Shenanigans! Predatory Lending Edition

There is an opinion piece in today’s Wall Street Journal worth commenting on. Todd Zywicki writes that the Consumer Financial Protection Bureau (CFPB) under its previous leadership “pummeled American consumers and the economy while doing little to promote financial stability.”

He argues:

The pain was especially acute for low- and middle-income consumers who lost access to credit cards, faced higher bank fees and reduced access to free checking, and found it harder and costlier to obtain mortgages, especially as first-time homebuyers. In response, consumers turned to payday loans and alternative products as financial life rafts—only to have Mr. Cordray poke holes in them by imposing regulations that would effectively outlaw payday lending.

He is on sound footing in regards to the regulatory burdens imposed on small banks and credit unions. His comments regarding consumer choice may look good on paper but to my eye appear ignorant of the reality on the ground.

This passage in particular irks me:

When the CFPB prototype was first proposed nine years ago, I wrote in these pages that the architects of the new agency should “treat borrowers like adults.” Instead, Mr. Cordray’s CFPB viewed consumers as too dumb, irrational or vulnerable to make their own decisions about whether to enter into a contract with an arbitration clause, take out a payday loan, or bargain with a car dealer over an auto loan.

The problem is that the people who are targeted for “alternative” credit solutions tend to be desperate individuals of limited financial sophistication. They are precisely the kind of people who lack the financial literacy to make informed decisions regarding things like arbitration clauses. Or compound interest, for that matter.

When I worked in consumer lending, I frequently encountered these borrowers. In fact, we had a couple of subprime lenders up the street from our office (we sat at the nexus of several communities varying dramatically in wealth). Disgruntled customers would often drift over to us when the punishing cost of their loans finally dawned on them. Even at the height of ZIRP here in the US, they were carrying mortgages at 10-15% and auto loans at 20%+.

None of these people understood the loan docs they had signed. Some of them might have been victims of deliberate mis-selling. However, I believe the overwhelming majority were simply financially illiterate. I could tell I had finally gotten through to one befuddled borrower on compound interest when his face lit up and he exclaimed, “so that’s how Warren Buffett does it!”

The key issue here is that the only way to make money as a lender is to charge punitive interest rates. Subprime borrowers are genuinely awful credits. Default rates are high and recoveries are low. (what quality collateral do you suppose someone is bringing to the table when he is willing to take a mortgage at 10% with Prime at 3.25%?)

There is certainly an argument to be had about whether the government should be in the business of protecting financially illiterate consumers from themselves. Mr. Zywicki obviously does not believe so. But I feel it’s important to at least properly frame that debate.

For in the land where only 39% of people have the savings to cover a $1,000 emergency, there are a great many people who are, in fact, too dumb, irrational or vulnerable to make informed decisions about borrowing money. Let alone make informed decisions about money borrowed at crushing interest rates.

(Note: FT Alphaville also published a longer rebuttal to the op-ed, specifically in the context of the financial crisis)

UPDATE: After some discussion on this subject with others, I developed the below analogy to cigarettes.

People get addicted to cigarettes, which are bad for their health and have broader negative impacts on society at large (read: healthcare costs). So, the government imposes punitive taxes on cigarette consumption. You remain free to buy cigarettes, but you are penalized for doing so. The reason is that the rest of us are forced to bear the cost of your bad habit.

Subprime lending is similarly corrosive. Subprime loans are “unhealthy” for the borrowers. They also undermine social cohesion more broadly by promoting distrust of the regulated financial system and markets in general. So, why should we as a society promote the proliferation of this type of financing?

As part of the above referenced discussion, I pulled a OneMain Financial (OMF) 10K. In fiscal 2017, OMF took a $955 million provision against something like $2.4 billion of net interest income. They are reserving something on the order of 40% of net interest income for expected loan losses.

On the one hand, I can look at this as the high cost of “serving” this customer demographic. As noted above, I have no illusions about these consumers being awful credits. Subprime lending is not a rainbows and butterflies kind of business. Far from it. From the business point of view, eggs must be broken to make the omelette.

On the other hand, I question the ultimate economic purpose of the enterprise. To me it looks a lot like a means of extracting wealth from the poorest, least financially literate communities and transferring it to management and shareholders (I have similar objections to our use of lotteries and casinos as regressive taxes on the poor). Such businesses certainly have a right to exist. However, they are businesses that should be kept on a tight regulatory leash.

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