Saturday, May 24, 2014

Excuse Me?


NOTE: These 12 essays are being reproduced from my now defunct blog Random Notes, as I intend to cite them in my upcoming essay on the use of words will emotion-heavy connotations and little in the way of actual denotation (such as "need" versus "want", or "exploit" and "fair").

I was going to write an essay on how the Wikipedia article on "predatory lending" was a perfect example of how utterly useless most Wikipedia "written by committee" web pages are. However, having spent so much time beating up on Wikipedia, I decided to let Wikipedia off the hook this one time.

However, while reading the article, one claim caught my attention, only because it showed how absolutely ignorant "community activists" are when it comes to economics. You see, the very first practice which is claimed to be "predatory" is "risk-based pricing".

The problem is, interest is almost entirely based on the concept of risk. Whenever interest is brought up, there are two components mentioned, time preference and risk or uncertainty. We charge money to defer consumption both because we prefer to have things now rather than later and because the future is uncertain. See? Risk is built right into the definition of interest in almost every economic theory. In fact, it is arguable that some part of time preference is itself a risk premium, because we prefer current consumption to future consumption due to future uncertainty. But, whatever the percentage that is risk dependent, the fact remains, interest is based entirely on the concept of risk.

So, how do community activists expect lenders to price loans if they cannot adjust for risk?

Well, in that case we have an answer. They expect something akin to the Community Reinvestment Act, and we have all seen the wonderful outcomes that produced. When you price loans the same for risky borrowers and reliable borrowers, you end up overpricing for those with good credit and underpricing for the riskiest borrowers. As a result, you end up having too high a percentage of defaulting loans, as the good credit borrowers take too few and the bad credit borrowers take too many. That is simple economics, and obvious to anyone not a community activist.

Then again, I really think the term "predatory lending" is meaningless, as, for that matter, is "predatory borrowing" which has been suggested by some as the corresponding practice on the part of borrowers. In my mind, there are two acts. There is borrowing, which is lawful, and then there is fraud, on the part of the borrower or lender. Provided neither party makes a misrepresentation, the agreement is freely reached, and there is nothing "predatory". On the other hand, if there is fraud, either through misrepresenting terms of the loan, or the borrower's income, or the value of the property, then it is simply fraud, and not "predatory" anything.

Of course, some will argue that the lender can set up things so the deal works out in its favor, and that is abusive. I would counter by arguing that the borrower can likewise work the deal to his advantage, using tricks to improve his credit rating, his income or the value of the house, all of which fall short of fraud, but clearly make the lender give a loan at a lower rate than he otherwise would.  Some think just because the lender is the "big guy" he holds all the power, but that simply is not true, as the slew of defaulted subprime loans shows. Many times the borrower is in just as strong a position, having all his time to devote to the single deal, while the lender splits his attention between dozens of similar negotiations*. The truth is, in come deals the borrower will end up in the advantageous position, in some the lender, and in most the two will end up about in the middle. None of that means that a deal is "predatory", simply that the free market does not guarantee any single deal will be reached at the optimal price, just that overall the average of all deals will tend toward the optimal average price. Even with an absolutely free market, bad negotiators will end up with a raw deal while sharks will usually get the long end of the stick. That is life, and why it is good to be the king. (Or at least why having a glib tongue and a smooth line of patter is advantageous in many areas of endeavor. Just ask the occupant of the "Office of the President Elect.")

But perhaps that deserves a more thorough treatment. I know I am still putting off my post on regulation I have been promising for a week. And i have also been putting off another post I wanted to write about conspiracy theories. But I suppose it won't hurt to another. So, after I write about conspiracies and regulation, I will have to write about the fact that freely negotiated agreements, though they may be denounced as price gouging or predatory lending, all serve a valid economic function and are always to be preferred to the imposition of government decreed prices.

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* Often when someone is the victim of fraud, someone will ask "why didn't you notice this before?" The answer is something similar to this situation. The man who is committing fraud spends all his time thinking about your money, while you spend very little time thinking about preventing fraud. So he is at a clear advantage. Likewise, having only one deal on which to focus, the borrower often has a better position in terms of fiddling with facts, jiggering documents or creating a misleading impression. The lender just does not have the time to thorough verify each and every bit of evidence prior to making the deal, while the borrower has a lot more time to slant the evidence in his favor.

Originally posted in Random Notes on 2009/01/06.


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