Charging Higher Interest Rates To Poor & Risky Borrowers Does NOT Make Loans "Predatory."

“In Richard Thaler’s and Cass Sunstein’s book, Nudge, which uses urinals, ABBA, and Homer Simpson (and cutting-edge research) to argue that by simply giving more thought to the way they present choices to people — or “nudging” — choice architects can preserve freedom of choice while dramatically influencing the choices people make.”

That’s how one of my favorite blogs (and books) – Freakonomics introduces the book I’m currently reading, Nudge: Improving Decisions About Health, Wealth, and Happiness. Actually, I’ve been reading this book for a while and on the plane ride home I just happened to hit the chapter on Credit Markets. Now, this is government regulation that I can get behind! I’m going to provide an excerpt of the parts I thought were the most relevant to what’s happening in our economy right now, but first I want to give you a little more detail on one of the fundamental concepts of the book, that of Libertarian Paternalism.

The idea behind Libertarian Paternalism is that “we” want to change people’s behavior for their own good, not for our personal gain alone. That’s the paternalism piece. The other key aspect is that in doing so, we must not enact any rules, bans or laws. People must choose to make these changes of their own free will. That’s the Libertarian piece. Take smoking as an example. It is generally accepted that smoking is bad for you. Even smokers will agree with this. No one says, “Tomorrow, I’m going to start smoking.” But, you often hear people say, “Tomorrow, I’m going to quit smoking.” So, an appropriate nudge would be to help the person choose, of their own free will, to quit smoking as it is for their own benefit. The book delves deeper into this and other issues, but I want to focus on the Credit Markets chapter because it is so relevant right now in teaching us, in part, how we’ve found ourselves in this mess and what we might do to keep it from happening in the future:

When markets get more complicated, unsophisticated and uneducated shoppers will be especially disadvantaged by the complexity. . . These factors are exacerbated in the segment of the market that caters to the poorest and highest-risk borrowers, the so-called subprime market. . .

Some, particularly those left of center or in the news media, label all such loans with the derogatory term “predatory.” This broad brush fails to recognize the obvious fact that higher-risk loans will have to have higher risk interest rates to compensate the people who lend the money. The fact that poor and risky borrowers pay higher interest rates does NOT make these loans “predatory.” . . . On the other side, some observers think that the hue and cry about predatory lending is based entirely on the failure of left-leaning journalists and others to understand that risky loans require higher interest rates. As usual, the truth lies somewhere between the two extremes. Subprime lending is neither all good or all bad.

The good feature of subprime lending is that it offers credit to those who could not otherwise borrow, and makes it possible for some poor or high-risk families to become homeowners (or business owners). Subprime loans give people a valuable second chance. . . (134,135).

I’m going to stop here for a minute to backup and explain that one of the things Thaler & Sunstien have previously brought up in the book is how nudging can be used by the government. It is the simple idea of making complex consumer decisions more transparent. Take the cell phone market, for example. An appropriate nudge would be for the government to step in and regulate not how much carriers could charge for their services, but their disclosure practices. It would require carriers to make their fee schedules public in a standard spreadsheet type format and must include any and all fees the customer could be charged. Once a year, carriers would be required to send their customers a complete listing of all the ways they had used the phone and all the fees that had been incurred, thereby allowing the customer to easily see and compare their current plans with those of other carriers (93, 94). A real life example is the Truth In Lending Act which required credit companies to reveal a standard calculation of an annual percentage rate (APR) of interest to consumers. It then became quite easy to compare credit cards and make better decision about which one might be best for us (generally, the one with the lowest APR for the longest amount of time). Now that you understand that concept, I’ll continue with the excerpt:

In 2007 there was an eruption of subprime foreclosures, which caused ripples throughout financials markets, prompting many government bodies to think harder about how to help. Of course markets, left alone, will solve some of the problem, because investors who had been buying up subprime loans learned the hard way that the loans were riskier than they seemed. (In many ways, the mortgage brokers were deceiving the investors who bought up the loans as well as the people who borrowed the money.) But market forces did not prevent the problem from occurring, so there have been calls for more intervention. Some demand an end to predatory lending, but because loans do not come stamped “predatory,” it is hard to implement any such ban without depriving many deserving but high-risk borrowers from any source of financing. And of course, we libertarian paternalists do not favor bans. Instead, we prefer [to help] people make better choices and avoid loans that really are predatory – loans that exploit people’s ignorance, confusion, and vulnerability.

[We suggest changes to the Truth In Lending Act to make it relevant once again.] . . . Mortgage lenders would be required to report lending costs in two categories: fees and interest. . . research finds that people who get the best deals – by a lot! – are those who pay no fees (. . . the broker pays all the fees out of his commission. . .) The likely explanation for this result is that when the fee is zero, it is simpler for borrowers to compare terms, because the interest rate is the only thing they have to look at. The interest-rate disclosure would include the rate, of course, but also a schedule of payments over a period of years, assuming that the underlying interest rates do not change. This would ensure that borrowers at least know what their payments will be when the teaser rate ends. It would be a good idea to add some kind of worst-case scenario information so that borrowers can see how much their payments could go up in the future.

Lenders would also have to provide a detailed . . . report, that incorporates all the fees and interest rate provisions, including teaser rates, what the variable-rate changes are linked to, caps on the changes per year, and so forth. This information would allow independent third parties to offer much better advice. Our strong hunch is that if [this data] were made available, third-party services would emerge to compare lenders.

[This data] would thus make it much easier to shop for mortgages online, which would make the mortgage market more competitive. Online shopping is especially likely to help woman and minority groups. A study of automobile shopping found that women and African-Americans pay about the same amount as white males when they buy a car online, but at the dealership they pay more, even after you account for other factors, such as income (136-138).

I’ve been hearing and reading so many different opinions on our current economic situation in terms of what caused it, who was at fault, and what steps should be taken to keep it from happening again, that I thought this chapter was very interesting and written “in layman’s terms” to help me understand all the talk about predatory lending and subprime markets. If you had questions, as I do, here’s hoping you found this post helpful. Nudge: Improving Decisions About Health, Wealth, and Happiness is a super interesting read and I highly recommend it.

Both Sunstein and Thaler have made posts on the nudges blog specifically discussing the current economic situation if you are interested in reading them. If you are interested in reading a Q&A with the authors of Nudge, you can find one on the above mentioned Freakonomics blog here and on the website here (scroll down to the editorial reviews). You can also click here for a link to the Nudges website.

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