The Credit Snobs

I rather like the title "voodoo priest of free market economics" so I am happy to take the blame for the sub-prime mortgage defaults and at the same time stick a few pins in Nouriel Roubini.

Roubini and others generating hysteria about defaults in the mortgage market are credit snobs – they think credit is something that only the rich can handle.  Just look at the language that Roubini uses to analogize borrowers – they are "reckless patients" who "spent the last few years on a diet of booze, drugs and artery clogging junk food."  Similarly, the Washington Post tells us that it’s the end of the "borrowing binge."

Yeah, we get it.  Credit is ok for us, the "sober" borrowers but poor people can’t handle credit.  Too much credit among the poor generates decay and social pathology.  Credit must be regulated.  We can’t, for example, have credit stores in poor neighborhoods.  Don’t you know that credit is bad for people without self-discipline?   Let the poor buy on installment credit?  That’s unconscionable.  Today’s furor over sub-prime mortgages is the same old story.

Basic economics says that people should borrow so that they can consume based upon their permanent income.  Modern day financial markets are finally making this possibility a reality.  Combine financial innovation, strong US economic performance and a global savings glut and it makes sense that credit should become easier to obtain.  We see the benefits of financial innovation in bringing credit to the poor not just in the United States but around the world.  Will Roubini
next be calling for the retraction of Muhammad Yunus’s Nobel Prize?

The fact that there are defaults is partly a learning process in response to financial innovation, and thus evolution, but also partly a simple matter of risk.  Defaults are to be expected.  I see no reason to expect contagion.  All lending statistics must now be marked to the global financial market which means that diversification is now more extensive than ever before and thus net risk is lower.  Moreover, the whole point of recent financial innovation (and reformed bankruptcy law) has been to reallocate risk way from borrowers and towards those lenders in the world wide market for capital who are in the best position to handle the risk. 

The democratization of credit worries the credit snobs.  The credit snobs fear that capitalism isn’t just for the rich. 

Comments

Excellent post!

It does appear that the left wing of modern politics who the most prescriptive. The mummy knows best nanny state.

Egg-cellent post. Except you forgot to mention that you are also "toxic waste."

What a strange post... I suppose I am a credit snob. I disagree with the idea of pink slip loans and paycheck loans because I've seen how they devastate a community and hurt the very people we pro-free market people are trying to help--those with the goals and means to pull themselves up the ses ladder. Would sub-prime have been as big a problem if the marketing of such loans hadn't been as facile, rooted in floating interest loans, etc?

Surely you're smart enough to see that people see the (pre-crash) effects of easy credit and leap to the conclusion that the way to prevent the effects is to remove the cause. Why on earth would you resort to ad hominem instead of using your usual analytic and normative talents?

It's easy to caricature this sort of thing, but it's not really particularly helpful. I think the following are both relatively uncontentious:

(1) There is some subset of the poor whose situation is in part caused/perpetuated by poor decision-making, including poor credit decisions.

(2) Poverty tends to make the consequences of poor decision-making more difficult to deal with. Rich people make bad decisions too; it's just that the consequences aren't necessarily as bad.

The issue is whether the costs of tying to solve these problems (including possibly making credit more difficult to come by for those who will make good decisions - although regulation need not entail that) are worth bearing. Calling people credit snobs doesn't seem to me to advance that debate much.

If poor people aren't worse at making financial decisions, then why are they poor?

Alex needs to post more.

AT's post, caricatured though it may be, matches my experience. Before, people were like,

"OMG! Why won't you lend to the poor? You jerks! Don't you understand that they need access
to credit in order to advance? Here, let's throw up a bunch of regulations so that you have
to rigorously document why you denied someone a loan."

Now that lenders did that, it has become:

"You idiots! What were you thinking? Don't you understand these people can't pay you back?"

Alex,

I'm afraid there's a whopping fallacy in your argument at least a mile wide and just as deep.

You cite the example of Mohammed Yunus, yet you fail (perhaps egregiously, perhaps not) to cite the critical difference between the microfinance his bank provides and tens of millions in dud mortgages written by Joe's Loans For Bums, Inc.

The Gramman Bank demands collateral.

Not financial collateral, for sure - but social collateral. If Gramman borrowers don't repay their loans, Yunus tells their neighbours and friends. It's a pretty good way of keeping the loan book healthy.

Does that make Yunus a 'credit snob'? Maybe yes, maybe no - but it means his bank specialising in $25 loans holds more true to basic banking principles than any number of bum outfits selling 'new' and /or 'creative' products.

Maybe he should be appointed to the Fed. Or the SEC.

Or George Mason University.

Incidentally, radicals like you always, always put the cart before the horse. If credit is easy, what incentive is there to save? And thus to work?

I mean, I'm no economist, but is that point so simple it doesn't need to be said?

At least some thought should be aimed at the public costs of this fallout, which, I suspect, are really behind the current push for so-called 'predatory lending' regulations. There are three kinds of neighborhoods in our cities. Uniformly rich, Uniformly poor, and Mixed Middle-Class. As those who have borrowed heavily from sub-prime lenders (ARMS, with no money down, etc.) to move into the Mixed Middle Class from their poor neighborhood default, a flood of houses in these neighborhoods pushes down the value of every other house in them. Also, there is always a welfare cost to government when these things happen, and more people apply for state assistance. Most state and federal government budgets are pretty thin, and not really ready to handle a flood of people into bankruptcy and welfare programs. I agree with Tyler, and am myself, a credit snob. However, the evolution of society towards a more enlightened credit-consuming state is not going to be easy.

eddie No, he's angry at middle-class and wealthy borrowers who borrow too much.

That sums it up. From the screech:
First, distinguish between true victims of predatory lending and deadbeat borrowers who were into early strategic default.
That is one angry dude.

What really annoys me is the world that Roubini's setting up: lenders have to worry how they are going to be judged for a making or not making a loan based on emotions disguised as economic science (is borrowing allowed for a house at 2.2 or 3.8 times income this year?) and borrowers can pray that Roubini gifts them with absolving their economic sins if he feels like it.

General statements and arguments about motivation seem beside the point when looking at upcoming ARM resets or the rate of foreclosures.

ARM resets:

http://www.autodogmatic.com/forum/viewtopic.php?p=1226#1226

Foreclosures 2006Q4 look to be at the historical average rate of 1%, but have been increasing quickly since 2005Q1.

Roubini is making a subjective judgement rather than an objective one, even if he is correct in assessing the economic situation. The Fed created an easy money scenario, and the Federal government through tax policy and Bush's subsidies for first time home buyers (remember he made it a point to boost home ownership) virtually guaranteed the home bubble. Instead of staying objective, however, Roubini complains about the idiotic people who used MEW to buy snowmobiles, flat-screen TVs, and trips to Disneyworld. To that I say, maybe he is the idiot for not borrowing at a real rate of around 1.5-2.5%. If there is a credit crunch, and mortagage rates are up around 7-8% and CDs are yielding 6-7%, who is the idiot: the guy who didn't borrow "recklessly", or the guy who is paying off a 5% mortgage?

Good post. And yet, even while the left wants credit regulated, they would claim that people are poor because of external oppressions (racism, underfunded schools) and not their behavior.

Mark: "I'm not sure what permament income is?"

So look it up, Mark. That's what this series of tubes we call the internet is for.

Also, many financial institutions are now gearing products to take advantage of certain people's inability to pay - because they can make more money through fees and charges on defaulted payments than they would on normal interest.

Err, I think not. Can't squeeze blood from a stone, eh? Banks are most certainly gearing products to generate fees (i.e. late fees, over-limit charges) as a huge source of income, but the folks targeted most certainly do have the ability to pay...or at least the banks think the majority of those in the segment do. Else they'd rapidly be looking at charge-offs and no interest or fee income forthcoming.

There's a nice post at calculated risk about actual information problems in the mortgage lending process:
http://calculatedrisk.blogspot.com/2007/03/ficos-and-aus-we-will-add-your.html

I agree that Roubini is too shrill, but there were some market failures. They're temporary, to be sure--the market is already re-pricing MBS risk. I certainly don't want more regulation, but I also very much do not want any kind of government bailout for the banks or for those in default.

It may be that advances in automating the calculation of credit risk have made credit available enough that some GSEs are obsolete.

Mitch, I don't think you can call it a "market failure" per se. Market failures are persistent pricing failures, but what we see here is mostly a repricing of mistakes from 2006. As housing slowed, rates rose and normal refis dried up, nobody wanted to be first to cut capacity. Ergo, the weaker independent lenders underpriced certain risks to hold on to market share and thereby keep their infrastructure intact. The fallout, as with any industry with overcapacity, is both normal and expected; you can't defy gravity for very long by holding inventory or "stuffing the channel". Capacity needed to fall. One year later, it is falling. :^)

No matter what happens, Alex, we know that everything that happens
is ultimately going to be your fault, :-).

I am actually surprised that this post has received any sort of praise. To my thinking, Alex's analysis is no deeper than simply applying his stock libertarian to a complex issue.

Here is a problem with libertarianism that is revealed in this post: people vary widely in intelligence, ability, and luck, and applying the same rules to everybody can lead to disastrous results. On the other hand, applying different rules to people can also have disastrous results. Therefore, life is complicated and so is policy.

But not for Alex! Everything is easy when you're an ideologue.

sorry, i meant "Bernard, ..." in my previous comment.

Wow Dave, excellent post.

dave,
Who's desperate to get a mortgage?

The reformed bankruptcy law made it harder made it harder to file under chapter 7 where debts were discharged. What ever its merits it is reallocating risks toward borrowers not lenders.

Roubini is analogizing mortgage brokers not borrowers as people who "spent the last few years on a diet of booze, drugs and artery clogging junk food."

Note the following “Suppose you were a poor African American or Hispanic or a white poor with low income and no assets who wanted to pursue the American Dream of home ownership and you did not qualify for a regular mortgage because of your low income. No problem – told you the mortgage broker – we will give you a NINJA (no income, no job and assets) or liar loan, i.e. a loan with no documentation of your income and assets. You did not afford any down-payment because of little assets? No problem as we will let you to put zero down-payment so that you start with zero equity in your home. You could not afford principal payments? No problem as we will give you an interest only loan. You could not afford a fixed rate mortgage? We will give you a 2-28 ARM where the rate is fixed at low level for two years and then you move to much higher market rates†¦† It is the mortgage broker desperately looking to get a deal done to get the commission that he is characterizing as gluttonous.

You cannot rationally rely on bad decisions by an entire class of customer for a long period of time, addictive substances not withstanding. If you loan money regularly for a long period of time to people who cannot pay, you will eventually suffer charge-offs, losses and finally bankruptcy yourself.

For mortgage brokers and other intermediaries it was not building a business but getting the money while they could by exploiting the looseness of underwriting standards.

Payday lenders can “rationally rely on bad decisions by an entire class of customer for a long period of time.† Their customer may not have enough money left over to pay for food and rent, but as long as they get the collateral of the bank account number where the pay check is deposit then they don’t suffer a lose.

Is regulation truely the answer here? I liked Alex's point about this supposed catastrophe being part of the information process. Lenders and borrowers have entered into contracts that have not worked out particularly well for either side. Why is this a market failure? Let people who make bad decisions have to pay for those bad decisions. Why does Roubini state that we should not argure that the government creates a moral hazard problem when the government bails people out who enter into bad deals? Let them pay for their foolishness and allow those who dont enter into bad deals to live undetered by the events. People do respond to incentives and surely an economist of Roubini's credentials realizes this simple truth? I will say that his article was a great piece of political writing even if it was severly disjointed from relevant normative analysis of the current situation.

Since this site doesn't seem to offer trackbacks, here is the longer response I have to Tabarrok's post. As I went through it, I really couldn't believe what poor reasoning he used (and on a issue where I think there may be something of an argument for limiting government intervention... but it certainly wasn't made here).

Here's the link:

http://www.blogdenovo.org/archives/001642.html

You may be interested in this report on using non-traditional payment data to expand credit access to low-income communities. It uses 5 commercially used scoring models and looks at about 8 million consumers. It suggests that the risk profile of low-income households is not as bad a people think they are and are comprable in many ways to that of non-low-income households.

http://www.brookings.edu/metro/umi/pubs/20061218_givecredit.pdf

The discussion here seems to be proceeding on the mistaken assumption that Tabarrok's assertion is correct: that someone out there of a liberal persuasion is arguing that poor people don't deserve credit. I've yet to see support for that claim. Again, I think the opposition to the subprime lenders and other predatory lenders is the *terms* on which they offer the credit, combined with their failure to ensure that the borrowers know what they are getting into. But, I suppose if it interests you that much you can all continue to take swats at the strawman.

Wow... I'm sorry I missed that. You are right, "Person", and your argument makes everything I have said crumble like so much dust. How stupid of me to miss out on the fake conversation between hypothetical people!

Could you also please tell us the world is flat? I would like to cite it in my next scholarly article.

This is all sort of pointless, but what the hell, I'll take the bait.

You are right... lenders should be allowed to set the terms they wish. As the terms move farther away from what a reasonable person would consider the norm, lenders have a greater and greater duty to ensure that the borrower fully understands the terms of the loan. That is the legal doctrine of unconscionability as it relates to loans.

Many poor people do have access to credit, and they handle it just fine. Plenty of poor people borrow money on excellent terms. They borrow from banks at good rates, or if their credit is bad they often borrow at not-so-good rates. However, they are informed that the details have been fully explained to them, because banks are closely regulated, suffer from bad publicity and are usually reasonably permanent.

However, the business of subprime loans and other predatory businesses is such: they make a large number of loans to a large number of people without credit or with bad credit, most of whom do not understand the terms or have a mistaken understanding of them, often due to the influence of the lender. They usually have to "seek out" this business, by going door to door, placing their businesses within walking distance, or by telemarketing. They fully collateralize these loans, often to an amount well in excess of the loaned amount. People do not understand these terms, they take out the loan, and often repay them plus the usurious interest and STILL have their collateral taken away. When the terms change (for example when the payment goes up after two years.... terms that a lot of people were vague about, because the seller has little interest in explaining it to them), they lose their home, they lose their payments, and sometimes more. In a leading case on unconscionable lending practices, Maxwell v Fidelity Financial Services, a door to door-salesman sold a middle aged couple a solar water heater on the premise that they would save money in the long run on their electricity bill for almost $6,000. The heater never worked and the company went out of business, but not before the company collected on the sale of the loan contract to Fidelity and gone out of business (which illustrates a problem with predatory lending: the seller of the loan is often not the ultimate financier). The loan provided for a 19.5% interest rate and, get this, was collateralized by their *house*. After making payments for 6 years and fully repaying the principle on the overpriced water heater (that never worked, and never saved them money on their electricity bill), the couple finally sued for unconscionability to avoid losing their home when they couldn't make payments.

(Please note that I did not have to make that story up, cite to an idiot nor have a hypothetical conversation with myself to support that story. You can look it up... the Arizona Supreme Court, 1995).

There are people who make loans to the poor at non-usurious rates. Community Development Funds are non-profit businesses (yes, they earn profits on the loans, but those profits are then reinvested into further loans) that make loans to low income people that are not collateralized and are earmarked for investment, not consumption. They have single-digit loan rates. This is your basic business loan, but restricted to the poor. They have terrific repayment rates. They have low overhead costs, because the people involved in running them are not paid as much as for-profit bankers, and they don;t have sales costs because they are not seeking to rapidly expand their business so as to capitalize it, and as a result are not aggresively pushing loans on people low education poor people... though they are situated in their neighborhoods.

But most predatory lending is done to sell a consumable. They target people by selling them something that they can't afford, and slip in usurious rates and ridiculous collateral. Predatory lenders convince their targets that they CAN afford that stero, car, water heater, or home, with no payments for two years, or no money down, or that it will save them money on other things, or whatever... BUT they include usurious rate and rate hikes, and often ridiculously collateralize the loans. They have the party sign away their life, sell the contract, and move on. When the bill comes due, it's not their problem anymore.

Now... I am arguing all this not because I want to get involved in a conversation about whether or not the parties involved did or did not have a duty to repay, or whether the free market is good, or whether there should be greater regulation of subprime credit markets, nor anything else substantively. I am arguing this because you all keep on cackling that anti-predatory lending types are all saying they don't want the poor to have credit. Which is, frankly, horseshit. When you create a hypothetical argument for the opposing side, and then argue against that hypothetical argument, you create what is called a "strawman." Strawmen, of course, are easy to knock down. Example:

It is clear Bush hates black people (repeat after me, children: this is a strawman). Therefore, Bush shouldn't be President because he is a racist. (How true!)

So when you state, without any logical reasoning, support, or connection to reality, that people who are anti-predatory lending are anti-poor (which is patently absurd, since many of them are involved in responsible lending programs to the poor), that is also a strawman. Of course, your argument against the strawman looks great... who could respect a person who hates the poor? But really, like "Person" you are just arguing with yourself.

For the last friggin' time, besides "Person" talking to himself and Tabarrok's fantasies, NO ONE is saying that there shouldn't be credit available to the poor. What they are saying is that rates shouldn't be usurious, and if the they are the duty is on the lender to ensure that the borrower fully understands the terms. Stop being an idiot and pretending that your strawman is real! The intellect you save could be your own...

Sure. I won't mock your name. Particularly when there is so much more to mock.

OK... I'll take your guarantee. Cite on person... just one... who at one point said something along the lines of "Banks should make more credit available to poor people" and then later said "Banks shouldn't make credit available to poor people."

Millions and millions of people's thoughts are on the internet... just find one. One!

Until then, I'm done playing remedial thinking with you.

Good luck!

Dave,
Why is it the responsibility of the lender to make sure I understand the terms of the loan? They're in the lending business, not the education business. Where does this obligation come from?

It's not the responsibility of the lender. It's the responsibility of the regulator to make sure the loan industry works for the benefit of all and doesn't take advantage of gaps in knowledge.

And here's the Fed saying they should have done just that: http://www.bloomberg.com/apps/news?pid=20601087&sid=a1.KbcMbvIiA&refer=home

"The Federal Reserve could have acted faster to prevent a meltdown in the subprime-mortgage market by curbing the lax lending standards that contributed to the crisis, the Fed's chief bank supervisor said.

"Given what we know now, yes, we could have done more sooner," Roger Cole, the Fed's director of banking supervision and regulation, told the Senate Banking Committee in Washington today, as regulators testified for the first time before Congress on the market rout.

[snip]

"It is clear that some subprime lenders have engaged in abusive practices, and we share the committee's strong concerns about them," said Emory Rushton, senior deputy comptroller in the U.S. Office of the Comptroller of the Currency.

--

So, clearly, the US government, in the form of the Federal Reserve, the US Treasury and the US Congress, all seem to disagree with Alex's position. Namely, they recognize there is such a thing as "predatory lending" and want regulations to be created and enforced against it. Would Alex call these entities "credit snobs" too?

Dave claims that " NO ONE is saying that there shouldn't be credit available to the poor. " The trouble is that markets are like a balloon. If you squeeze them in one area (e.g. unconscionable rates), they'll pop out in another area (lesser availability of loans). If a market for something is reasonably free in that there are lots of sellers and lots of buyers, and you don't like the terms they're offering each other, you need to look in a mirror to find the market failure.

I'd like to contradict the general opinion that credit is not demacratic or not available for all, or whatever. It is evident that credit terms for people with bad credit are violent, I mean the rates and fees and the lowest credit limits. Credit cards for bad credit are pricey and don't give the needed freedom. But as you grow your credit score, you acquire access to most beneficial credit terms. For comparison, take credit terms in countries where credit history is not practiced (Russia for example). Banks just install high rates for all credits and cards and people, irrespective of their payment history, have to pay 15% and more interest rates for their credit.

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Prof. Cowen: You wrote that "I see no reason to expect contagion." Given what's happened over the 17 months since you wrote that, I would be interested in seeing how you would evaluate this claim today.

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"Basic economics says that people should borrow so that they can consume based upon their permanent income."

Yunus spearheaded micro-credit to businesses, That's very different from financing consumption. Now, yeah, financing consumption can be rational. But before sitting back on your laurels and claiming that there isn't a problem with people irrationally living beyond their means, I suggest talking to some of your colleagues who teach personal finance in community venues.

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If poor people aren't worse at making financial decisions, then why are they poor?

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For the last friggin' time, besides "Person" talking to himself and Tabarrok's fantasies,
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NO ONE is saying that there shouldn't be credit available to the poor. What they are saying is that rates shouldn't be usurious, and if the they are the duty is on the lender to ensure that the borrower fully understands the terms. Stop being an idiot and pretending that your strawman is real! The intellect you save could be your own...

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Moreover, the whole point of recent financial innovation (and reformed bankruptcy law) has been to reallocate risk way from borrowers and towards those lenders in the world wide market for capital who are in the best position to handle the risk.

This thread is a lot of laughs all around three years later, but this is the kicker. The global economy collapsed because of these loans and it was the poor who are still suffering. The banking class that the GMU is an apologist for (at a state university mind you) didn't suffer a lick long term, but the poor can't get out from their debt in part because of that slavery bill passed in 2005.

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