Lending Lunacy Can’t Be Repeated

021208 bernanke web Lending Lunacy Can’t Be RepeatedFor years and years a minority of savvy people would ask themselves, “Just how long can this go on?” The “this” was lending people money that they were not earning enough to repay. Now we know. Now the question is not how long can this go on but how come it went on so long.

Lending money to dubious risks is hardly something invented in the past 10 or 15 years. Until recently, however, the rule was that high risks paid high interest rates. The payday loan industry operates on that basis, as do the gangsters who lend to people gambling on sporting events. For that class of borrowers failure to pay may also entail knee-capping or finger-smashing.

Knee-capping, however, does not necessarily get a gangster/borrower his money back. Such lenders draw a line at proven deadbeats. They are denied loans.

Thus, in a crude way, the nether regions of the credit system have been self-regulating. It does not take government regulation for some people to figure out that if you cannot afford the interest, don’t borrow the money; or, conversely, if the applicant looks like a really bad risk, regardless of the interest, don’t make the loan. Proper assessment of risk ensures that the guys with the baseball bats, or the slightly more respectable payday lenders, do not suffer fatal financial bubbles.

In our case, the simple set of relationships obtaining in the netherworld of credit has been disrupted over the years. The first disruption, and least important, was setting price controls on money via the usury laws. Controls on the price of money—that is, interest—are easily evaded but they foster a climate of dishonesty, black marketeering and forms of bookkeeping that defeat transparency. It is surprising that Hillary Clinton, with her oft-boasted experience, did not understand what she was advocating when she came out in favor of putting a cap or price controls on mortgage interest rates.

The disruption of self-regulation in borrowing and lending in the upper world of finance begins with the government policy of promoting low interest rates. The rates were not forced down by promulgating price control rules but by making money cheap, by, in effect, printing a lot of it. The connection between high interest rates and high risk was broken. When self-regulation is working, only good risks get low rates; now everybody got them.

Both political parties were content. The business people backing the Republicans were having trouble counting the money, it was coming in so fast. The Democrats were seeing a jump in the standard of living of their lower-income constituents. In the past few years, low-interest, no-down-payment financing had come close to being a substitute for public or subsidized housing. The difference was, as few cared to say out loud, that sooner or later the new homeowners would have to pay for their nice new homes.

The old system of self-regulation roughly worked because of self-interest. Bankers did not want to get stung by making bad loans. The new system of low interest rates might have gone on working—sort of—if the self-regulatory arrangement had been buttressed or replaced by public regulation. But regulating is no fun and nobody wanted to do it, and so it did not get done.

Anyway, thanks to low interest and the Fed printing press, everybody was swimming in cheap money. In short order avarice coupled with idiotic optimism made businesspeople stop doing their job, which is to understand the risks of each and every transaction. Instead, they proceeded apace, believing that higher prices would cover any problems.

The higher prices depended on the Fed keeping the country awash with money so that mortgages could be kept current by refinancing houses adjudged to be worth more by the hour. The moderation that supply and demand normally imposes was vitiated in a gold rush frenzy.

What was happening in real estate was happening in cars and retail sales, thanks to the banks’ credit card divisions. There also interest rates were decoupled from risk and credit was extended to anybody with a pulse. College kids and doddering ancients living on Social Security were offered credit cards. Instead of the banks and the bond packagers who bought the credit card debt doing their job, which consisted of saying no to credit-unworthy applicants, the banks lobbied through Congress new, tough strictures in the borrower bankruptcy law.