Predatory Finance & Community Development

I believe in capitalism because it offers an incredibly powerful incentive system that is essentially self-perpetuating. Broadly speaking, the most significant issue with socialism as an economic system is that it requires either central planning or a high degree of willing cooperation among market participants to allocate resources. The latter is not compatible with human nature. The former does not have an especially strong record — Venezuela is just the most recent example of a centrally planned economy imploding in spectacular fashion.

However, capitalism requires a robust and healthy financial system to flourish. Poor communities in the United States do not have ready access to healthy financial systems. In fact, they are targeted by predatory financial businesses.

Retail Banking

Retail banking products are not designed for the poor. Since the poor by definition spend most of what they earn, what they really need from a retail bank is a simple account they can use to cash paychecks and maybe accumulate some cash savings.

The problem for the banks, and therefore the banks’ low income customers, is that these types of banking relationships are not profitable (if they are profitable at all). The average “free” checking account costs a bank anywhere from $200 to $500. Now this is not so bad if you can offset those costs with interest income from loans and credit cards. In more affluent areas these accounts are simply loss leaders that give the banks a shot at the customers’ mortgages, credit cards and auto loans.

However, for obvious reasons the poor do not make for very good credits (more on that below). So there is not much incentive for retail banks to serve these markets. Even companies that have launched products specifically designed for this demographic have struggled to execute. Finally, since the poor spend most of what they earn they do not contribute much to deposit growth that can fuel asset growth elsewhere.

In the absence of traditional retail banks, poor communities are often forced to rely on check cashing services. These are sometimes offered through other retail stores and other times through financial service companies such as payday loan stores. Check cashing services are extraordinarily expensive. Transaction fees can run 10% or more. That is a significant economic drag on individuals, families and entire communities.

Lending

Much of the predatory financial activity that takes place in poor communities is related to lending. Payday loans, car title loans, subprime mortgage and auto loans, property rental (a.k.a rent-to-own) businesses. The specific mechanics of these businesses are different but the underlying principles are the same. It is more or less legalized usury. Effective interest rates can exceed 100% annually.

Subprime lending is a brutal, rip-your-face-off business. The customers are poor credits. That is not a moral judgement but simply reality. Thus the only way to sustain a subprime lending operation is to charge exorbitant interest rates and aggressively repossess collateral (to the extent loans are collateralized at all). This is death spiral financing for individuals.

Early in my career I worked in retail banking. I met many individuals trapped in the subprime debt cycle. They typically came to me hoping they could refinance their 10% car loan or mortgage at a lower interest rate. I was able to help a grand total of zero of these individuals. Most of them were doomed to personal bankruptcy. However, I would try to help educate them if there was an opportunity to do so. This itself was difficult because the level of financial sophistication in the subprime demographic is very low (the financial sophistication of the general public being mediocre at best).

One man had taken out a subprime mortgage. He came to me believing he had been cheated by the lender because he had paid vastly more interest than his loan note estimated. In reality what had happened was that he had taken the company up on a “skip-a-payment” offer on several occasions. These offers are common. They allow the customer to literally skip a payment on his loan, with no adverse effect on his credit score. These offers are often released around the holidays under the guise of giving customers a break during a difficult time of year. However, the loan continues to accrue interest in the meantime. This is disclosed in the fine print but financially unsophisticated customers tend not to read the fine print.

You see why the subprime lenders love these deals. The interest compounds on interest over time. In the above case the lender did not appear to have done anything overtly illegal. However, the customer was almost certainly a victim of mis-selling. He was ignorant of the most basic mechanics of loan finance.

Conclusion

Subprime finance is a dangerous business.

One of the main reasons it is dangerous that does not seem to get much air time is that victimizing large swaths of communities erodes collective trust in the financial system and indeed even capitalism itself over time. In this way predatory financial businesses impede the development of healthier, more productive financial infrastructure in poor communities.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s