Michael A. Covington Michael A. Covington, Ph.D.
Senior Research Scientist
Adjunct Professor of Computer Science
Associate Director
Artificial Intelligence Center
The University of Georgia
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Daily Notebook

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This page is http://www.covingtoninnovations.com/michael/blog/0703/banking.html.

For the full Daily Notebook, go to http://www.covingtoninnovations.com/michael/blog.

Below is the full version of an entry that was shortened in the main body of the Daily Notebook. It sums up some concerns that I've been mentioning for a long time. I should emphasize that this is not sour grapes — I have not been a victim of these practices. But I am concerned when a major segment of American and British business, on which we all have to rely, seems to have lost its moral compass and now is in some peril for its financial security.



The subprime-lending mess
Does the financial industry know what's good for itself or anyone else?

Fan mail tells me this Notebook is now attracting as much readership for the financial and economic comments than for the technological, scientific, and philosophic topics normally covered here. So today I'm going to hold forth on a financial topic. Please note that I am not a professional economist.

In this Notebook, I've had a lot of bad things to say about the recent practices of the credit-card industry. And it's not just me; the same concerns have been raised by consumer advocates, government regulators, and Senate hearings. Now there are two documentary movies about to come out, Maxed Out and In Debt We Trust. I'm eager to see them.

But what about this subprime mortgage business? There has been a genuine, though limited, worldwide stock market shock as everyone has realized that U.S. banks have lent out a lot of money they're never going to get back.

If you are interested in this issue, see also the web site of the Center for Responsible Lending and especially this document of Senate testimony by Martin Eakes. I discovered both of these after writing this entry.

Notice that this is not the result of a weak economy. Except for the housing market (which is, all told, not too bad, but worse than it was), the economy is quite strong.

What's going on, then? I see a lack of two things, ethics and common sense. Consider common sense first. I'm convinced that a lot of middle-level managers and sales representatives in the financial industry don't understand their own business. Upper echelons tell them to sell something, and they do it, without thinking anything through.

Here's an example from the past. In 1974, a very respected local insurance agent tried to sell me a whole-life insurance policy that would gradually build up a "cash value" of $25,000. I did some calculation and determined that if I set aside the money that the $25,000 policy would have cost, bought term life insurance with part of it, and banked the rest, I would soon have $25,000 in the bank and would no longer need the term insurance. And this would take only a few years, not my whole life.

At that time I was a voice crying in the wilderness. I couldn't get anybody to believe that my calculations were correct. A year or so later, insurance expert Joseph Belth came out with the same recommendation — and he was a voice crying in the wilderness. But in the 1980s, every financial advisor in the country finally started to see things my way.

(This sidesteps the obvious question: what do you need life insurance for? Even if whole-life insurance were a good deal, most people don't need a fixed amount of insurance their whole life long, sitting there, being whittled away by inflation. People with small children need a lot of life insurance; retired people may not need any.)

Now back to moneylending. You'd think all those subprime mortgage lenders would have realized that you can't make money by lending money to people who can't pay it back. For a while, lenders were issuing "stated-income loans" secured only by a house — if you had a reasonable credit score (which only says that you pay your bills on time, not how much money you have), you could say your income was so-and-so, and come away with a mortgage.

The interest rates were generally set to rise sharply a few years into the loan (one example: 5.75% for two years, 7.75% for one year, and 9.75% from then on).

Now we're a few years into the loan. What were they thinking? That everybody would sell their houses, at a tremendous profit, to pay off the no-longer-sustainable loans? What if they don't want to sell their houses?

Many of the borrowers were only qualified (judged able to pay) for the lower initial payment, not the higher payment that was slated to kick in three years later. This is not prudent lending.

So much for the deficit of common sense. Now for ethics.

Business revolves around mutual benefit. A legitimate business transaction is not one person taking money from the other; it's two people exchanging things so that both of them end up with what they want. If that's not what happens, then to put it crudely, what you have is not a business transaction, it is a theft.

And that's the problem with a lot of recent lending practices. Are they intended to leave the customer better off? No; only the lender. In my opinion, it's wrong for a lender or seller to maneuver a customer into a situation that the customer will regret.

Some specific practices that are, in my opinion, unethical include the following:

  • Extremely different fees for different customers. When one customer pays 5% interest and another pays 30%, you can't tell me that both of these interest rates just cover the cost of doing business. If the second one is "risk-based," well then — if you really have a 25% risk of not getting paid, you shouldn't be making the loan at all.

    The same goes for credit-card fees. Some people get their credit cards free, with $50,000 credit limits. Others pay $270 for a card with a $350 credit limit (example here). And you will find examples of everything in between. It is not at all clear what costs these high fees are supposed to reflect.

  • Use of "penalties" as a source of income, rather than merely to deter misuse.

    Until a few years go, when you went over your credit limit, further transactions would be declined. Now, they're accepted, ad infinitum, and a fee of something like $40 is tacked onto each. This way you can eat $45 hamburgers, drink $42 cups of coffee, and stay in debt forever.

    It's perfectly clear that lenders are using these "overlimit fees" as a cash windfall, and that they have no desire to stop people from going over their credit limits. Better to deliver a nasty surprise to the customer. After all, the customer is always wrong, right? What ever happened to the notion of mutual benefit?

    Related practices include universal default, the now-discredited practice of raising a credit card's interest rate to about 30% whenever the cardholder is late with a payment to some other creditor.

  • Planning to seize the collateral (e.g., to foreclose on houses) a substantial percentage of the time.

    This is the essence of John Wesley's objection to pawnbrokers. It's one thing to use collateral as security against distant, unforeseen calamity; that's how a mortgage works. It's quite another when seizure of collateral becomes routine.

  • Raising interest rates independently of changes in the economy as a whole.

    I can certainly understand interest rates that are pegged to the prime rate, or the federal funds rate, or something of the sort. But raising an interest rate on a particular loan, unconnected with changes in interest rates economy-wide, suggests a bait-and-switch tactic.

  • Deliberately imposing new, heavy costs on people who are in financial difficulty, in order to squeeze money out of them while making their difficulties worse.

    This is what moralists have always called usury and have always considered wrong. I've just described some examples of it. Deliberately scheming to make people worse off is wrong, even if you blame them for their misfortunes.

  • Deceiving the customer (perhaps using deceived or foggy-thinking sales reps as intermediaries) and promoting deals that no rational customer would accept (the implication being that deception must be occurring).

    Again, everybody agrees that this is wrong, but it's common practice. Financial transactions are often complicated and hard to understand.

What should be done for the victims of unreasonable lending? That's hard to say, and I don't have a quick answer. No matter what happens, there are going to be costs imposed on all of us, not just the borrowers. But here are some thoughts.

  • Perhaps we need to modify the bankruptcy laws (which were recently tightened up) to make it hard to collect high interest rates or exorbitant "penalty" fees. Make those the least collectible category of debt.
  • Maybe we need some good old-fashioned regulations, such as limits on fees and on interest rates. This would prevent some high-risk loans from being made at all, which would not be a bad thing.
  • We might need to limit rises on interest rates for existing loans even if the rises have already been agreed to.
  • We definitely need tough investigation of potentially deceptive practices. If a deal is so bad that no reasonable customer would take it, then obviously, somebody's been tricked. The trickery may be spread over several layers of management, each of whose understanding is vaguer than the last, so that no individual is conscious of lying. But the system, not just the individuals, needs to be held to a higher standard of honesty.

But I don't think we can or should release people from all the consequences of their own decisions. In many cases, the customer is partly to blame. Some people want a McMansion so badly they will accept a barely sustainable house payment, knowing it's going to rise and giving no thought to the morrow.

I don't want to use public funds to bail them out completely. That would penalize the rest of us for living within our means.

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