From the February 2010 issue of Research Magazine • Subscribe!

Undemocratic Credit: Finance (Including Banking) Finance Regains Prudence, at a Price

As democratization extended credit to poorer and poorer households, some banking products shifted from a fire insurance model to a life insurance model.

In the old days, bankers only wanted to do business with rich people. If you needed a million dollars, you could never get it from a bank. But if you already had a million, there were plenty of banks willing to lend you another one.

The poor lived hand to mouth and the middle class mostly took out loans at a credit union or a local S&L. Going into debt was a major decision for many American families, and mortgages and auto loans required a thorough background check and income assessment -- not to mention a hefty down payment that would fully protect the bank against default. Credit cards were something the upper middle class flashed at a store or restaurant, sending a respectful hush over the rest of us.

It all began to change with deregulation in the 1970s. Importantly, banks and credit card issuers were allowed to set their own interest rates, often disregarding old anti-usury laws. In particular, in 1978, the Supreme Court struck down interest rate limits on credit card debt. All of a sudden, financial institutions could put a price on the risk they were taking.

However, this didn't lead to the customization of credit -- a situation in which each borrower gets assigned his personal risk-adjusted interest rate, based on his unique risk parameters. That wouldn't have worked, anyway, because a borrower with a high risk profile would be assigned extremely high interest rates, making default a self-fulfilling prophesy.

Moreover, banks sell products in which risk gets pooled. This means that in any group of borrowers there are those who pay their debt on time, as well as deadbeats. Statistics estimates the percentage of deadbeats in any group. The larger the sample and the longer the time frame the more accurate the forecast will be. A single interest rate on a product then takes into account the likely percentage of defaults and restructurings, as well as a nice profit for the lender.

In other words, a very large number of people who service their loans on time will subsidize those few who don't. No one objects, since it is impossible to tell beforehand who will end up in financial trouble. Thus, the democratization of credit began.

The Insurance Model

Banking shifted to an insurance model. A company that sells fire insurance, for instance, doesn't expect all the insured to avoid fires. It just knows from historical data what percentage of homes burn down every year and what the average damage from a fire adds up to. Based on those calculations, it determines the insurance premiums it charges.

By adopting this model, bankers stopped worrying much about checking borrowers' credit history or employment situation. They even dispensed with collateral. Credit cards became as common as McDonald's. Pre-approved credit cards began to be distributed by direct mailing, and substantial credit lines were offered on demand. With interest rates of 25 percent a year and more -- plus various delinquency and late payment fees -- it seemed the credit card issuers pretty much expected mass defaults.

As democratization extended credit to poorer and poorer households, some banking products shifted from a fire insurance model to a life insurance model. In the subprime residential mortgage sector, bankers seemed to be laboring under the assumption that all such loans would sooner or later default. The question was when. This extremely risky segment of borrowers couldn't begin by paying the full interest rate required by its risk parameters and had to be started with low teaser rates instead.

Basic Mistakes

But there are two fundamental differences between insurance and loans. First, insurers get positive cash flow from the start. They begin to collect money from customers today and keep accumulating it in exchange for a promise of paying a set compensation in the future.

There is a reason why professional options traders prefer to write a put, instead of buying a call. In a speculative transaction, the premium charged on the option becomes an extra cushion. Thus, insurers have a pool of money which they invest and on which they earn a return -- which is a reason the insurance business remains profitable despite periodic debacles that require large payouts. Bankers, on the contrary, have to lay out a large sum up-front and then begin to get it back in small installments.

The second difference is that insurable events tend to have a low correlation. A fire in one neighborhood doesn't cause another house, in a different neighborhood, to burn down the next day. The same is true of life insurance, since deadly epidemics are rare in a modern industrial society.

Not so in the banking sector. Since the democratization of credit spread in the 1980s and 1990s, recessions have tended to be mild in the United States and, more important, employment generally continued to grow after every shallow downturn. If we accept it as given that a capitalist economy is cyclical and that recessions play an important salutary role by punishing those who become overextended, then by keeping the economy from a recession the Federal Reserve merely helped problems accumulate and fester, ensuring there was going to be a severe recession some time down the road.

In a recession, especially when it is accompanied by a sudden and painful rise in unemployment as has been the case in the current slump, credit defaults become a chain reaction. Moreover, financial institutions contribute to rising default rates because they often sell repossessed houses at fire sale prices, further depressing an already soft market.

For many years, life insurers have enjoyed nice returns because mortality declined dramatically -- and unexpectedly -- whereas life expectancy increased across the board. The premiums charged by life insurance companies over decades have been too high. But if now a severe new epidemic -- such as the swine flu -- suddenly erupted to claim the lives of tens of thousands of previously healthy individuals, it would not only be a national tragedy but it could ruin many life insurance companies.

This is what happened to bankers in the current economic downturn. They can no longer earn easy profits by providing loans to the mass consumer. While bankers are no longer confident that the average consumer can pay them back, consumers are no longer eager to borrow. On the contrary, they want a spending pause in which they can pay down their existing debt.

At the same time, another key link in this chain, the bond investor, no longer wants to buy bonds backed by consumer loans and mortgages, because their risk parameters are no longer easily defined. And, of course, insurers such as AIG are no longer willing to sell credit default swaps, products that protect investors against default.

For now, at least, the democratization of credit has run its course. The Fed and the Obama administration are calling on banks to return to their old democratic ways. But business is very different from politics. Britain has upheld its democratic system even when facing a continent full of triumphant tyrants across the English Channel.

Today, in banking, democracy doesn't pay and the banks are returning to more prudent practices of the past. This could mean lower interest rates to creditworthy borrowers and no loans to riskier consumers. However, it could also create a deflationary spiral and sharply slow growth in the U.S. economy.

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