I’ve said before that a “financial crisis” means, roughly, “that someone borrows money from someone else and can’t pay it back, and it is socially or politically unacceptable that the people who loaned the money not get their money back.” So the way to avoid financial crises is to clearly define the classes of people whom it is socially and politically acceptable not to pay back.
The quote isn’t supposed to define financial crisis. It’s claiming that a financial crisis isn’t called a crisis if the people who lose money are unpopular.
Though I read the link and still don’t know what people Matt’s thinking of.
When someone says “Something is called an X when it has properties P, Q, and R”, they need not be endorsing the definition. They might simply be saying (with more or less cynical exaggeration) “This is how the term gets used in practice”. Like when someone says that a language is a dialect with an army, or that a freedom fighter is a terrorist the speaker approves of.
I paraphrase Mike Levine’s comment, in its context, thus: “If you look at how politicians and newspapers and the like use the term ‘financial crisis’, you will find that the point at which those words start getting used is the point at which someone is owed money they aren’t going to get, and the powers that be find it unacceptable for them not to get it. From this cynical perspective we can see what’s going on with these proposed new rules about banks: the idea is to make it clearer what sorts of debt the government can be expected to make sure gets paid back, and crucially what sorts it can’t, in the hope that future bank failures will be less likely to be classified as financial crises.”
I haven’t looked at how the term “financial crisis” actually gets used carefully enough to know whether Matt Levine’s description is defensible (as it stands, or as a deliberate overstatement for cynical effect). Perhaps it isn’t. But the right criterion to judge it by isn’t whether it offers a good definition of “financial crisis”, but by whether it offers a good description of the (perhaps very bad) way in which that term actually gets used.
Like when someone says that a language is a dialect with an army, or that a freedom fighter is a terrorist the speaker approves of.
Yes, I got a whiff of the “when a prole loses everything no one cares, when a fat cat gets pinched it’s a crisis” flavour in the quote, but didn’t bring it up since it was just a whiff and nothing conclusive.
I don’t mind Matt Levine saying all these things in his column. But I don’t see how it is a rationality quote and the smell of class struggle certainly doesn’t help here.
Loosely speaking, what is meant by a “financial crisis” is that someone borrows money from someone else and can’t pay it back, and it is socially or politically unacceptable that the people who loaned the money not get their money back. That last part is crucial: If someone borrows money and can’t pay it back, and the lender loses money and no one else cares, then that’s just capitalism, not a crisis.
Puerto Rico’s Slide
So part of the trouble in Puerto Rico—which borrowed a lot of money and can’t pay it back—is figuring out how sympathetic the lenders are. The hedge funds telling Puerto Rico to close schools to pay them back: not hugely sympathetic. But the individual retirees, in Puerto Rico and elsewhere, who bought Puerto Rican municipal bonds because they were tax-free and supposedly safe, might be more appealing.
I know we kind of hate authority here, but the guy did work on wall street for a number of years, and has written his financial newsletter for years as well.
I feel like the quotes I’ve made recently have been taken less charitably than is usual here.
Anyway, with this particular claim, I think it’s meant more as a simplistic view that gets at some truth versus something that’s always true, in which case that might be naive (although you didn’t provide any counterexamples).
but the guy did work on wall street for a number of years, and has written his financial newsletter for years as well.
That doesn’t make him an authority on financial crises. It makes him a Wall St. M&A lawyer who went into journalism.
I feel like the quotes I’ve made recently have been taken less charitably than is usual here.
Perhaps try with quotes that are more than “a simplistic view that gets at some truth”?
I see no reason to be charitable to quotes, anyway. There is a very very large number of quotable sentences around and stringent curation is much better than loose, lest we drown in clever turns of phrase without much insight behind them.
I’m not really arguing for a different norm. I’m just noting that it seems the norms have changed.
Also, you still haven’t really justified your opposition to the claim. Even if you aren’t going to be charitable, you should at least explain why you’re rejecting it, in a more substantial critique than “naive”.
I’m inclined to call it “not even wrong”, but let’s take an example. The Financial Crisis is the crisis of 2008. It started (the crisis itself, not the preshocks), notably, with a bankruptcy of Lehman Brothers which the Fed allowed to happen. This, by the way, was later deemed to have been a mistake and the TBTF—Too Big To Fail—monsters were born. The immediate danger during the September and October of 2008 was that the global payment network would freeze because of counterparty uncertainty and that the world finance would, essentially, collapse. That did not happen, but the effects on real economy were severe nevertheless—consult any GDP graph for the relevant period.
So let’s apply Levine’s definition. Who in 2008 were the borrowers and who were the lenders? It was deemed “socially or politically unacceptable” for which creditors to not get their money back? Is it a useful way to think about the situation?
AIG was the borrower (and separately Fannie and Freddie), banks were the lenders, it is absolutely useful to think about the situation in those terms. It highlights the conflict between our political intuition that insurance should be protected and financial speculation should not—some people thought AIG was doing one, some people thought the other. Likewise some people thought Freddie and Fannie were widows-and-orphans investments that the government should guarantee and some people thought they were private financial traders. Clarifying these things could have averted the crisis, it’s absolutely a useful model.
I feel like the quotes I’ve made recently have been taken less charitably than is usual here.
I don’t know about other quotes but I think this quote also would have gotten resistance years ago.
Complex problem X can be simplified to Y and solved with populist solution Z is not a template that generally popular in the rationalist quote thread.
I kind of expect someone disagreeing with a quote to at least look at the context. Do you think quoting the entire section would have gotten a better reaction?
I looked at the context—the quote was made while Levine was talking about Puerto Rico. It still does not make sense. He might have meant it as a fancy way of saying that if nobody cares then nobody cares, but that’s a trivial observation.
If this is a way to avoid financial crises, then we can prevent anything bad from ever happening by clearly defining “bad things” as “things that cannot happen.”
The example given is explicitly labeling certain debt as “not expected to be paid back if there are troubles”, so that someone who buys that knowingly accepts the risk. That’s more substantive than just defining it away, although the catchy way in which it’s worded might not give that away.
That will only work if you label all debt in that way, since you cannot have 100% certainty of any debt being paid back. And this means that there will be no real difference in the world except that people realize that debts are not always paid back, which they ought to realize anyway. It does not prevent anything bad from happening, just as my redefinition of “bad” does not.
That will only work if you label all debt in that way
And, of course, people do that. It’s called a “credit rating” and there are a few large institutions which assign ratings to bonds. Pretty much all bonds traded in financial markets have credit ratings.
I think there may be something to consider in the idea of having
“Loans where society has promised to go to great lengths to enforce the will of the creditor, even if the debtor’s reasons for nonpayment are convincingly sympathetic.”
and
“Loans where society may forgive the debt, if the debtor offers a good reason to do so, even if the creditor disagrees with society’s judgement on this issue.”
be legally distinct types of lending, such that the creditor and the debtor can negotiate on which type it will be without society retroactively altering the agreement. Creditors will of course prefer the first class of loan, but society as a whole would have a preference that many loans of the second type be available for personal emergencies.
such that the creditor and the debtor can negotiate on which type it will be
Why wouldn’t the market price these two types more or less efficiently meaning that the second type will have to charge a higher interest rate to compensate for the option of the politicians deciding not to pay the loan back?
It would? I don’t quite follow the question. Yes, the second type of loan would invariably have a higher interest rate. Let’s say there’s two loans for 10000$ and that, regardless of the loan type there is a 0.1% chance that a debtor will have an accident. If the debtor is poor, they will be forced to choose between not making loan payments and (for example) losing a leg to gangrene. If the debtor is rich, they will can pay both their loan payments and medical bills at the same time.
Loan A asks for 1000$ in total interest and has enforced payment which will prevent a poor debtor from paying their medical bills. Regardless, the creditor has priority in payment and receives their interest either way. Expected value to the bank: 1000$.
Loan B asks for 1010$ in total interest, but has a hardship forgiveness clause. There is a 0.1% chance that the creditor will lose 10000$, but no chance of the debtor losing a leg. Expected value to the bank: 1000$.
The bank is indifferent between the two loans, as both have the same expected return (lets ignore variance for now on the bank’s part; we can assume they deal in a large enough volume of loans or charge slightly more interest to compensate). The poor debtor prefers Loan B, as 10$ is a small price to pay for protection against crippling disability. The rich debtor prefers Loan A, as they do not want to pay 10$ to avoid a negative result which they are already protected against.
I don’t see any particular social problems arising from this situation. Do you?
I have a feeling you’re trying to reinvent the wheel. Bond insurance, as well as various forms of bond guarantees, exists and is used when it make sense. Junk bonds have a non-trivial risk of default (reflected in their yield), but are actively traded. Moreover, if you are talking about bespoke loans, their conditions are entirely determined by what’s in the contract, so there is nothing preventing the borrower from negotiating some appropriate “hardship” clause.
What do you want to make possible that is not possible now?
It’s not about possible vs impossible. Its about industrial and social standards.
If a private individual goes to a bank and asks to take out a loan, and then starts asking about the possibility of more forgiving terms in the case of a default, the bank suddenly becomes incredibly suspicious. Planning for unexpected emergencies is seen as admitting that you intend to default. As a result, banks largely don’t let people negotiate for generous debtor protection clauses, or, when they do, they only agree after incredibly punitive interest rates are agreed to. As a result, private individuals by and large just don’t ask for that sort of thing. It’s Not Done.
What I feel would be better is if creditors had a culture of less suspicion here. Debtor forgiveness clauses should be the default that a debtor opts out of with a bespoke loan exchange for a lowered interest rate rather than something they have to opt into if they’re allowed the option at all. A debtor arranging their affairs such that a sudden injury does not financially cripple them should become the new norm, not an example of unusual prudence. Likewise, a debtor asking to take on that risk in exchange for a lower rate should be by seen creditors as dangerously recklessness rather than as confident and therefore trustworthy.
A poor person comes to the bank and wants a loan. The bank judges them a high risk, and either declines to offer the loan or offers it at a high rate of interest.
No way of drawing up loan contracts differently can affect that basic relationship between the risk of a loan and its cost.
Banks are not charities. They provide a service in return for a profit. As with any business, they must make a profit on whatever service they provide, at least on average, or they will cease providing that service. Even if the bank were set up as a non-profit organisation for the good of its customers rather than its shareholders, it still has to have a business model that breaks even. Selling £10 for £5 is not a business model. Laws and regulations that make a business sell £10 for £5 result in the business ceasing, or changing its form to avoid the laws.
ETA:
Its about industrial and social standards.
I think the causality works the other way round. You can’t make up social rules and say “wouldn’t it be nice if people behaved like this?” That’s not to say that what we have at present is the only possibility, but one has to think about how an alternative would actually work, and not merely imagine happy faces.
FFS the bank makes a profit in every example provided. I don’t want to say that you obviously didn’t read the post, but I honestly can’t see any way you would come to post this comment otherwise.
Loans are a service. Loans with gentle defaults are a more desirable service. Those seeking loans would often purchase such services preferentially and at a profitable premium to the bank, if they were available or if asking for them were socially acceptable. Laws should be passed to encourage banks make such offers.
Consider the usual death spiral: the “gentle default” (GD) loans are more expensive than “normal” loans. This activates the self-selection bias—people with good credit will take “normal” loans and people which expect that their probability of default is high will take the GD loans. This makes the population of GD borrowers skewed towards high default rates. To compensate for this, the bank raises the rates on GD loans. This, in turn, reinforces the self-selection and the GD borrowers population becomes even more skewed towards high default. Rinse & repeat, crash & burn.
Besides, if you insist that this service would be profitable for the banks, why are they not offering it? The social conventions which prevent individuals from asking for these terms do not apply to banks—if this idea were good, they would take the initiative and create such a product.
FFS the bank makes a profit in every example provided.
Because you have chosen imaginary numbers to produce that result. But however the loan is structured, the bank must get its return or it will decline the business.
As Lumifer pointed out, you are proposing an insurance scheme against default. This is an existing structure, perhaps too much so. In the UK it is called Payment Protection Insurance. The problem with PPI is that it was sold under pressure to people who did not need it. The fallout from that has cost some banks billions, or rather, it has forced them to give back billions they should never have received. to the extent that a whole secondary form of dodgy business has sprung up to assist people in making claims for having been mis-sold these policies.
A poor person comes to LW and wants to post a laborious article. LW judges them a high risk, and either declines to post the article or offers it at a high rate of 2 Karma points. PS: Sorry to misuse your comment; it was the most recent one. ;)
If a private individual goes to a bank and asks to take out a loan, and then starts asking about the possibility of more forgiving terms in the case of a default, the bank suddenly becomes incredibly suspicious.
Well, moral hazard is a thing. Besides, the borrower always has the option of bankruptcy. You’re talking about the situation when the debtor thinks he might not pay back the loan and not declare bankruptcy, right? I don’t see why the bank should be sympathetic.
I also have trouble imagining the situation you’re describing. Banks rarely lend money outright to individuals without any protection. The great majority of loans involve collateral—a house (in the case of a mortgage), a car (in the case of an auto loan), securities (in the case of the margin loan at the broker), etc. And in practice, if you default, the bank gets the collateral and that’s the end of it.
Given this, what kind of “debtor forgiveness clauses” do you have in mind and what protections against abuse will be there?
An example might be an auto loan with a clause that allows a debtor who is rendered unable to pay through no fault of their own (as judged by a court or other agreed upon mediator, for example) does not lose their car (the collateral) despite not being able to pay. And to compensate the bank for this low probability but high impact loss, they pay slightly higher interest rates.
So, this is basically mandatory partial insurance on loans? Economically this means (assuming your proposal is revenue-neutral for banks) forced wealth transfer from borrowers who were able to pay off the loans to borrowers who were not able to.
I don’t think it’s a terribad idea which will doom the Western civilization, but I don’t think it’s much good, either. You’re effectively setting up a “bankruptcy lite” regime where you still have to go to court and show that you’re destitute (“unable to pay”, so presumably you have no cash and nothing in your bank accounts), but if the court decides it was not your fault, you get to keep some of your assets. Meh.
You’ll also get a bunch of unintended consequences, as usual. Off the top of my head here are two:
If there is a significant chance the loan will be forgiven if the debtor has no money, banks will start to take credit scores seriously. People with a healthy bank account will be given loans, people who live paycheck to paycheck will be denied loans or charged exorbitant rates. There is no right to credit, and no right to low rates either. Make it too easy to default on a loan and the banks will react by just not giving loans to people likely to default.
Specifically with respect to auto loans, if there is a chance you won’t be able to get your collateral (the car) back, the banks will have incentives to find other ways to finance. For example, you can structure a lease with an option to buy at the end to be much like a car loan: make the monthly payments larger, make the residual value smaller, and it’s quite similar. But the crucial difference is that you can always repossess the leased car. Therefore under your proposed regime, leases will become more frequent.
So, this is basically mandatory partial insurance on loans?
I read them less as proposing it should be mandatory and more as proposing it should be opt-out. In a perfectly efficient market the latter would make no difference compared to opt-in, and in the real world it would move some trivial inconveniences around.
This is an existing structure, perhaps too much so. In the UK it is called Payment Protection Insurance. The problem with PPI is that it was sold under pressure to people who did not need it. The fallout from that has cost some banks billions, or rather, it has forced them to give back billions they should never have received.
Loan A asks for 1000$ in total interest and has enforced payment which will prevent a poor debtor from paying their medical bills. Regardless, the creditor has priority in payment and receives their interest either way. Expected value to the bank: 1000$.
The US might have a system where something like that happens but Europe generally doesn’t. You don’t need two types on lending in this case. You just need laws about enforcing loans that are written in the public interest as they are written in a country like Germany and not laws that are written by banking lobbyists.
This proposal is equivalent to just having society never forgive debts. If society doesn’t ever forgive debts, you can still do the equivalent to case 2 by simply writing a normal contract and adding a clause saying that the debt is cancelled under these conditions, then listing the same conditions that would cause society to cancel it under your proposal.
This proposal is equivalent to just having society never forgive debts.
Nope, the second type is just a bond with an embedded option to not pay if you can convince the politicians you shouldn’t. I expect it to be very expensive :-/
As to never forgive debts, well, there is a reason for bankruptcy laws. Blood out of stone, and all that.
I do not think it would actually be the same in practice, due to coordination problems.
To make an analogy, consider unions: In theory, unions are unnecessary because the collective bargaining unions exist of facilitate can be undertaken without a formal structure. In practice, people will simply refuse to strike unless they have a strong, formal assurance that their fellow workers will follow through with their part of the strike. The same sort of situation exists for a hypothetical hardship forgiveness clause in a loan—creditors have every incentive to use their disproportionate negotiation position to deny all such clauses and debtors are in no position to boycott the creditors in response giving a lack of credibly coordinated collective action.
By making hardship forgiveness a standardized aspect of some classes of loans, you establish a Schelling point in loan negotiations—“I will not agree to any loan without the standard protections against unexpected hardships financially ruining me”—and frame the issue in the minds of consumers such that they are explicitly thinking of a generous default clause as a protection to them (which it is) and a lack of such a clause as a salient risk to their future finances (which it is).
tl;dr: It is currently possible to demand generous debt forgiveness clauses when asking for a loan, but creditors will not concede your demands if you do. Giving such clauses social and legal sanction and framing loans without such clauses as being very risky would encourage customers to negotiate collectively for such clauses where they would otherwise not do so.
If you do that you might end up simply shifting the bad thing that happens from being “someone doesn’t get paid back” to “someone doesn’t get a loan who needed one.”
Matt Levine
Um, no. That is, to put it politely, a naive view of what a financial crisis is. I can express it less politely if need be.
The quote isn’t supposed to define financial crisis. It’s claiming that a financial crisis isn’t called a crisis if the people who lose money are unpopular.
Though I read the link and still don’t know what people Matt’s thinking of.
It sure looks like it’s trying to.
Unpopular? That’s an even worse way to try to define a financial crisis.
When someone says “Something is called an X when it has properties P, Q, and R”, they need not be endorsing the definition. They might simply be saying (with more or less cynical exaggeration) “This is how the term gets used in practice”. Like when someone says that a language is a dialect with an army, or that a freedom fighter is a terrorist the speaker approves of.
I paraphrase Mike Levine’s comment, in its context, thus: “If you look at how politicians and newspapers and the like use the term ‘financial crisis’, you will find that the point at which those words start getting used is the point at which someone is owed money they aren’t going to get, and the powers that be find it unacceptable for them not to get it. From this cynical perspective we can see what’s going on with these proposed new rules about banks: the idea is to make it clearer what sorts of debt the government can be expected to make sure gets paid back, and crucially what sorts it can’t, in the hope that future bank failures will be less likely to be classified as financial crises.”
I haven’t looked at how the term “financial crisis” actually gets used carefully enough to know whether Matt Levine’s description is defensible (as it stands, or as a deliberate overstatement for cynical effect). Perhaps it isn’t. But the right criterion to judge it by isn’t whether it offers a good definition of “financial crisis”, but by whether it offers a good description of the (perhaps very bad) way in which that term actually gets used.
Yes, I got a whiff of the “when a prole loses everything no one cares, when a fat cat gets pinched it’s a crisis” flavour in the quote, but didn’t bring it up since it was just a whiff and nothing conclusive.
I don’t mind Matt Levine saying all these things in his column. But I don’t see how it is a rationality quote and the smell of class struggle certainly doesn’t help here.
Oh, I completely agree that it doesn’t seem at all like a rationality quote.
The original source is more explicit:
Puerto Rico’s Slide
I know we kind of hate authority here, but the guy did work on wall street for a number of years, and has written his financial newsletter for years as well.
I feel like the quotes I’ve made recently have been taken less charitably than is usual here.
Anyway, with this particular claim, I think it’s meant more as a simplistic view that gets at some truth versus something that’s always true, in which case that might be naive (although you didn’t provide any counterexamples).
That doesn’t make him an authority on financial crises. It makes him a Wall St. M&A lawyer who went into journalism.
Perhaps try with quotes that are more than “a simplistic view that gets at some truth”?
I see no reason to be charitable to quotes, anyway. There is a very very large number of quotable sentences around and stringent curation is much better than loose, lest we drown in clever turns of phrase without much insight behind them.
I’m not really arguing for a different norm. I’m just noting that it seems the norms have changed.
Also, you still haven’t really justified your opposition to the claim. Even if you aren’t going to be charitable, you should at least explain why you’re rejecting it, in a more substantial critique than “naive”.
I’m inclined to call it “not even wrong”, but let’s take an example. The Financial Crisis is the crisis of 2008. It started (the crisis itself, not the preshocks), notably, with a bankruptcy of Lehman Brothers which the Fed allowed to happen. This, by the way, was later deemed to have been a mistake and the TBTF—Too Big To Fail—monsters were born. The immediate danger during the September and October of 2008 was that the global payment network would freeze because of counterparty uncertainty and that the world finance would, essentially, collapse. That did not happen, but the effects on real economy were severe nevertheless—consult any GDP graph for the relevant period.
So let’s apply Levine’s definition. Who in 2008 were the borrowers and who were the lenders? It was deemed “socially or politically unacceptable” for which creditors to not get their money back? Is it a useful way to think about the situation?
AIG was the borrower (and separately Fannie and Freddie), banks were the lenders, it is absolutely useful to think about the situation in those terms. It highlights the conflict between our political intuition that insurance should be protected and financial speculation should not—some people thought AIG was doing one, some people thought the other. Likewise some people thought Freddie and Fannie were widows-and-orphans investments that the government should guarantee and some people thought they were private financial traders. Clarifying these things could have averted the crisis, it’s absolutely a useful model.
I don’t know about other quotes but I think this quote also would have gotten resistance years ago. Complex problem X can be simplified to Y and solved with populist solution Z is not a template that generally popular in the rationalist quote thread.
Maybe you did post different quotes in the past?
He’s mostly describing what’s going on, not giving advice on what should be done. And the TLACs he’s discussing are not populist.
(This may be clearer in context.)
“clearly define the classes of people whom it is socially and politically acceptable not to pay back.” sounds to me like a populist suggestion.
To the extend that you quoted him out of context, that’s still an issue with the quote.
I kind of expect someone disagreeing with a quote to at least look at the context. Do you think quoting the entire section would have gotten a better reaction?
I generally do think that quotes in this thread are supposed to be able to stand alone.
Lumifer probably still would have objected.
I looked at the context—the quote was made while Levine was talking about Puerto Rico. It still does not make sense. He might have meant it as a fancy way of saying that if nobody cares then nobody cares, but that’s a trivial observation.
If this is a way to avoid financial crises, then we can prevent anything bad from ever happening by clearly defining “bad things” as “things that cannot happen.”
The example given is explicitly labeling certain debt as “not expected to be paid back if there are troubles”, so that someone who buys that knowingly accepts the risk. That’s more substantive than just defining it away, although the catchy way in which it’s worded might not give that away.
That will only work if you label all debt in that way, since you cannot have 100% certainty of any debt being paid back. And this means that there will be no real difference in the world except that people realize that debts are not always paid back, which they ought to realize anyway. It does not prevent anything bad from happening, just as my redefinition of “bad” does not.
And, of course, people do that. It’s called a “credit rating” and there are a few large institutions which assign ratings to bonds. Pretty much all bonds traded in financial markets have credit ratings.
And one of the big issues leading to the financial crisis was that a lot of these ratings were wrong and a lot of AAA bonds defaulted.
I think there may be something to consider in the idea of having
“Loans where society has promised to go to great lengths to enforce the will of the creditor, even if the debtor’s reasons for nonpayment are convincingly sympathetic.”
and
“Loans where society may forgive the debt, if the debtor offers a good reason to do so, even if the creditor disagrees with society’s judgement on this issue.”
be legally distinct types of lending, such that the creditor and the debtor can negotiate on which type it will be without society retroactively altering the agreement. Creditors will of course prefer the first class of loan, but society as a whole would have a preference that many loans of the second type be available for personal emergencies.
Why wouldn’t the market price these two types more or less efficiently meaning that the second type will have to charge a higher interest rate to compensate for the option of the politicians deciding not to pay the loan back?
It would? I don’t quite follow the question. Yes, the second type of loan would invariably have a higher interest rate. Let’s say there’s two loans for 10000$ and that, regardless of the loan type there is a 0.1% chance that a debtor will have an accident. If the debtor is poor, they will be forced to choose between not making loan payments and (for example) losing a leg to gangrene. If the debtor is rich, they will can pay both their loan payments and medical bills at the same time.
Loan A asks for 1000$ in total interest and has enforced payment which will prevent a poor debtor from paying their medical bills. Regardless, the creditor has priority in payment and receives their interest either way. Expected value to the bank: 1000$.
Loan B asks for 1010$ in total interest, but has a hardship forgiveness clause. There is a 0.1% chance that the creditor will lose 10000$, but no chance of the debtor losing a leg. Expected value to the bank: 1000$.
The bank is indifferent between the two loans, as both have the same expected return (lets ignore variance for now on the bank’s part; we can assume they deal in a large enough volume of loans or charge slightly more interest to compensate). The poor debtor prefers Loan B, as 10$ is a small price to pay for protection against crippling disability. The rich debtor prefers Loan A, as they do not want to pay 10$ to avoid a negative result which they are already protected against.
I don’t see any particular social problems arising from this situation. Do you?
I have a feeling you’re trying to reinvent the wheel. Bond insurance, as well as various forms of bond guarantees, exists and is used when it make sense. Junk bonds have a non-trivial risk of default (reflected in their yield), but are actively traded. Moreover, if you are talking about bespoke loans, their conditions are entirely determined by what’s in the contract, so there is nothing preventing the borrower from negotiating some appropriate “hardship” clause.
What do you want to make possible that is not possible now?
It’s not about possible vs impossible. Its about industrial and social standards.
If a private individual goes to a bank and asks to take out a loan, and then starts asking about the possibility of more forgiving terms in the case of a default, the bank suddenly becomes incredibly suspicious. Planning for unexpected emergencies is seen as admitting that you intend to default. As a result, banks largely don’t let people negotiate for generous debtor protection clauses, or, when they do, they only agree after incredibly punitive interest rates are agreed to. As a result, private individuals by and large just don’t ask for that sort of thing. It’s Not Done.
What I feel would be better is if creditors had a culture of less suspicion here. Debtor forgiveness clauses should be the default that a debtor opts out of with a bespoke loan exchange for a lowered interest rate rather than something they have to opt into if they’re allowed the option at all. A debtor arranging their affairs such that a sudden injury does not financially cripple them should become the new norm, not an example of unusual prudence. Likewise, a debtor asking to take on that risk in exchange for a lower rate should be by seen creditors as dangerously recklessness rather than as confident and therefore trustworthy.
A poor person comes to the bank and wants a loan. The bank judges them a high risk, and either declines to offer the loan or offers it at a high rate of interest.
No way of drawing up loan contracts differently can affect that basic relationship between the risk of a loan and its cost.
Banks are not charities. They provide a service in return for a profit. As with any business, they must make a profit on whatever service they provide, at least on average, or they will cease providing that service. Even if the bank were set up as a non-profit organisation for the good of its customers rather than its shareholders, it still has to have a business model that breaks even. Selling £10 for £5 is not a business model. Laws and regulations that make a business sell £10 for £5 result in the business ceasing, or changing its form to avoid the laws.
ETA:
I think the causality works the other way round. You can’t make up social rules and say “wouldn’t it be nice if people behaved like this?” That’s not to say that what we have at present is the only possibility, but one has to think about how an alternative would actually work, and not merely imagine happy faces.
FFS the bank makes a profit in every example provided. I don’t want to say that you obviously didn’t read the post, but I honestly can’t see any way you would come to post this comment otherwise.
Loans are a service. Loans with gentle defaults are a more desirable service. Those seeking loans would often purchase such services preferentially and at a profitable premium to the bank, if they were available or if asking for them were socially acceptable. Laws should be passed to encourage banks make such offers.
I don’t see why this would be so.
Consider the usual death spiral: the “gentle default” (GD) loans are more expensive than “normal” loans. This activates the self-selection bias—people with good credit will take “normal” loans and people which expect that their probability of default is high will take the GD loans. This makes the population of GD borrowers skewed towards high default rates. To compensate for this, the bank raises the rates on GD loans. This, in turn, reinforces the self-selection and the GD borrowers population becomes even more skewed towards high default. Rinse & repeat, crash & burn.
Besides, if you insist that this service would be profitable for the banks, why are they not offering it? The social conventions which prevent individuals from asking for these terms do not apply to banks—if this idea were good, they would take the initiative and create such a product.
Because you have chosen imaginary numbers to produce that result. But however the loan is structured, the bank must get its return or it will decline the business.
As Lumifer pointed out, you are proposing an insurance scheme against default. This is an existing structure, perhaps too much so. In the UK it is called Payment Protection Insurance. The problem with PPI is that it was sold under pressure to people who did not need it. The fallout from that has cost some banks billions, or rather, it has forced them to give back billions they should never have received. to the extent that a whole secondary form of dodgy business has sprung up to assist people in making claims for having been mis-sold these policies.
A poor person comes to LW and wants to post a laborious article. LW judges them a high risk, and either declines to post the article or offers it at a high rate of 2 Karma points. PS: Sorry to misuse your comment; it was the most recent one. ;)
Well, moral hazard is a thing. Besides, the borrower always has the option of bankruptcy. You’re talking about the situation when the debtor thinks he might not pay back the loan and not declare bankruptcy, right? I don’t see why the bank should be sympathetic.
I also have trouble imagining the situation you’re describing. Banks rarely lend money outright to individuals without any protection. The great majority of loans involve collateral—a house (in the case of a mortgage), a car (in the case of an auto loan), securities (in the case of the margin loan at the broker), etc. And in practice, if you default, the bank gets the collateral and that’s the end of it.
Given this, what kind of “debtor forgiveness clauses” do you have in mind and what protections against abuse will be there?
An example might be an auto loan with a clause that allows a debtor who is rendered unable to pay through no fault of their own (as judged by a court or other agreed upon mediator, for example) does not lose their car (the collateral) despite not being able to pay. And to compensate the bank for this low probability but high impact loss, they pay slightly higher interest rates.
So, this is basically mandatory partial insurance on loans? Economically this means (assuming your proposal is revenue-neutral for banks) forced wealth transfer from borrowers who were able to pay off the loans to borrowers who were not able to.
I don’t think it’s a terribad idea which will doom the Western civilization, but I don’t think it’s much good, either. You’re effectively setting up a “bankruptcy lite” regime where you still have to go to court and show that you’re destitute (“unable to pay”, so presumably you have no cash and nothing in your bank accounts), but if the court decides it was not your fault, you get to keep some of your assets. Meh.
You’ll also get a bunch of unintended consequences, as usual. Off the top of my head here are two:
If there is a significant chance the loan will be forgiven if the debtor has no money, banks will start to take credit scores seriously. People with a healthy bank account will be given loans, people who live paycheck to paycheck will be denied loans or charged exorbitant rates. There is no right to credit, and no right to low rates either. Make it too easy to default on a loan and the banks will react by just not giving loans to people likely to default.
Specifically with respect to auto loans, if there is a chance you won’t be able to get your collateral (the car) back, the banks will have incentives to find other ways to finance. For example, you can structure a lease with an option to buy at the end to be much like a car loan: make the monthly payments larger, make the residual value smaller, and it’s quite similar. But the crucial difference is that you can always repossess the leased car. Therefore under your proposed regime, leases will become more frequent.
I read them less as proposing it should be mandatory and more as proposing it should be opt-out. In a perfectly efficient market the latter would make no difference compared to opt-in, and in the real world it would move some trivial inconveniences around.
To quote from RichardKennaway’s comment
googles “Payment Protection Insurance” and educates self
The US might have a system where something like that happens but Europe generally doesn’t. You don’t need two types on lending in this case. You just need laws about enforcing loans that are written in the public interest as they are written in a country like Germany and not laws that are written by banking lobbyists.
This proposal is equivalent to just having society never forgive debts. If society doesn’t ever forgive debts, you can still do the equivalent to case 2 by simply writing a normal contract and adding a clause saying that the debt is cancelled under these conditions, then listing the same conditions that would cause society to cancel it under your proposal.
So we’ve already had this. It didn’t work well.
Nope, the second type is just a bond with an embedded option to not pay if you can convince the politicians you shouldn’t. I expect it to be very expensive :-/
As to never forgive debts, well, there is a reason for bankruptcy laws. Blood out of stone, and all that.
I do not think it would actually be the same in practice, due to coordination problems.
To make an analogy, consider unions: In theory, unions are unnecessary because the collective bargaining unions exist of facilitate can be undertaken without a formal structure. In practice, people will simply refuse to strike unless they have a strong, formal assurance that their fellow workers will follow through with their part of the strike. The same sort of situation exists for a hypothetical hardship forgiveness clause in a loan—creditors have every incentive to use their disproportionate negotiation position to deny all such clauses and debtors are in no position to boycott the creditors in response giving a lack of credibly coordinated collective action.
By making hardship forgiveness a standardized aspect of some classes of loans, you establish a Schelling point in loan negotiations—“I will not agree to any loan without the standard protections against unexpected hardships financially ruining me”—and frame the issue in the minds of consumers such that they are explicitly thinking of a generous default clause as a protection to them (which it is) and a lack of such a clause as a salient risk to their future finances (which it is).
tl;dr: It is currently possible to demand generous debt forgiveness clauses when asking for a loan, but creditors will not concede your demands if you do. Giving such clauses social and legal sanction and framing loans without such clauses as being very risky would encourage customers to negotiate collectively for such clauses where they would otherwise not do so.
If you do that you might end up simply shifting the bad thing that happens from being “someone doesn’t get paid back” to “someone doesn’t get a loan who needed one.”