Marginal Revolution: The Credit Snobs

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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.

Posted by Alex Tabarrok on March 21, 2007 at 07:21 AM in Economics | Permalink

Comments

Excellent post!

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

Posted by: Stuart at Mar 21, 2007 7:38:57 AM

Is it not odd that those who favor legislation limiting the ability of the poor to borrow, on the ground that poor people are too dumb to figure out what's best for them, never advocate property qualifications for voting?

Posted by: Alan Gunn at Mar 21, 2007 7:39:27 AM

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

Posted by: Tyler Cowen at Mar 21, 2007 7:43:07 AM

It's a lot worse than being a credit snob and absurdly blaming the sub-prime mortgage lenders, who are just responding to market signals, distorted though they are.
And who's the Big Distorter, who goes unmentioned by Roubini? That would be Easy Al Greenspan, just named Stocks, Futures and Options magaine's "2007 American Hero." Easy Al's two-step monetary binges of the second half of 1999 (to head of the pseudo-Y2K problem), and post-9/11 should get him a long jail stretch at the very least.

Posted by: Bill Stepp at Mar 21, 2007 7:48:00 AM

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?

Posted by: tsoodonym at Mar 21, 2007 8:23:13 AM

"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."

They have the goals and the means, but apparently not the financial acumen? Wouldn't this be like any other "protect them from themselves" situation where education, not legislation, is the answer? The sad fact is that our public schools and colleges are failing miserably at financial education, and this is simply just one more symptom of that failing.

Posted by: Brian at Mar 21, 2007 8:45:30 AM

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.

Posted by: conchis at Mar 21, 2007 8:56:02 AM

The critical question for me is how much pain the subprime loans really cause their borrowers. Yes, some people will end up homeless and with their savings wiped out, and their suffering will be severe. But many people will end up in rental housing (i.e. where they would have been all along if subprime lending was not available), and not all will lose their houses. And many people with ARMS and low initial rates are significantly better off than they would be if they had chosen traditional fixed-rate loans, especially young families who intended from the beginning to move when their 5 year locked rate expired.

Posted by: DK at Mar 21, 2007 8:57:22 AM

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

Posted by: Anderson at Mar 21, 2007 9:11:02 AM

I'd second conchis' comment. One part of the cause of many people being in poverty is bad decisionmaking, which is presumably driven by a combination of not having been taught how to manage finances by their parents or the schools, low IQ, little education, low literacy, few obvious examples in their lives of good money management, etc.

It's also possible that poor people serviced by microcredit in very poor countries are drawn from a pretty different population in terms of abilities than poor people in first-world countries. All you need is an assumption that the better/freer your economy, the larger fraction of poor people are poor partly because of bad decisionmaking. Then, you might expect making credit available to the very poor to have a radically different result in Bangladesh than in East St. Louis.

Posted by: albatross at Mar 21, 2007 9:22:23 AM

Alex needs to post more.

Posted by: eddie at Mar 21, 2007 9:57:32 AM

Roubini may sound increasingly shrill, but he's not talking about individuals in the text you quote. There's plenty there to criticize without being inflammatory.

Posted by: tucker at Mar 21, 2007 9:59:10 AM

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?"

Posted by: Person at Mar 21, 2007 10:02:09 AM

I think Alex is misidentifying Roubini's outrage. See, he's not angry at poor borrowers. That wouldn't be liberal. No, he's angry at middle-class and wealthy borrowers who borrow too much. They're a much more appropriate target for self-righteous leftist scorn: "yuppie", "consumerist", "entitled", "privileged". Don't forget "soccer mom", "SUV-driving planet haters", and, of course, "mom" and "dad". The idea that these people are selfishly destroying the global economy by borrowing too much and then defaulting is very attractive to people like Roubini. Of course, the people that are lending to them are simply conspirators in this orgy of economic ruin. Presumably everyone should have known that offering and accepting these kinds of loans would lead to default, so presumably now that they have we can lay the blame squarely on those who lent and borrowed, making them morally responsible for the horrible consequences, namely... um.... something.

You see, the poor are victims here, not the guilty parties. Because the uppity middle class arrogantly borrowed as much as they wanted to from people who were willing to lend it to them, the lower class was hoodwinked into doing the same thing. And now they're having to pay the price for middle-class wrongdoing. Namely they're going to have to move out of houses that they can't afford, after having lived in them for several years paying less in interest payments than they would have spent on rent.

Posted by: eddie at Mar 21, 2007 10:17:31 AM

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?

Posted by: Martin at Mar 21, 2007 10:18:58 AM

I think there are two things going on here.

The first is the one "Person" hit on with the outrage of not lending to "poor" people. I put poor into quotes because its not necessiarly "poor" but "poor credit" worthy individuals. Individuals like Roubini don't want change, they want more regulation, they want to take money from business and give it away. They probably are credit snobs from the standpoint that that they want to make the "rich" pay and just give the truly poor the money.

The second point is that it the subprime market is a combination of government intervention into the market. The Fed being the most problematic with its Easy money policies of the early 21st century (sorry just had to do it) and the government backing of FreddieMac and the sub prime market. From a business stand point, why should I give a rat's rearend if I can loan to Joe down the street at 130% of LTV and then turn to sell it to the government entity that doesn't have a problem accepting risk.

For Roubini-if the government did it wrong its not because it did it wrong, but because the market "failed". If only the market had done what it was "suppose" to do!?!? When in fact the market failure is exactly the right thing for the market to do. It reigned in the malinvestment created by the easy money policy and government supported sub prime market.

Posted by: Matt C. at Mar 21, 2007 10:25:49 AM

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.

Posted by: Darin London at Mar 21, 2007 10:28:50 AM

That brief of the Walker-Thomas case wasn't very good. The unconscionable term in the contract in that case was the cross-default with all of the other merchandise that the person had bought from the store. The remedy would be to strike the cross-default, not to declare the entire contract unconscionable. Any decent discussion would have brought that out...

Posted by: John Jenkins at Mar 21, 2007 10:43:10 AM

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.

Posted by: BlogReader at Mar 21, 2007 10:47:48 AM

Alex, I think you most definitely get to the implications of the people who originate and perpetuate this meme, but to the run of the mill liberal on the street, this subprime mortgage thing is a condemnation of irrational actors in the free market... An example of why heavy regulation of (name your activity) would be better than a free market. I will have to try this line of argument with some liberal friends and see how it rings!

Posted by: Brad Hutchings at Mar 21, 2007 10:49:30 AM

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.

Posted by: lw at Mar 21, 2007 11:00:25 AM

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

I'm not sure what permament income is? People lose jobs, people anticipate higher future income, others have a much more variable estimation of income (bonuses). Does 'easy credit' include people who lie about income and mortgage brokers who fail to check it? This isn't the black and white situation Alex makes it out to be.

Markets are interconnected and large enough market failures in one area spillover into other well-managed financial sectors. There is a real role for government regulation and intervention here. Countrywide's terrible oversight policies are going to affect more than just Countrywide.

Posted by: Mark at Mar 21, 2007 11:42:31 AM

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?

Posted by: Another Matt C at Mar 21, 2007 11:44:50 AM

Congress needs to institute a regulatory requirement for brain size measurements as a precursor to accessing credit ;-)

Posted by: brianS at Mar 21, 2007 11:46:57 AM

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.

Posted by: Justin at Mar 21, 2007 12:22:11 PM

The ARM adjustment problem is overblown: http://www.firstamres.com/MPR2007

Posted by: Bernard Guerrero at Mar 21, 2007 12:39:30 PM

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.

Posted by: josh at Mar 21, 2007 12:52:21 PM

I think Alex misunderstands what predatory lending means. It is not a complaint about providing credit to the poor. It is about rapacious individuals and companies selling inappropriate credit products because their take of the pie is up front and don't need to worry about the consequences of a bad loan. Since they'll pass the loan to someone else, all they need to worry about is the sale, not whether the loan fits the person. This is a gap that distorts the credit process, and it is precisely this kind of problem that government regulation is effective.

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. This gives them an incentive to encourage debt bondage. That is not healthy for a society. Furthermore, many of the traditional debt protections have been stripped away which encourages those practices further. The predators are more likely to know of the new opportunities than the poor will of new dangers.

Posted by: Chris Durnell at Mar 21, 2007 1:19:04 PM

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.

Posted by: Bernard Guerrero at Mar 21, 2007 1:29:48 PM

As an aside, it seems like an awful lot of respectable businesses (credit card companies and cellphone companies in particular) do this sort of thing to screw their middle-class customers, who can pay, but who often don't have time to figure out the complicated fees or don't bother to complain about them. I wonder why that works. It seems like this kind of bad behavior would end up being bad business, since customers remember being screwed. But it seems really widespread.

Posted by: albatross at Mar 21, 2007 1:39:42 PM

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.

Posted by: Mitch at Mar 21, 2007 1:51:20 PM

Albatross,

Part of it relates to the explanation for NYC parking prices on another thread, I think. Bang somebody for a fee a few times and you collect a nice premium over interest. It effectively means that the borrower is paying a higher rate, but they don't see the fee worked into the headline APR on their statement. Also, in a sense, they are paying the extra bucks for the convenience of not having to think or be organized with regards to their bills. :^)

Posted by: Bernard Guerrero at Mar 21, 2007 1:52:14 PM

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. :^)

Posted by: Bernard Guerrero at Mar 21, 2007 1:59:09 PM

Even though I buy Roubini's point that a lot of sub-prime lending is aimed at exploiting bad decision making by the poor, I really have problems with his conclusion that tougher regulation is the answer.
How should that look like ? Restricting the complexity of mortgage deals and thereby wiping out gains from trade ? Linking complexity to size of mortgage ( or income ), which means discriminating against to poor but financially literate borrower. Stating a limit on disposable income that can be spend on mortgage payments and thereby implicitly telling people how to spend their money ?

Nevertheless Roubini poses a real problem here. What is good regulation in a market with a large share of financially illiterate participants ? Competition alone does not do the trick. No point in relying on product comparisons if customers does not fully understand the products s/he is comparing. Competition might work if customers were at least aware of their limitations. This might create some demand for simplicity and possibly self-selection into different degrees of product complexity. But what is to be done if some market participants lack this awareness ? In this case we face some difficult normative questions, having to trade off the welfare of the financially literate against that of the financially illiterate.

Posted by: authe at Mar 21, 2007 2:22:01 PM

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

Posted by: Barkley Rosser at Mar 21, 2007 2:37:01 PM

Authe,

Even though I buy Roubini's point that a lot of sub-prime lending is aimed at exploiting bad decision making by the poor

I can't join you, for the reason I stated a couple of posts above. 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. Loaning to those at a high-but-not-guaranteed risk of default is another matter. My guess is that the vast majority of even the crappiest products originated in late 2006 will eventually pay, and that recoveries on the minority that don't will not approach 0%. And that the borrowers will mostly be happy they had access to the cash and the house. Roubini is moving beyond shrill....

Posted by: Bernard Guerrero at Mar 21, 2007 2:43:02 PM

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.

Posted by: scl at Mar 21, 2007 2:48:09 PM

Roberto,

borrowers might not default, they might simply be tricked into spending more on their mortgage than they intended to. Certainly they should learn over time, but there is always a new generation on the market.

I'm somewhat more skeptical towards Roubini's argument concerning defaulting borrowers. While I can see how lenders could get financially illiterate borrowers to sign mortgages they cannot afford to repay, I really do not believe that the institutions that buy this risk from the intermediary are equally incapable.

Posted by: authe at Mar 21, 2007 3:10:05 PM

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

Posted by: authe at Mar 21, 2007 3:17:01 PM

Wow... what poor reasoning.

First of all, your hyperlink for unconscionability is ridiculous. Rather than choose a balanced citation for a term of art, you chose a ideologically predetermined ridiculous mis-statement of the rule.

To determine that a contract is unconscionable, a court needs to determine two things: substantive unconscionability (terms of a contract that, yes, shock the conscience.... they must be terms that a reasonable person would find to be oppressive given the circumstances of the parties involved), and also procedural unconscionability (that the actual person involved did not, in fact, fully understand the variety of consequences of a contract that may be described as unconscionable, and that the form in which they entered it took advantage of differences in bargaining power, education level, who wrote the forms, whether there was a full understanding of terms, etc.).

You need BOTH of these elements to prove unconscionability. In other words, if as you seem to describe it, a savvy poor person, trying to get ahead in life, takes out a loan with what the "reasonable person" would find to be oppressive terms, that's fine as long as there is evidence that the party he contracted with sufficiently insured that the credit seeker knew the terms of the deal he is entering into.

One would assume that this approach is a preferable one to advocates of the free market. One of the premises of a successful free market system is reasonable equality of access to information (including legal and financial information). Rather than asking the state to prescribe the acceptable terms and form of credit availability in order to balance out the inequalities in bargaining power, unconscionability offers incentives for the result of making sure that the party with unequal bargaining power has access to decent legal and financial information. Thus, the farther down the scale of a unreasonable terms that a creditor wants to contract for, the greater its duty to make sure that the other party fully understands the terms.

In this sense, Grameen is exactly the opposite to subprime mortgage lenders or cash stores. It's success is predicated on ensuring that the borrowing parties know exactly what the consequences of default are: the lost of creditability of the group of lenders involved in the microcredit loan, the creditee's neighbors. Cash stores and subrime lenders success is based on exactly the opposite: presenting the loans on the best terms possible under the law, and burying the sunstantively unconscionable terms in the fine print.

Of course, you may be of the opinion that there aren't unequal bargaining terms between a often semi-literate, often overworked and often desperate borrower and a mortgage lender and its army of lawyers and financial analysts. if thats the case, we really have nothing that we can discuss together rationally.

Posted by: Dave at Mar 21, 2007 3:29:19 PM

Wow Dave, excellent post.

Posted by: Mark at Mar 21, 2007 4:35:26 PM

MattC
I think you missed a paragraph of the article, the GSE's were backing off the overall market (and sub-prime by definition is stuff that isn't conforming). I'll give you the Fed, but the Enterprises weren't buying subpirme mortgages.

To everyone else-
This was entirely and totally a failure of underwriting, which isn't a surprise given that the underwriters got paid only loan creation and people respond very, very well to incentives.
The big question I have, is ultimately someone had to put up real money to back each and every one of these loans, and why didn't they take even a peek into the credit of these borrowers? From what I've seen in anecdotes, it wouldn't have taken any real effort to have seen the shakiness of the underwriting. Stuff like Target hourly employees stating income of $100,000 and up. Why were their risk premiums so tight even after home prices stopped ascending (they started flattening by fall of 2005).

Posted by: nelsonal at Mar 21, 2007 5:09:40 PM

dave,
Who's desperate to get a mortgage?

Posted by: LisaMarie at Mar 21, 2007 5:14:33 PM

nelsonal,

As per my other post above, it was a competitive issue. You might as well ask why Ford or Chrysler were building cars in 2006 they thought might not sell in 2007.

Posted by: Bernard Guerrero at Mar 21, 2007 5:22:06 PM

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.

Posted by: sort_of_knowledgeable at Mar 21, 2007 6:25:35 PM

It is the mortgage broker desperately looking to get a deal done to get the commission that he is characterizing as gluttonous.

But then he's being silly. "Liar loans" made up a minor portion of orginations with the exception of 2006, and they were mostly confined to a small number of independents, and even then most aren't expected to default. And for this Roubini gets to start tossing around "toxics" and "zealots" in every third sentence? It's done. They were trying to hang on to market share to survive the inevitable shakeout but some of them had to go and they are, unsurprisingly, going

Posted by: Bernard Guerrero at Mar 21, 2007 6:36:50 PM

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.

Posted by: sort_of_knowledgeable at Mar 21, 2007 6:59:48 PM

I can only speak from experience, but the vast majority of my peer group made a series of poor credit decisions throughout early adulthood which cost them quite a bit of money over the long haul. Most of them had enough human capital such that they made enough money to pay off their mistakes while maintaining a decent standard of living, then proceeded to move forward as much more rational actors.

Why do I bring this up? Because if one's first (or among one's first) encounter with the financial system and its complexities is a single very large transaction, it's reasonable to expect that the persons involved will not yet have evolved the rules of thumb they need to make good decisions -- or at least that the proportions will be different between them and other folks.

Obviously, the rational response to this is to get people involved in the financial system early, so they can burn through their learning period with smaller transactions and costs. But in the absence of a systematic effort to do so, it starts to be reasonable to wonder if the subprime products are designed to meet a genuine need or represent a way to capitalize on knowledge rents.

Posted by: Kimmitt at Mar 21, 2007 7:35:49 PM

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.

Posted by: John Pertz at Mar 21, 2007 11:38:41 PM

Bernard,

Thanks for the cite to Cagan in support of ARM being no problem. I did not see where Cagan allows for property values to fall; he points out that the fraction of loans with negative equity dropped a bit in the last interval surveyed (06 vs 05) and stops there. He does not explore the possibility that the 1% of loans predicted to fail ceteris paribus may have an effect on property values, putting the next tier of loans underwater. The analysis would be difficult and quantitatively speculative, but this is a big omission. Also missing is an assesment of stated income loans/ MEW spending; he assumes that borrowers now making payments are no riskier than borrowers in the past. Perhaps the insiders selling Countrywide's stock did notice these possibilities.

Posted by: lw at Mar 22, 2007 12:09:22 AM

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

Posted by: Dave at Mar 22, 2007 12:27:46 AM

I read Dave's URL - not much there. But it did inspire me to reread Roubini's piece again and it's even more amazing on a reread than on first perusal. "Millions of homeless" - due to being thrown out of their homes - the 1980's S&L crisis due to deregulation? Couldn't they rent after they all walk away from the homes in which they have no equity? And here I thought that the government guarantees on S&L deposits allowed bankers to roll the dice and let the taxpayers pay up for the mess. Boy was I fooled! This guy is supposed to be a professional economist and he is practically frothing at the mouth in this irrational analysis.

Posted by: Rich Berger at Mar 22, 2007 12:31:21 PM

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

Posted by: Robin at Mar 22, 2007 1:56:30 PM

Also this paper by Ross Levine suggests that greater access to credit can help growth (no surprise) and reduce poverty but may also decrease inequality.

http://www.econ.brown.edu/fac/Ross_Levine/Publication/Forthcoming/Forth_3RL_Fin%20Inequalily%20Poverty.pdf

Posted by: Robin at Mar 22, 2007 2:00:20 PM

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.

Posted by: Dave at Mar 22, 2007 2:40:09 PM

Dave, you may be interested in checking out my post, in which I pointed out that liberals *did* believe
the poor deserved credit (and that lenders were evil for not providing it) and then turning around 180
degrees and saying, "how stupid of you to lend to these people!". Did they know what they were getting
into? Maybe, maybe not. But the person who doesn't take care to learn the terms of a mortgage, really
didn't deserve it. It's not like you can complete a mortgage application in a few minutes.

Posted by: Person at Mar 22, 2007 3:32:44 PM

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.

Posted by: Dave at Mar 22, 2007 6:34:58 PM

Dave,
Person's right. Either people borrow money on the terms on which people are willing to lend money, or they don't borrow money at all. You can't have it both ways and say that people should have credit, but lenders should not be allowed to set the terms they wish. Lending is a business, not a charity. Regulation is not going to suddenly make a functioning market where everybody gets credit but no one gets in trouble with credit because of their poor decision making. Either people who are poor credit risks get credit on the terms lenders are willing to offer (they're the ones risking their money), or these people are shut out of the opportunities that credit can make possible. It's one way or the other.

Posted by: LisaMarie at Mar 22, 2007 6:45:03 PM

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...

Posted by: Dave at Mar 22, 2007 8:19:56 PM

Dave, first, please don't mock my family name.

Second, can you please explain these over-collateralized loans? When I applied for a mortgage and was given ridiculous terms (~10% 3/1 ARM), and I tried to offer additional securities to reduce the risk of the loan, the loan officer acted like I told her I killed her mother. (Of course, what differentiates me from the greedy fools who bought houses on those terms is that I'm smart enough not to pay 10% interest for access to what is little more than a status symbol.) It's been my experience that banks can't handle the concept of "collateral beyond a house for a mortgage".

Third, it *is* a reversal to, at one point, claim that lenders are underestimating the poor's creditworthiness and now claim they overestimated it. Now, recall that I didn't necessarily agree with everything AT had to say, but I agree with the sentiment that, for the left, whatever banks do, is stupid and unconscionable. If you lay down how you think banks should behave, and they do it, and it fails, your next complaint will be that they followed your advice. I guarantee it.

Posted by: Person at Mar 22, 2007 9:28:18 PM

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!

Posted by: Dave at Mar 22, 2007 10:22:56 PM

Isn't a "credit score" itself a form of "snobbery"? Why have credit scores in the first place if not to assess credit worthiness?

Posted by: Morgan at Mar 22, 2007 10:40:58 PM

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?

Posted by: LisaMarie at Mar 22, 2007 10:49:23 PM

It is the fundamental obligation of any person entering a transaction to make a good faith effort to establish that the other party has a full understanding of the terms of the transaction and to walk away if they cannot establish that fact.

Otherwise I am committing fraud, either by commission or omission, as I am selling something which my recipient believes to be something else. That's the point of the liberal commentators, that these transactions are rife with effective fraud.

Posted by: Kimmitt at Mar 22, 2007 11:14:38 PM

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?

Posted by: Morgan at Mar 22, 2007 11:17:48 PM

Contract law. Look it up!

Posted by: Dave at Mar 22, 2007 11:18:05 PM

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.

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Posted by: Chris at Mar 27, 2007 4:18:21 PM

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