents) doesn’t provide much benefit.

    so maybe my objection was just about car loans in particular, and not about other forms of loans.

  4. hang on a sec says:

    “is it ethical to sell a loan you think has an 75% chance of not being repaid? What if that loan doubles the chance of the person going into bankruptcy?”

    I don’t know of a bank on the planet that thinks it’s a good business model to lend money to someone who can’t pay it back. Lenders set rates based on the type of credit risk the borrower presents. It’s pretty clear that just about every lender got too comfortable with borrowers’ risk profiles, but I promise you none of them made a loan with the expectation they wouldn’t get it back.

  5. Mike says:

    to hang on a sec – Thanks for the comment. Let’s airquote banks here – there’s a lot of ways to massage this number, but a conservative estimate on the expected yearly default probability of a subprime loan is 10%. Over three years that is 27% chance of default. That’s an incredibly high number, and I’d be shocked if loan originators weren’t aware of it (I wonder if adverse selection ran the opposite way during the 2000s, where banks were more aware of the quality of the borrower than the borrower was).

    Also, I’m being slippery on the idea of “paying it back.” Switching from secured to unsecured loans, you’d agree with me that all the real juice in the credit card market is from getting debt to people who can’t pay their balance, and from sneaking as many charges and fees onto the deadbeats who pay their balance as possible?

  6. hang on a sec says:

    I would agree that loan originators are almost certainly aware of historical default rates on subprime borrowers, but that actually further illustrates my point. The bankers know, in aggregate, that some loans will not be repaid. That is the nature of lending, and it happens regardless of some borrowers’ credit history (obviously a lot more so for subprime borrowers). However, the banks have no idea precisely which loans (subprime or otherwise) are going to default, or when. This presents an interesting problem for an organization whose livelihood is dependent upon making loans. The only way to compensate is to diversify the loan book as much as possible and attempt to minimize the risk that you are hit with a wave of defaults. If you expect 27% of your subprime book to default, you have to price in that risk via higher rates for the most suspect borrowers. Bankers are not so stupid as to fail to recognize that a loan that isn’t repaid is not profitable, regardless of the interest rate. Banks are generally not in the business of intentionally losing money.

    It’s also worth mentioning that consumers have choices. That is, generally speaking, they can choose 1) whether to borrow money at all, and 2) from whom to borrow money. This again puts lenders into an interesting situation: price the default risk accordingly while staying competitive in the lending arena. Competition in the banking industry is fierce, and consumers benefit from that, although as we’ve seen, that transfers risk to the bank. But at the end of the day, no lender is making a loan to any individual thinking, “well, I’ll never see this $5 million again, better charge him 18%!!”. In the short and long run, it hurts the bank.

    You are right on with the credit card market, but these are MUCH smaller balances compared to most other loans, and as you mention, they are unsecured. But the principle is the same. If borrowers have a history of running CC debt or defaulting on their balance, they are going to find higher rates on outstanding balances, not because the banks are trying to exploit the consumer, but because they might not get that money back, and now there’s nothing to back it up. And yeah, some credit card companies try to sneak fees in if you actually pay your balance, but I would argue that’s probably a reflection that they aren’t getting compensated enough on the rates which are actually set too low for the risk, in order to be competitive. Thus, they try to capture some of that lost revenue from the low risk borrowers that pay their balance on time. But again, competition rules. If you have a very strong credit score and don’t generally carry a balance, you can shop around and find a good rate with low/no fees.

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