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Wednesday, December 05, 2007

Is it Moral to Knowingly Send Borrowers into Default?

I have a question. Suppose you are a mortgage loan officer, and you have been assigned to the subprime loan division.

You look through the statistics and find that, using your firm's criteria, if you loan to people who are subprime 15% are going to have serious troubles and default, but 85% will not. Fortunately, even with a 15% default rate, with the interest rate you are charging on these loans, the loans are still profitable to the firm (but wouldn't be if the default rate went up, but we'll hold the default rate constant for this exercise). If you could sort people into those who will default and those who won't you would, but a priori, given the information at your disposal, there's no way to do that.

So here's the situation. If you make the loans - which is profitable for both you and the firm since you are on commission - you will be sending 15% of your customers into a troubled situation, but 85% will do just fine.

If we take an asymmetrical information approach, as is common, i.e. that borrowers know more about their ability to repay then lenders, then some of these loans that go into default are due to borrowers knowingly getting in over their heads. But that won't be true in every case, perhaps not even in most cases, so there are quite a few loan customers who will find themselves, unexpectedly, in serious trouble.

Should you feel guilty about making these loans? Is it ethical to make them at all, i.e. to knowingly send 15% of your customers into foreclosure (even though you don't know for sure who it will be)? It's hard to imagine the government allowing any other product to be sold that would, upon bringing it home, cause serious difficulty in the lives of 15% of the customers, so why is this different? If you think it's okay to make these loans, would your answer change if, say, the chances of repaying/defaulting were 50-50 or worse? Is it okay no matter the default rate so long as it's profitable? I have a feeling that different answers to this question explain a lot about who we think ought to be held accountable for the subprime mess.

I would make the loans even though 15% of them would cause people trouble. So long as the loans remains profitable, and they are not sold fraudulently so that people enter willingly and with full knowledge of the probability of default, I would accept an even higher default rate. Does that make me a bad person? I get the feeling some people think loan officers should only make loans when there is a very high probability of repayment - near 100% - but I can't agree with that as it would prevent an awful lot of people from purchasing a home. But it does seem like as the default rate increases, there comes a point when the default rate is sufficiently high so as to make one wonder about the morality of making the loans even if they remain profitable.  If two-thirds of my customers would be completely ruined from purchasing my product, I might wonder about that. So why is 15% okay? Is it because the 85% of the customers who benefit more than compensate for the 15% who do not? That's my answer.

What do you think? [Update: Mostly, so far, you think I missed the boat, in particular that the real question is the morality of steering people into loans that are more profitable for the firm, but are not as good for the borrower, something that relies on asymmetric information, but here it's the lender who has superior information about loan products, loan risks, and eligibility (is this like steering a customer to purchase a sports car that is more profitable for the firm even though another, safer, lower monthly payment model fits the customer better, or is it fundamentally different?).]

    Posted by on Wednesday, December 5, 2007 at 09:45 AM in Economics, Financial System | Permalink  TrackBack (0)  Comments (70)


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