I know some lenders use ethically unsound logic such as giving a person a loan after bankruptcy with a crazy interest rate. Why? Because they know the person cannot file bankruptcy again for a certain length of time, therefore they will have nothing to stop them from taking every asset away from that person if they stop making payments.

And if they do make payments, the lender makes a huge profit off of the interest. Like credit card companies that give you a $200 limit, and you make the month payment which barely covers the interest, so you end up paying $700 for the $200 you actually spent.

I feel as if most banks have a special department whose goal is to figure out how to rip the most amount of money off the most people. If they were not doing this, then there is no way people would be getting loans for homes, cars, and other large assets that are too close to barely tipping over the means they can really afford.

Thanks for the tip about Caskey’s work. I’ll definitely have to check it out. What really interests me is in the justification — both economic and ethical — of the different ways that lenders and insurers determine whether a particular transaction is risky or not. From a purely economic risk-management perspective, the following practices are probably all justifiable, though they are very different from an ethical (and legal) perspective:

1) Higher loan interest rate because a borrower has a history of making loan payments late.

2) Higher health insurance rate because of a pre-existing medical condition.

3) Higher loan interest rate because people of the borrow’s race have a higher default rate than the national average.

My intuition is that the ethics involved depend in large part on how the transaction works at the individual level, as opposed to the broader perspective of economics. If an individual pays a higher price for a given product (in this case, a loan), because of the individual’s past behavior (bad credit history), that seems more justifiable than paying a higher price based on something beyond the individual’s control (health status, race).

I’m a former student (Spring ’02) and first-time visitor to your blog.

I think that there’s a related issue to your original question that’s not fully addressed in the comments. I agree with your summary that subprime loans per se weren’t really a major issue in terms of the overall economic crisis, but I think that your question is useful in examining how subprime mortgages relate to “predatory loans.”

It’s my understanding that people usually distinguish between regular subprime mortgages and predatory loans, in that the latter is usually associated with deceptive marketing or racial discrimination. But the discussion here seems to indicate that subprime mortgages are by definition predatory in that they impose higher fees on people with the lowest ability to pay them. As with payday loan centers, pawn shops, and places like Rent-a-Center, subprime mortgages match high-risk customers with high fees in order to give lenders an incentive to deal with an otherwise unattractive population. On a population-wide level, you can see how this group of customers benefits from the availability of high-priced commerce as opposed to no commerce opportunities at all. But on the individual level, if you’re a low-risk person being classified as part of a high-risk population, you get screwed.

Or, as you put it, “it may not be a great way to increase social welfare, but it makes money.” I think that’s a pretty important point, regardless of whether or not subprime mortgages were a major issue in the economic crisis.

Silly as this seems, this strategy did work in areas like Southern California where prices were rising at 20%/year for almost a decade. I think one big cause of real-estate bubbles like this is that people have a very short view of history, using maybe the past 2-3 years to define “normal”; thus at some point housing prices had been rising at 20%/year for effectively forever and people act accordingly…

And the problem with blaming the securitization of mortgages is that this is merely a logical extension of productive and prudent capitalist business as usual. First, in the sense that making money involves risk and prudent risk involves securitization. Second, in the sense that abstracting liquidity from concrete assets is the signal development of the modern economy. Think replacement of land with stock as the engine of capitalism, replacement of the gold standard with fictional gdp backing, etc. Without this move nothing like the relative economic, demographic and political prosperity of the last couple hundred years would have been possible.

Just like a loan doubles + liquidity by taking a single sum and turning it into the sum plus its own future repayment, securitization takes the repayment and multiplies it again by guaranteeing the repayment as its own notional value (I’m out of my depth on terminology here, hope I’m making sense). This can be done over and over, each time multiplying the liquidity derived from the original asset, in effect printing money without inflationary consequence. It’s really nifty.

I’d have to look up the reference and time is short before my carpool, but apparently there’s an economist at Yale who’s arguing that the problem was not too much securitization but too little – that if sub-prime borrowers had had their own access to insurance against default, rather than restricting that asset to a few big players like AIG, the inevitable downturn of housing prices and rise in defaults would have been much better granulated and not run into the ‘too big to fail’ problems we’re in now.

If you lend money, and accurately know the average default rate amongst your clients then you simply adjust the terms of the loan such that you still make profit.

Let’s consider the simple case where I lend ???100 to 10 people (???1000 total). If I know that 50% of the people will never repay I can simply set my interest rate such that each person ends up paying me back the ???100 they borrowed, an extra ???100 to make up for the 50% that defaults (i’ve now got my original ???1000 back by charging 5 people ???200) and i can add an extra ???10 on to each loan make my profit. So after the loan period i get ???1050 returned to me. Obviously this can be adjusted to take into account any default rate.

The only way that you can lose on this proposition is if you underestimate the risk. In the competition to sign people on for loans i could see some banks shaving a bit too much profit off but i don’t think this would explain a world encompassing recession.

It’s at this point it becomes important to see what the bankers did when they repackaged the loans. Basically they took loads of loans and threw them together into a bucket. Now all these loans had a high default rate but individually that should mostly have been taken care of by the terms that the loans were offered with (sure the terms might have been too lenient but is that enough for a global crisis?). However in the repackaging the bankers played another clever trick.

From our bucket of loans we take all the repayments and pay them into one account. By promising that people who buy the most expensive contracts (i.e. CDS’s with a AAA rating) get paid first from the money that comes into that account (if you have a cheap contract then you get paid last or not at all if the money runs out) we’ve reduced the risk that the customer with the AAA contract doesn’t get paid. Here’s the crux. How much have we reduced that risk?

This seems to be the point at which the whole issues turns. The banks assumed that the risks of people defaulting on their loans was uncorrelated (technically that means you can assume a gaussian distribution for your risk). So they priced these contracts accordingly. When you assume a gaussian distribution you’re basically assuming that there’s a big chance something small could go wrong but a small chance that something big could go wrong.

But this isn’t true. There’s a good chance that the reason that you can’t repay your loan (i.e. you lose your job at the factory) is the same as mine (i also lost my job because i worked at the same factory). This means the risk of defaulting is correlated and our assumptions for the pricing are incorrect (in fact there is literally no known mathematical way for dealing with correlated risks – one of the reasons why very smart bankers bought into this; there is literally no other nicely quantifiable way). Or something really hug may go wrong – like a housing bubble bursting.

So we now see why the assets are mis-priced (banks underestimated the risk), but why the massive crisis? Well, i think it’s because at the point where these loans were repackaged people realised that they could do away with tying them directly to loans. Simply by betting on the outcome of a few loans, effectively as a side bet (or if you play blackjack, it could more accurately be described as betting behind. If you play you realise immediately here that the behind bet is can be many times larger than the original bet – in the same way a few billion of bad loans led to a few trillion of global losses), you can increase the amount of money invested in these assets. And because the mis-assessment of risk tended to underestimate the chance of an unlikely but catastrophic event, this wasn’t noticed until it was too late. There are other factors (the bonus culture and the interdependency of modern banks) that made it worse/global.

Simply put:
Banks underestimate risk of people repaying

Banks think because they’re making huge profits that they must be doing something right (not realising that it’s specifically the rare events that they’ve underestimated) so invest many many times the value of the loans

Housing bubble collapses

The loans aren’t paid back and because the banks are hugely leveraged they are exposed many times over so they make massive losses

Banks unwilling to lend any more (credit crunch)