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Don founded Kamakura Corporation in April 1990 and currently serves as its chairman and chief executive officer where he focuses on enterprise wide risk management and modern credit risk technology. His primary financial consulting and research interests involve the practical application of leading edge financial theory to solve critical financial risk management problems. Don was elected to the 50 member RISK Magazine Hall of Fame in 2002 for his work at Kamakura. Read More

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Jun 24

Written by: Donald van Deventer
6/24/2009 9:51 PM 

The Reuters story on Elizabeth Warren’s comments can be found at this link:

http://www.reuters.com/article/newsOne/idUSTRE55M7CY20090624


Some would argue that protecting consumers from borrowing money that the consumers want to borrow has a lot in common with smoking.  As a child in the 1950s, I was fully aware that smoking causes cancer and that it was addictive.  For that reason, I have never smoked a single cigarette.  Tobacco clearly does more harm than “bad loans,” with 400,000 premature deaths a year estimated to come from smoking.  The government has been warning of the harmful effects of smoking for more than 50 years, but many people much younger than I am choose to smoke.  Why do we not (a) make tobacco illegal or (b) create a Consumer Anti-Tobacco Prevention Agency that intervenes so that consumers do not have the option to do something that is obviously “not in their best interest”?

Our recent blog post on risk management strategies for individual investors argued that if your income doesn’t rise and fall with interest rates, one should never borrow to buy a house using an adjustable rate loan.  If one thinks one can predict interest rates, we said, trade bond futures so your success or failure will stand-alone.  Just like smoking, we think it’s obvious that someone whose income has little upside is rolling the dice to buy a house with (take your pick) an adjustable rate mortgage, a pay option ARM, a “NINJA” loan (no income, no job, no assets), a liar loan, and so on.  Why do people do it?

We think there are really three classes of borrowers who take this risk.  The first class goes triple or nothing, buys three houses with 100% loan to value loans, rents them, and prays.  They know they are taking the risk, they know they can go bankrupt, they like the odds and they do it.  They also buy lottery tickets and don’t cry when they don’t win the lottery.  Should we stop consumers who want to do this from acting on their desires?  Don’t banks already have an incentive not to lend to consumers with such a high probability of default?  These are questions with easy answers.  The second class of borrowers takes on a risky loan structure because they really, truly believe that interest rates will move in their favor with such high probability that it’s impossible not to take the “small” risk that they will be wrong.  This people also do bungee jumping, because they think the rope won’t break, they won’t get whiplash, and there won’t be any rocks in the river below the bridge they jump off.  Should we keep these people from learning economics in an unforgettable way?  Again, the answer is obvious.

The third class of people literally doesn’t understand the risks they are taking by taking on a floating rate loan or an adjustable rate mortgage on a fixed income.  They have the same risk expertise as a series of CEOs at AIG.  These people need help because they really truly don’t understand that they are doing something dangerous.  At AIG, the solution is a stronger board of directors, like our blog post from earlier this week. For these unsophisticated retail borrowers, how should they be protected?  I’d argue that a “truth in lending” risk assessment would do the job and that existing government agencies already have similar responsibilities and can fill this gap.

Another view comes from DS, who argues that this issue has been dealt with in South Africa successfully already.  Here’s what he says in this note earlier today:

“Just some comments on The US Consumer Financial Protection Agency and the question "How can the US government fix dangerous borrowing by consumers if it hasn't convinced 20% of the population to stop smoking after 50 years?" (from www.twitter.com/dvandeventer)

“In my view, some of the major issues that have faced banks over the past few years are as follows:

  • Incomplete information about potential customers - not all financial information being disclosed in credit applications.
  • The advent of aggressive loan products including "stated income loans", "interest only mortgages", "negative amortization loans", "no down payment loans" and other loan types.
  • A significant increase in competition during a period of benign credit markets and continually increasing underlying asset values.
  • Pressure on production and loan book growth at the cost of risk management, especially during a period when asset values were increasing and bad debt levels were low, in many cases well below the long run or "through the cycle" average.
  • Insufficient investment in risk management systems.

“On piece of legislation that was introduced in South Africa was the National Credit Act.  Simplistically, The Act sought to protect consumers from the trappings of being granted too much credit.  The protection mechanism embedded within the Act is that financial institutions and other grantors of credit are required to assess a potential customer’s overall financial and debt position before approving a credit facility.  The onus on disclosure of facilities lies with the consumer, but the onus of assessment lies with the financial institution.

“From a credit manager's perspective, this is a very good piece of legislation as it requires the assessment of a customer’s overall circumstances, financial position and income before granting credit. Full disclosure of existing credit facilities enables a credit manager to assess the impact of the additional facility and enables the calculation of the impact of an interest rate increase on the customers overall debt service ability.

“There was some criticism from certain sectors when the legislation was passed.  However, this was primarily in the retail (motor vehicle finance etc) and property sectors who regarded the Act as having a negative impact on their businesses.  In effect, the Act probably did have somewhat of a negative effect on property and vehicle sales (et al) as customers’ financial statements were more thoroughly scrutinized making the obtaining of finance more difficult.  From my perspective, the negative impact would not have occurred if these standards had been in place prior to the legislation.  Effectively, those that qualified for finance were granted such finance, whilst those that did not, were declined.

“It will be interesting to see what changes occur in countries that have experienced unprecedented levels of retail consumer defaults.”

DS’s comments highlight two issues. The first is this: do financial institutions in the US have the ability to see the full extent of the consumer’s total borrowerings?  Perhaps unlike South Africa and Japan 20 years ago, the answer to this question is predominantly yes.  The obligation to assess the total risk of the borrower should be first and foremost in the mind of a US banker already. While securitization has distorted the incentives of loan originators in this regard, the blame for the result of that lies with the purchasers of securitized assets who didn’t do their homework.  The second issue is this: the heart of Elizabeth Warren’s advocacy seems to lie in slightly different areas than the South African experience.  The lender has the full picture of the borrower’s assets, income and liabilities.  The lender wants to lend, the borrower wants to borrow, but the borrowing has a high probability (perhaps priced appropriately from the lender’s point of view) of not being paid in full.  Should the Consumer Financial Protection Agency stop the borrower and lender from doing what these consenting adults want to do?  And should they stop the borrower and lender from smoking, skydiving, and riding motorcycles?  And is eating junk food ok? What about that second glass of wine?

DS, many thanks for your comments!

Comments welcome at info@kamakuraco.com with real time follow-up at www.twitter.com/dvandeventer

Donald R. van Deventer
Kamakura Corporation
June 26, 2009

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