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Wednesday, March 21, 2007

Does Debt Get Enough Credit?

David Leonhardt on our love-hate relationship with debt:

Once Again, Debt Is Miscast as the Villain, by David Leonhardt, NY Times: Later this year, the National Film Preservation Foundation is going to re-release a silent movie from 1912 called “The Usurer’s Grip.” It’s a cautionary tale about borrowed money that revolves around the Jenkses, a fictional middle-class family who need a $25 loan so their young daughter can be treated for consumption. After a loan shark tricks Mr. Jenks into borrowing at an interest rate of 180 percent, the family is brought to the brink of ruin. ...

Just like the Jenkses, thousands of families have recently fallen sway to the sweet promises of moneylenders. Today’s version of the story typically involves a house that a buyer couldn’t actually afford or a refinanced mortgage that had a devil lurking in the fine print. As everyone knows by now, delinquencies and foreclosures have started rising, and they will certainly rise further. ...

Now, a lot of people are saying that the economy is finally going to pay the price for its spendthrift ways. Which, when you stop and think about it, is roughly the same warning we have been hearing since at least 1912.

Americans have a very strange relationship with debt. We seem to take on more of it than any other society ever has, but, boy, do we like to beat ourselves up about it. Benjamin Franklin implored his fellow citizens, for the sake of their own independence, not to become “a slave to the lender.” ...

[I]t’s important to remember that the mortgage market is following a classic cycle that nearly every other form of consumer credit has also followed. When somebody comes up with an innovation, be it consumer loans, credit cards or creative mortgages, it inevitably leads to an explosion of borrowing that includes a good amount of excess and downright abuse. After the abuse is cleaned up, though, most families end up better off.

That’s what I find so appealing about “The Usurer’s Grip.” It came out at a time very much like today, when the excesses were becoming so obvious that they obscured almost everything else. The producer of the movie was ... Arthur Ham, ... arguably the Progressive movement’s leading crusader against the consumer-loan business, according to Lendol Calder, ... an expert on debt. To Mr. Ham, moneylenders were “sharks, leeches and remorseless extortioners” with “an arrogant disregard of human rights.”

And some clearly were. But Mr. Ham didn’t really distinguish between the true sharks and the lenders who were in fact selling a useful new product, namely loans for ordinary families. To him, anyone charging a higher interest rate than banks then charged businesses (6 percent) was a crook.

This, Mr. Calder argues, made the message of the movie “more wrong than right.” Mr. Ham himself came to realize as much in the years that followed. By 1916, he had teamed up with the better elements of the lending business to pass laws that set a standard rate of 42 percent — an eye-popping rate by today’s standard but, at the time, still progress. “It was the birth of the modern personal finance business,” Mr. Calder says.

It’s easy to see everything since then as a step in the wrong direction... But think about what life was like before easy money. Think about how hard it would be to buy a house or pay for college if a 42 percent interest rate still seemed normal.

Some of the changes are surprisingly recent. Just a generation ago, a temporary setback, like illness, divorce or job loss, was much more likely to force a family to take drastic measures than it is today. That’s in large measure because of debt, which allows families to smooth out the rough edges of their financial lives. ...

Mortgages are a big part of this story. ... If you take out a mortgage today, you’ll pay thousands of dollars less in upfront fees than you would have in the mid-80s. ... Home buyers who know they’re going to live in their house for only a few years now also have the ability to get an interest rate that reflects their situation. The 30-year fixed-rate mortgage isn’t the only game in town.

Of course, people in the mortgage business ... like to argue that the current problems are mere footnotes compared with all the progress. They are wrong about that. The excesses were real, and they were big. We’re still figuring out just how big.

The solution will have to involve new guidelines, voluntary or government-imposed, that force lenders to be clearer about the terms they’re offering borrowers. But as long as we take tough measures to clean up the mess, we’ll end up with a healthier mortgage market than we had beforehand. And then we can go looking for the next form of debt to captivate and torment us.

If we decide to go the regulatory route, I'm not sure that forcing "lenders to be clearer about the terms they’re offering borrowers" is the solution. The story that borrowers did not understand the terms of their loans doesn't ring true to me, though I have no real evidence one way or the other and may have to change my mind about that. It seems more likely to me that buyers were overly optimistic about prices continuing to rise, the ability to rent condos and other investment properties to tenants, to believe whatever they needed to believe to justify the purchase.

I think there is a market failure here, an asymmetry in the information that buyers have relative to the information possessed by real estate agents and lenders. When the lender tells the buyer that the rental rate on condos is 86%, or whatever, buyers cannot easily verify these claims and the claims are likely to be believed, especially when the buyer wants to believe. These numbers and others like them that are overly optimistic end up on the loan papers and are ultimately used to justify the loan's approval. Perhaps an examination of the quality of the data being used to justify some of these loans and more stringent guidelines as to what is and what isn't acceptable would be a place to start. A situation where, for example, it's common knowledge that the amount listed as income on many high-risk loans is inflated isn't optimal. The shake-out in the industry going on right now will cure some of the excesses, but the even so the regulation of these markets needs to be reexamined.

But I think we have to be careful not to be overly restrictive and inadvertently prevent worthy buyers from purchasing a home, and therefore I'd err on the side of too many rather than too few loans when thinking about regulating these markets. However, with reality-based, verifiable, and reasonable guidelines in place, having lenders deny loans when borrowers cannot meet the conditions is better than expecting buyers to turn down their dream house when it's dangled in front of them.

Update: Caroline Baum's view is different. She is pushing Congress to take a hands-off approach saying people took the risks and this is what happens, or, in her words, "Early indications from Congress are that fingers will be pointed at everyone except constituents." See "Government Is 'Here to Help' Subprime Borrowers."

    Posted by on Wednesday, March 21, 2007 at 03:33 AM in Economics, Financial System, Regulation | Permalink  TrackBack (1)  Comments (57)

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