Sub-prime Loans and the Failure of Credit Welfare
Bad for the poor, bad for taxpayers
The big story since U.S. markets tanked yesterday, with Asian and European markets following suit this morning, is the "big surprise" in the U.S. sub-prime market: when a big chunk of your borrowers can't pay back loans they should never have been offered in the first place, the lender's business suffers. With legislation already proposed to bail out borrowers and lenders with government funds, the politics of selective government protection from risk is already making the econ blogs.
Here's my position.
The idea of making credit card (unsecured) and mortgage (secured) loans available to anyone with bad credit or no credit record in amounts greater than any reasonable, historical measure of credit-worthiness justifies in order to "help" them is a fraud.
Credit, like savings, to be long lasting and meaningful must be built over time. Credit cannot be given away as a one-time windfall so-called "loan." Institutions, backed by the state and taxpayers, either via insurance or implicit bailouts, that lend money to individuals with insufficient credit, are conducting what amounts to state sponsored credit welfare, and doing it badly. We learned over decades that a system of poorly managed incentives in the cash state welfare system does not help most poor in need; it creates disincentives to develop the skills needed to increase income, fails to get money to those who need it most, where it will have the most beneficial results, and wastes taxpayer money. Why is anyone surprised that bad lending practices by banks, made economical only by government supported GSEs and obtuse financial engineering, disingenuously packaged as a ticket to the land of "ownership," is proving to be a loser, too?
Lending marginal borrowers more money than their income enables them to repay does not help them. It sets them up to fail (pdf). Evidence abounds that coercion and fraudulent lending practices–such as no-doc loans, misstatement of income on loan applications, manipulation of FICO scores, and so on–have been used by lenders with scandalous frequency for years, while regulators looked the other way, resulting in loans that destined for default. When these bad loans inevitably go into default, sometimes when the very first payment is missed, credit which took years–often a lifetime–to build is destroyed.
This is helping the poor and middle class?
If not borrowers, then who is helped by this lending? Investment banks feeding the seemingly bottomless market for securitized debt products over the past few years and commercial banks adding hundreds of billions in assets to their balance sheets.
Who will pay the price when the borrowers default, besides those who were coerced and defrauded of their already limited credit? The risks of these bad loans is supposedly magically hedged away by the banks via credit derivatives, but this default insurance merely temporarily disperses and hides the liabilities created by widespread fraudulent lending practices. When these bad loans go into default, the price of derivatives used to hedge credit risk for new loans of all kinds rises the way flood insurance shoots up after a deluge. The result is tighter lending standards, higher interest rates and fees for loans of all types for all kinds of borrowers. This hurts small businesses, families, and the U.S. economy as a whole, and will contribute to the recession that we are expecting later this year. In addition to increased loan costs, decreased loan availability, and economic malaise, to add insult to injury legislation is in the works which proposes to use taxpayer money to bail out the lenders and banks that made these bad loans in the first place–welfare for banks.
Lending more money to anyone than can be repaid at high rates of interest using coercion and deceptive practices is the domain of loan sharks and criminals. FDIC insured banks and lenders registered with the government that engaged in these practices need to be treated according to existing laws against these practices. Under no circumstances should these banks be bailed out with taxpayer money as the first line of defense. We believe strongly in free markets; these banks should be allowed to fail, their remaining assets sold off on the open market to the highest bidder, the proceeds from the sales of the assets used to compensate borrowers in those cases where coercion and fraudulent lending practices can be demonstrated. Only after these measures are taken should the taxpayer be tapped.
Credit welfare needs to be reformed with the objective of creating a lasting incentive for banks and lenders to desist from further abusive and dysfunctional lending practices, and support those with poor credit by allowing them to build it systematically over time–over many years–rather than just in time to add a few more bucks to a bank's books to help them make the quarter.
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