Public's Appetite for New Subprime Credit Grows

In addition to official Government interest in seeing increased lending, some companies too want to increase the number of new sub-prime loans.

GM wants more subprime buyers; will lender agree? (AP)

Wait a second! Didn't we just finish a major part of a severe economic downdraft inspired by subprime credit? Aren't we still burdened with trillions of dollars of public debt directly related to the excesses of asset-based lenders who overextended themselves in taking on too much leverage in order to serve all debt markets, especially and including subprime? Isn't one of the lessons that should have been learned is that taking on too much debt, whether individual, corporation, or nation, a bad idea? Aren't people at this moment basking in their new-found frugalness, thanking God for the lessons they have learned, and feeling the benefits of increased rationality in their financial lives?

Aside from the normative statements we could make here, there are telltales to note. GM appears to have benefited as much as it can from the past year's recovery in the economy. Strumpf writes: ""There's a real sense of urgency on GM's part to maximize its sales" as it gets closer to the stock offering, said Kirk Ludtke, senior vice president of CRT Capital Group in Stamford, Conn."

Some possible conclusions to draw:

• negotiate hard on price if buying a GM vehicle; they really need the sale
  
• avoid buying shares of the IPO, if it occurs
  
• look for bank earnings to level off, as competition increases among lenders to make subprime loans
• in your macroeconomic models (you have one, right?), increase the probability of a new credit crisis occurring in 2010, 2011, or 2012
  

Commentators Exceed LATimes Columnist

Put this in the "measurements of quality" category. David Lazarus is a syndicated LA Times financial columnist. A recent 4/25/10 column on bank reform legislation made reference to "puppies and kittens." I went looking for other telltales, and found Bank of America yanks Countrywide Financial customers' credit lines.

What's interesting is that reader comments show more sobriety than the columnist's original prose. For example, KathyA says:

"Mr. Lazarus, you seem to want it both ways. In the past, you have (rightly) raked banks over the coals, especially Countrywide (now Bank of America), for risky financial decisions in mortgage lending. You can't expect to be taken seriously when you now criticize these same institutions for making fiscally conservative financial decisions."

Lazarus' complaint is that Bank of America has declined to renew home equity lines at the five-year mark, as the contracts issued by Countrywide permitted. His reaction, over the bank's failure to provide an explanation, seems puzzling. At least, until you draw an analogy of the bank as bartender and home owner as alcoholic. The alcoholic doesn't like being cut off, even if, or perhaps especially if, the reason for severing the drug supply is rational.

In summary, the problem, the way Lazarus has described it, is that Countrywide was a good co-dependent, and Bank of America is not behaving right as a co-dependent properly should.

Snicker snack!

Government Bailout Funds: 'Cause That's Where the Money Is!

I have to wonder, do people really think through their ideas, or are they just in love with the desired outcome? The most dangerous proposals are those where the real outcome is indeterminate but both sides imagine they will get what they want.

The thought that banks should be paying extra fees into a bailout fund so that Government can rescue them in the future is either wishful thinking or an extremely pernicious stab. Current legislation envisions a $50 billion fund created with taxes on financial institutions.

Where is the wishful thinking? The first wish is that $50 billion will be enough to ward off a future credit meltdown. The second, sneakier, wish is that the Government will have $50 billion it didn't have before.

Here is what will really happen: Willie Horton.

What? It is easy: A $50 billion pot of money will soon attract honey-seekers. The money will be there, tantalizing various special interests, seemingly doing nothing. Hence, it will not be in reserve for long. It will be transferred, borrowed, or stolen, for or by special interests via legislation, and will never be available for a bailout. Congressional action will loan it for other purposes. When a bailout really is required, the Government would then have to scrape up $50 billion from other accounts in order to effect the bailout, which will be that much harder to do.

Even worse, banks and financial institutions and their customers will believe that their actions are backed by a $50 billion bailout fund. Moral hazard will be increased, and many will act as though their actions are insured. Because, by gosh, they are insured. No illusions there, seriously! If that's what they've been told, in full faith, why shouldn't they believe it? You certainly can't blame them if they've paid insurance premiums under the impression that they are buying insurance.

The best argument for creating any sort of $50 billion is that it is a "rainy day fund." You save the money, just like an insurance company, against future hardship. The problem is that public finance has proven, over and over, that it an extremely poor steward of capital, and tends to overspend its budget, significantly and repeatedly.

Hence, the correct action to take is passing legislation that encourages the formation of private pools of capital that could intervene in the case of crisis. By encouraging private capital formation, the U.S. gets the benefit of rational self-interest, rewards the best stewards of capital in proportion to their skill, avoids the problems of attempting to retain and maintain public capital, obtains broad and powerful diversification across hundreds of thousands of small pools of capital, and generates a more powerful capital base from which to fund future technological investment.

What shape would such incentives have? The Government could buy special insurance, that would operate in two parts. First, it would pay a direct annual premium against failure of major financial institutions. Each capital pool owner would collect this premium from the Government in proportion to the amount of capital that they would guarantee as being available during a crisis. In the event of crisis, the claim is not for cash, it is for credit. That is, the insurance provider guarantees that they will make a loan available at a particular, contractually agree interest rate. For this loan, the Government also pays the interest. If the insurer is unable to make the loan, they would pay a penalty of multiples of the prior collected premium.

Direct cost to taxpayers of this system would be much lower. Annual premiums would be set by the market, of course, but since the insurer is only guaranteeing liquidity, they can invest their pool of capital elsewhere and still earn a return. The premium would be only a bonus. You can imagine that some of this capital would be in cash, money market funds, in deposits, and in stocks and bonds.

Obviously, the Government is not generating new capital when it makes a claim. Money moves as the insurers may be forced to liquidate stocks and bonds to post some of the claim. More importantly, though, a Government claim more likely forces highly liquid cash investments out of the hands of the insurer to the Government at exactly the time that a TARP-like rescue is required. It is during such crises that many private participants sit on cash hoards as a protection against uncertainty, so although the insurer may have less of a cushion than before, it is unlikely that such a capital claim will force down asset values. This system acts as a circuit breaker, forcing money back into circulation during a crisis when it is needed most.

The premiums paid by the Government could still come from premiums in turn paid by banks and major lending institutions. But such premiums would likely be much less, and the overall flow of funds would be less traumatic for all involved. Even better, the Government could still retain a fund of excess premiums it had collected, which presumably would vary but likely be much less than $50 billion. And there would be no public moral hazard to tap this Government slush fund.

[This post started May 12 and completed May 16.]

The Unintended Consequences of Unintended Consequences Articles

This is commentary on commentary. Actually, it should be "commentary on reporting," but the Forbes April 26 article "Careful What You Wish For" isn't really an article, it is opinion.

The idea behind the article is that current Congressional work on restricting banks' and financial companies' abilities to issue abusive debt to consumers will have unforeseen consequences that will impact the consumers in ways that the Government doesn't expect. This is a fine thesis, one that probably is even correct in the large, but the author fails to make his point in ways that really count.

The article has a whiny tone, the kind a liberal would expect a right-leaning article on consumer finance to have. Policy based on behavioral economics research is ridiculed as an "assumption." Phrases like "regulatory overreach," "furious new round of maneuvering," and "variety of dastardly practices" lay down a challenge to the reader, as though designed to stir a rebellion.

The article does admit that that "consumers do dumb things." But ultimately, this admission is drowned out by all the contention so that the article fails to score the direct hits that should have easy to come by. So since Forbes couldn't pull it off, here's my list:

- Some consumer financing products have drug-like qualities, with extremely high costs and the ability to addict some consumers to financing they don't understand.

- Some financial deals are made so complex that it is nearly impossible for even an educated consumer to find the implied interest rate. A perfect example are balance transfer offers at 5.99% with a 4% fee that have only a 6 month term. Most consumers don't realize that this "money saving offer" has an implied APR of 15.31%.

- When high-risk consumers are protected from high interest rates, banks will simply refuse to lend to them at all. Depending on your perspective, this could be exactly what should happen, or it could be a problem. After all, if a consumer always makes their borrowing decisions based on immediate gratification, then they are a terrible credit risk and perhaps they shouldn't be given credit at all. It isn't cruel; it's good parenting.

- Restrictions on pay day loans will cause an increase in illegal loan-sharking. If an instant-gratification-addicted consumer can't get a payday loan because they are illegal, they may turn to the black market for their financing. Prohibiting fringe behavior will drive it underground, where the dangers of non-payment are physical, not just fiscal.

- High interest rates are necessary where risk of default is very high. And some people are just really bad credit risks. They don't have the money, they don't intend to pay it back, or they just don't want to pay it. So credit grantors have lost more than $313 billion in the last decade, according to Forbes. Which means that the consumers "won" and the purportedly smarter banks got taken! So maybe financial regulation will protect the banks from themselves more than they protect consumers from themselves!

- The logical extension to protecting all of these bad banks and bad consumers from each other is that financial regulation will chill the credit market. I'm not sure that is a bad thing. It may be exactly what this country needs: A blast of ice water in the face that cools the prevalent idea that borrowing more than you make is a good idea. Perhaps forcing everyone to live a little closer to their actual production rate will pay huge dividends in moral values, savings rates, and set a better example for our children.

All in all, I think there were some valuable points to be made that were simply dropped on the floor. There is also a minor goof in the mortgage example in "Financial Foolishness" box.