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$.
The US might have a system where something like that happens but Europe generally doesn’t. You don’t need two types on lending in this case. You just need laws about enforcing loans that are written in the public interest as they are written in a country like Germany and not laws that are written by banking lobbyists.
It would? I don’t quite follow the question. Yes, the second type of loan would invariably have a higher interest rate. Let’s say there’s two loans for 10000$ 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.