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.