05/29/07
The logic of loans
In a Townhall.com article on Saturday, Phil Harris went on the attack against banking and credit card companies for a range of complaints.
I understand anger out outrageously high bank overdraft fees, credit card interest rates, and such things, but Mr. Harris' primary complaint was against higher interest rates being charged on loans to low credit quality, i.e. low income, borrowers. While higher rates for those borrowers clearly do not help them get ahead in the world, that does not mean the system is corrupt or functioning incorrectly.
I wrote a note to Mr. Harris about his article, and he took the time to respond, so below is my letter to him, followed by his response to me, and my response to his response.
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Mr. Harris,
While I understand your anger at the outrageously high fees charged by banks for short-term overdrafts as well as the nearly usurious rates on credit cards, your article’s primary complaint about higher loan interest rates for riskier borrowers is nonsensical and intentionally misunderstands free markets.
You argue that people with less means should be given credit at rates no worse, or even better, than rates given to more credit-worthy borrowers because somehow it is the banking system’s job to “make it ‘easier’ for people who are already struggling.”
If two people came to you asking for loans (not good enough friends that you’d simply loan them money at no interest rate), would you not consider the risk of your not being repaid when making your decision about what interest you would charge if you decided to make the loan at all? If your answer is that you would offer the same interest rate to anyone to whom you agreed to make a loan, and that you’ll agree to loan money to people with bad credit histories or more substantial likelihood of not being able to repay the loan, then you are not in a business, but instead you are a charity. Unlike you, banks have shareholders and taxpayers and other depositors to protect.
Interest rates are nothing more than the cost of money. And the higher the chance that you’ll never get something back when you loan it out, the higher the cost for the loan must be.
If 5% of loans to lower-income borrowers default versus 1% of loans to higher-income borrowers, of course the banks must charge a higher rate for the higher risk on loans to lower-income people. Not only is it logical, but it is the only way (short of refusing to make the loans, which I presume you would find even worse) of protecting depositors, shareholders and taxpayers from ending up holding the bag.
As far as ways to reduce loan risk, such as direct withdrawals from paychecks, that is fine as far as it goes, but it still does not help with the risk of someone losing his job and then not having the resources to repay a loan. So, while a program like that might be worth lowering an interest rate slightly, it will never be enough to lower the rate to that of a higher-income borrower.
Yes, there is occasionally a “distinct odor of gouging” in some areas, like certain bank and credit card fees. However, consumers know the rules of the game when they go in, and if they’re not prepared to play by them, they shouldn’t play.
More importantly, regarding your article, the primary “assault on logic” is yours: Higher loan rates for lower credit quality borrowers are not only logical, but they are necessary and appropriate.
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Phil Harris responds:
Hi Ross,
My father is long retired from a bank in a rural community after 45 years of service. I have discussed this with him in some detail, as it was his job as Exec. Vice President to manage the loan department. It is interesting to note that the policy of the bank, to set loan rates the same for all customers (2% above the rate paid for savings accounts) was harshly criticized by their larger affiliate peers in the state.
Despite the naysayers, the little bank grew to become the largest (agriculture lending bank) in the state, with several hundreds-of-millions on deposit. Not too bad for an institution serving a two-bank community of about 5,000. They were quite profitable, and enjoyed decades of prosperity through good times and bad.
In any case, the assault on logic occurs because the burden of operating in a common sense mentality is artificially placed on one side of the equation. It may be logical for consumers who have had difficulty, to voluntarily avoid (responsible budget management) taking on credit obligations. However, the same burden of logic is not placed on the lender, because the lender will in many cases agree to the transaction at the higher rate.
Where a consumer might make a poor credit decision based on their perceived need to acquire something, justifying in their mind that they will scrimp and control spending to make the payment work, lenders are making the same poor decisions and are in effect complicit in the irresponsible behavior. Lending money at a higher rate of interest, does nothing to change the ability of the consumer to meet the payment obligation, but in fact, places more negative pressure on the consumer's budget, thus making a bad outcome even more likely.
It is, in fact, possible for a lender to scrutinize a borrower's credit history, employment, income, and current debt load, to ascertain whether the loan should be made. Doing so will weed out most of the true dead-beat borrowers, who are most likely to walk away from their obligations, while revealing those who truly desire to manage their obligations.
The advent of the credit score has pulled lenders down this illogical path more than anything else. The credit score knows nothing of a borrower's circumstances, but attempts to predict outcomes based on statistics. Many consumers have been good, reliable debt customers, but for one reason or another have fallen onto difficulties along the way. Perhaps due to serious injury or illness, or an attempt at self-employment did not meet expectations, or a miscalculation on tax consequences left them in financial straights.
Even though the circumstances have been corrected, and the potential borrowers have adequate stable income and a sincere desire to meet obligations, they are now saddled with increased pressures as a result of higher loan payments. All this really accomplishes is to remove more money from the budget, which may otherwise serve to weather unforeseen events we all endure from time to time.
I am not speaking about the "stuff" people want, such as plasma screen TVs, recreational vehicles, or dream vacations to the Virgin Islands. Rather, I am concerned about reliable transportation, and home ownership. Again, if a lender were to scrutinize a borrower's current debt burden, he could know when a potential loan customer has a propensity to purchase anything and everything on a whim, versus those who have suffered a whack on the shins.
Yes, there is responsibility needed in making sound credit decisions. Unfortunately, the responsibility has been shifted entirely to the borrower, giving the lender a pass. My contention is that charging higher rates of interest based on a statistical credit score, does not constitute sound lending practice. The cost of dead-beat loans has been shifted entirely to the shoulders of otherwise responsible, hard-working borrowers, increasing the likelihood that they will suffer more setbacks due to higher debt payments for "necessary" purchases.
My beef with this is that lenders have recognized (statistically) that this practice has created an entirely new profit center, and they have embraced it as an opportunity from heaven. This, as opposed to the more logical and socially responsible practice of recognizing non-performing loans as a cost of doing business, and spreading that risk throughout the entire loan portfolio.
By the way, after briefly looking through your blog, it would seem that we agree more often than not. I knew this would be unpopular in the general conservative audience, and I certainly do not advocate for the removal of personal responsibility. I simply believe that in this area, the irresponsibility of a particular industry has been masked, and should be held to account.
Best Regards,
Phil Harris
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And now my response to his response:
Hi Phil,
Thanks for taking the time to respond.
Just a few things I'd like to comment on:
First, I believe that a bank in a relatively homogeneous rural community knows its customers much better than the average bank in downtown Chicago, LA, or NYC. It could understand the risks of any particular loan better and more quickly than most of the urban-located loans that usually generate this type of discussion. That's particularly true of a bank like your father's which (I surmise) lent primarily on one type of asset and business, i.e. farms and agriculture. So, your father's bank could probably more easily get away with policies that contained little or no differentiation among borrowers because the borrowers were already fairly similar.
Second, I think you have a valid point that a credit score alone seems a superficial, and maybe even foolish, way to determine whether to make a loan and what the loan's interest rate should be. There is clearly a lot more information to be had about a loan applicant, especially newer events which could make the loan a substantially better (or worse) risk than the credit score implies. However, you did not make this argument in your original article! You simply said that banks shouldn't charge higher rates for riskier loans, and not that the data the bank was using might cause them to erroneously conclude which loans were actually riskier.
Third, I simply don't see a place for the idea of "socially responsible" here. That's Hillary-talk. A bank is in business to make a profit for its owners/shareholders and to keep its depositors safe. If people want to make loans for social reasons, they should set up a charity to do that, or set up a bank that has that specified as their goal. I don't doubt that some people would invest or contribute, but it's simply not reasonable to demand that all business operate that way.
Bottom line, I thought you could have made more about the "gouging" from extremely high overdraft fees and credit card rates, many of which seem to suffer from a lack of competition between banks. But your main point about the loan rates wasn't very well-made, especially if you were really talking about the use of credit scores.
At the end of the day, I suppose that customers with little financial means have very little leverage whether we like it or not.
Just for the record, I don't consider myself part of the "general conservative audience". I'm much more libertarian....
Best regards,
Ross
6 comments
Hi Phil,
I’m delighted your father’s bank was so successful. The description, however, does not match well with my experience (formerly an executive for a top ten US bank).
First, let me tell you the bitter truth. Banks care about only one thing: pleasing shareholders. More truth: shareholders only care about returns on investment.
What this truth means is that banks try to secure funds as cheaply as they can (in other words, offer the lowest returns they can on their deposits while still securing enough customers to fund their loans – it’s a market out there). On the other side, banks will loan funds as expensively as they can (again, based on their ability to get customers to take it in a very competitive market) given a certain risk profile.
This is all banks do. They don’t care about anything else.
Credit scores, it turns out, are phenomenally predictive. They are really, really great. Yes, they are a single number but, you know what? They really work and can be looked up in a matter of seconds. Sure, you can use more refined tools to increase your predictive ability and lower interest rates offered to some customers. But that takes time and effort; typically, the volumes, the amounts outstanding, and the returns are such that it’s just not worth it for subprime customers. In most cases, they just don’t generate that much revenue to try to discern a few basis points difference (this analysis can be profitable, on the other hand, on large subprime populations for outbound solicitations, which most banks now do).
In other words, if you’re trying to get a credit card with a $500 limit (or some other small amount) the cost of analyzing the credit risk (beyond a cursory look at some employment and income data coupled with a credit score) is not worth the potential profit and may be a net loss.
The only way a bank can charge the same interest rate to all customers would be by subsidizing the high risk customers from the low risk customers. Such a bank would lose their prime customers and would be quickly stuck with deadbeat clients. Not a good business model.
On fees… why do you and Ross think fees are so evil. They are disclosed, agreed by the customer, and imposed accordingly. There is a brutally competitive market out there. If a customer is unhappy with a fee structure, he should switch provider; if no other provider will have him, then that says something about the risk.
Let me conclude with a question. Should my car insurance company charge me (43 year old, married, no tickets or accidents in the last 10 years) the same for my policy as an 18 year old man who’s totalled two cars in the last six months? Would that not be stupid? Isn’t it the same thing you’re suggesting banks should do?
Freak.
All I said about the fees is that they strike me as very high in the sense that I wouldn't expect real competition to create fees that high.
On the other hand, there's no real reason that banks should compete to get those customers who are, as you say, not likely to be a profit center for their shareholders.
And as always, I agree with your proposition that the rules of the game are known in advance, and people can choose whether or not to play.
on 05/29/07 at 15:36
There is nothing wrong with spreading the risk throughout the loan portfolio, but there is no logic in making loans that are not profitable. If one bank were to make loans based on this business model, a more clever bank would compete with them and take advantage of the poor decision making of bank one. As Ross said, the bank is not a charity and is fiscally irresponsible if they act like one. The market place determines the cost of money. In a large pool of loans, the net profit from the high interest loans should equal the profit from low interest loans once the defaults are considered. Reducing profits from low interest loans to pay for loans to high risk borrowers is recipe for making a bank insolvent.
on 05/29/07 at 15:50
Commerce Bank's Platinum Visa has NO overlimit, cash advance, or late payment fees. None. Their long term interest is about 10.5%, which is not terrible.
The issue is that most people can't qualify, but there's a reason for that...
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