Don't Demonize Debt

As Wall Street continues its slow-motion hari kari, tens of millions of people on the lower-end of the income spectrum are finding that their access to credit is becoming all but nonexistent. As banks set aside ever more cash to cover themselves against potential future losses, the credit spigot that flowed so promiscuously to riskier customers is now not flowing at all.

Even with the promising plan of the federal government to take the more toxic loans off of bank balance sheets and fold them into the so-called "bad bank," loans to the lower-end of the income spectrum are likely to be hard to come by and inordinately expensive. That is a problem that none of the current plans address and it is real one.

Just because people making under $30,000 a year tend to be at higher risk of defaulting doesn't mean that they should be denied access to vital credit. People at that income level represent as much as 40 percent of the country according to census data, and while granting someone with that income a $300,000 mortgage is absurd, so is granting them zero credit or credit at rates that would make a loan shark blush.

The experience of Grameen Bank, founded by Noble prize winner Muhammad Yunus in Bangladesh and now operates one branch in Queens, New York. A pioneer in microfinance, Grameen lends mostly to women, and in small amounts, but has a repayment rate that any commercial bank would envy. By maintaining close community ties and an on-going relationship between borrowers and lenders, the bank never forgets that one of the best risk controls is making sure that those who lend money have some direct relationship with those who borrow.

The experience of Grameen should be a reminder that credit is a vital source of economic activity and growth, especially for the less affluent. Demonizing credit creation because of prior lax standards risks an excessive caution against further debt, and that is exactly the wrong path. Debt is a powerful tool that can help generate robust activity is used and created wisely, just as it can be immensely destructive if allowed to spin out of control.

Technology can be used to create better risk controls, just as it was used to fashion quantitative models that would have made Pollyanna look like a sourpuss. Robert Shiller, the Yale economist has some novel ideas about how to use derivatives as a risk-management tool for the individual home-owner (for more on Shiller, see my piece on him here). Not all will agree with his ideas, but financial innovation can be a tool for greater prosperity - after all, once upon a time a mortgage was a new and untested innovation, and on the whole has been of more societal benefit than not, current morass notwithstanding.

Debt can be good, bad or indifferent. Denying it to a wide swath of society that can and does use it constructively is as distorted as the profligate dispersion of debt that we have just witnessed, and it will make it that much harder for millions of people who are determined to improve their lot in life. Finding the right balance between too much and too little is never easy, but replacing one extreme with another is no solution.

Comments

[mbaty]

One point that I think is very strong about this article is the advice that a good relationship between borrower and lender leads to most debts being repayed. However, that also brings in the notion of negotiation of repayment and respect of an individuals day-to-day livelihood. Can you imagine lending money to a friend and then asking for 20+% interest or tacking on strangely inflated "fees" for services that cost little to nothing like, "answering the phone, $10" I mean, this is the absurdity we at large have been dealing with for a while now, and it's really no surprise to many of us that the banks etc. are failing because of these shady, relatively immoral practices. We, speaking as the conglomerate consumer, will not be treated with such disrespect and still want to cooperate with those who will not negotiate. One persons beef may be with bank X, and then bank X wants to sell that "debt" to someone specializing in suing people for money, but the initial relationship wasn't dealt with, nor were the transactions that led to the default, particularly the transactions that any particular consumer is contesting. It's not that we the consuming and borrowing economy at large don't want to pay legitimate debts to those we owe, but we must have a voice in the way those debts are appraised, and there must be some compassion in the way those lenders deal with potential defaults, especially in these times.

[Crowhaul]

Instead of focusing so much on debt as the vehicle to obtain houses, cars, etc., we need to focus on reverting back to purchasing things with cash money.

This means buying things after saving for them.

This means buying what you can logically afford. It means that paying cash for a used car, instead of accepting additional debt for a new car, makes more sense.

What this also means -and this is the kicker - is that the credit-enabled overvaluation of things needs to fall to realistic levels: Small modest homes need to be priced at $50,000. Small, modest cars needs to be priced at $6,000 - $8,000. The insanity of instantly available credit that spawned ever-escalating pricing deserves to be well and truly over.

[WeTellTheTruth]

Some people just dont get the money thing.....­..

This writer does not get the money thing. Homeowners getting involved in derivitives? Are you kidding me ?

[Dystopic]

Where is the outrage against mortgage brokers? Alot of these borrowers went into their bank, tried to get a loan for $X, the bank tells them, you only qualify for $Y. The borrowers then goto the mortgage brokers, who tell them... not only can you get $X, you can alos have an additional $Z.

The brokers in a lot of cases will fake the documents, find a scummy appraiser to give them the value that the broker wants, and then gets the people the loan they cannot afford.

I am of the mind that if your bank tells you you can't afford what you want, then that's pretty good advice. Consumers who got into subprime mortgages are not sophisticated consumers, and were to a small degree taken advantage of because they did not understand what a subprime ARM is. They were told in alot of cases that "rates are only going down"...

When I got a loan on my home, I could have built a house twice the size, and probably could have continued to make the mortgage with no problems. I decided I didn't want to "work for my house", meaning that I could afford bigger, but will get a house that I am comfortable in, that I could make payments on if my situation changed.

There needs to be consumer education in the school system. Much like Home EC, with a focus on credit and financing.

[joebhed]

Debt-money is the problem.
Not credit or debt.

The difference is this.
With debt-money, ALL MONEY comes into existence as a debt.
It is a tool of the private bankers at the federal reserve banks.
It is not necessary.

If money were created debt-free, there would be no PAYBACK of that money and no interest to be paid on it.
AFTER that debt-free created money is in circulation, it MUST be deposited in a bank or credit union.
At that point it can be lent out.

The question is whether banks should be limited to lending real money, versus whether banks should be able to create ALL NEW MONEY as a debt in itself.

If you read the Volcker report, the national economic crisis is that we have an unaffordable DEBT-SERVICE-COST crisis.
We cannot create new debt-money fast enough to pay the interest on the debt-money already out there.
Read this 2-pager and understand "HOW Debt Money Goes Broke":
http://www.financialsense.com/fsu/editorials/2005/1212b.html

Debt is not the problem
Debt-money is the problem
It's the monetary system, folks.

[dnddays]

I agree debt is not the problem, it's the securitization of this debt with little to no regulations or enforcement. The banks behaved recklessly, unconcerned as to whether or not a borrower would repay, since they were just going to dump these securities onto someone else.