Democratization of Credit

A reader writes in response to my post about Thomas Geoghegan's article in Harper's calling for bringing back anti-usury laws:

I'm confused about your argument re: usury.

Isn't the scam that they charged too little for loans? That would be the case with AIG for sure, that they insured banks' assets for far too little. Rarely, it seems, does a crisis occur because the lender was too aggressive about charging for risk. Unless I'm missing something with your argument -- if anything, we need more usury.

Let me try to put the question in a more general context of the "democratization of credit" in return for higher interest rates, which has been a major trend in my lifetime.

But, first, I'll admit that the risk premiums for subprime loans were low -- a few percentage points -- compared to the much higher risk premiums seen for other kinds of loans to marginal borrowers. Presumably, this was because lenders assumed that they could get the collateral -- the house -- back from mortgage defaulters much more easily and profitably than they could get collateral back from, say, credit card defaulters. So, Geoghegan was, to some extent, using the mortgage meltdown to ride a hobbyhorse of his.

Still, Geoghegan has revived a very old perspective on human affairs that has been all but forgotten over the last few decades when "the democratization of credit" was the byword, and it's worth seeing what we can learn from that viewpoint.

I don't think what follows is by any means the full story, but the downsides of the democratization of credit is a line of thought that I, personally, just didn't pick up on during a rather conventional education in contemporary economic thought -- BA in Econ in 1980, MBA in Finance in 1982, long time reader of the WSJ op ed page after that, etc.

I could tell you all the arguments against anti-usury laws, but I couldn't tell you the arguments for them. I just assumed that protests against "predatory lending" were just economically ignorant and probably anti-Semitic to boot.

Now, I'm a pretty skeptical guy overall, who usually isn't bad at figuring the tradeoffs, the pros and cons, in various practices. I'm a staff guy by nature, who spent years telling CEOs stuff like: "If we do A, we'll come out ahead on X but behind on Y, while if we do B, we'll be worse off on X but better on Y, so, which do you choose?" And I didn't have any financial stake in high-interest lending. So, if I was a chump for the reigning zeitgeist that assumed that only anti-Semitic know-nothings used the word "usury," then how can I blame people in the financial business for falling for their own propaganda?

Here's what I've only recently figured out, after decades of thinking about economics.

Traditionally, there were legal or cultural limits on interest rates. Even though anti-usury laws and traditions were often perceived as a populist issue, it actually meant in practice that finance used to be much more elitist. If people in Arkansas got their state legislature to cap interest rates that New York banks could charge them, well, the New York banks would then lend only to the least risky Arkansawyers.

So, if you couldn't qualify for a prime mortgage, you didn't get a mortgage. If your corporation couldn't issue bonds above junk quality, no reputable investment bank would issue bonds for it. If you had a bad credit record, you couldn't get a credit card.

(Of course, this meant there existed a nether world of pawn brokers for the broke and loan sharks for the truly desperate or deluded.)

For example, up through the mid-1970s, respectable Wall Street investment banks wouldn't involve themselves in the issuance of corporate junk bonds. It just wasn't done. Now, some corporate bonds at the time did fall to junk ratings as their issuers teetered near default. The young Mike Milken did a study and found that these formerly solid but now junk bonds tended to be profitable to own, as long as you owned a wide enough portfolio to diversify away the threat of gambler's ruin.

So, Milken recruited hard-chargers from the fringes of the financial world to bid for publicly traded companies and promise to issue bonds that were junk from the get-go to pay off the takeover price. If they made the payments, then they wound up owning a fancy company. If they defaulted, well, it was back to the fringes for them after a few fun years of being big shots.

Similarly, this "democratization of credit" went on in credit cards, mortgages, student loans, and the like. "Why should laws and traditions restrict credit to yacht club members when willing lenders and willing borrowers could work out a mutually beneficial deal, just involving a few extra points?"

This was a widely appealing argument. Libertarians thought it made perfect sense. Business liked it because it meant more lending and more buying. Liberals liked it because it let poorer people buy more stuff. Leftwing community activists often started out protesting against "predatory lending" but would eventually figure out that if they succeeded in cutting down on lending, that meant no money for them. So, they would negotiate deals with financial institutions to provide them with "regulatory cover" that would call for more lending minorities. At least this way, the leftist activists could get a cut.

And, indeed, for many borrowers, this worked out fine: some of the old restrictions and traditions were too restrictive.

The problem was that you just couldn't push this practice of extending credit all that far, because the higher interest rates increased the chances of default even higher. So, you rapidly ran out of borrowers who were just moderately too risky under the old system, and soon reached potential borrowers who were walking time bombs under the sky-high interest rates that their low chances of paying back those sky-high interest rates demanded.

But, in modern finance, everything profitable gets pushed too far. The sons forget what their fathers painfully learned. Moreover, the entire literature of anti-usury argumentation was dropped down the Memory Hole because so much of it was either explicitly (e.g., Henry Ford's) or implicitly anti-Semitic (or, in Ezra Pound's case, anti-Semitic and crazy).

The destruction caused by lending to walking time bombs was amplified by the fact that, in general, the higher reaches of the financial world have traditionally treated debt as something where defaults are the exception to the rule. In contrast, pawn brokers have a perfectly reasonable way to deal with likely deadbeats -- they hold on to the physical collateral. But a financial world where the laws, regulations, customs, and institutions were built assuming that borrowers aren't going to default because anti-usury laws and customs denied loans to marginal borrowers is extremely vulnerable to erosion of the quality of borrowers, which the relaxation of limits on interest rates made profitable.

My published articles are archived at iSteve.com -- Steve Sailer