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Adam Smith Warned Against Subprime Lending

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One benefit of performing research is picking up interesting trivia.

Adam Smith, in The Wealth of Nations, advocated usury laws (limits on interest rates) because they would promote lending to prudent borrowers and productive projects, which was better for society as a whole:

The legal rate…ought not be much above the lowest market rate. If the legal rate of interest in Great Britain, for example, was fixed so high as eight or ten per cent, the greater part of the money which was to be lent would be lent to prodigals and projectors [promoters of fraudulent schemes], who alone would be willing to give this high interest….A great part of the capital of the country would thus be kept out of the hands which were most likely to make a profitable and advantageous use of it, and thrown into those which were most likely to waste and destroy it.

When the legal rate of interest, on the contrary is fixed but a very little above the lowest market rate, sober people are universally preferred, as borrowers, to prodigals and projectors. The person who lends money gets nearly as much interest from the former as he dares to take from the latter, and his money is much safer in the hands of the one set of people than in those of the other. A great part of the capital of the country is thus thrown in the hands in which it is most likely to be employed with advantage.

Now before you say this approach discriminates against the poor, banks like ShoreBank of Chicago, and not for profit mortgage lenders extend credit to lower income individuals with loss rates in line with prime borrowers, It takes (gasp) borrower education and in person screening, something most banks eschew.

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18 comments

  1. Anonymous

    Let’s just settle for banks that can’t “buy” any loans, especially if the FDIC is going to guarantee the deposits at the same bank.

  2. CSTAR

    I’ve always thought a similar argument would apply to imposing some limits on compensation and in fact limits (albeit fairly wide ones) on prices for goods or services. I think one could even make a theoretical argument for this principle based on the assumptions needed to prove the basic optimality properties of “Debreuian” equilibria.

  3. Anonymous

    Precisely the argument made in an article published in the March edition of Harper’s. Relaxation of usury laws allowed banks to bloat their profits which, in turn, pulled money from more productive investments (industrial companies, etc.) into the financial industry.

  4. Nemo

    Wait, I thought the problem was too much leverage fueled by interest rates that were too low?

    Oh well, never mind. Usury is bad, so whatever went wrong that must have been the cause, don’t think too hard about it.

  5. ndk

    I read the original myself for kicks, and to have condensed his writing and sentences down to two paragraphs like this must’ve taken more heroic elipses than is immediately apparent. It puts the transition from our current communication forms to “micro-blogging” into some context.

    Incidentally, Smith considered himself a philosopher first and an economist second. He sought in his other major book, The Theory of Moral Sentiments, to explain generosity and kindness in a world of enlightened self-interest.

    Both the starting point and the methodology are very different from today’s economics, where we actively encourage people to eschew their moral sentiments, which are dismissed as counterproductive or dangerous.

    But to put a modern twist on the old moral sentiments, I’ve always felt our emotions and social mores are not arbitrary or happenstance; they’re a set of rules that nature designed over millions of years. I feel extremely queasy when anyone decries social fabrics and generally accepted rights, particularly out of reason and logic, because I can’t help but wonder whether we’re really so much smarter than our nature just yet. And, even if we were, we’re still bound by it.

    Wait, I thought the problem was too much leverage fueled by interest rates that were too low?

    Oh well, never mind. Usury is bad, so whatever went wrong that must have been the cause, don’t think too hard about it.

    I don’t believe for a moment that you’re puzzled by the distinction between the prime rate, leverage, and interest rate spreads, Nemo.

  6. Anonymous

    Let us see. I have an 800 FICO, Never missed a payment, zero balance yet a major bank just raised my credit card rate to 17%!!!!!

    Terminate the bankers. This is all to fund their bonuses, nothing more.

    I can think of no greater evil than these big banks. We keep them alive to torture us???

  7. Anonymous

    It is interesting to hear that Smith argued for usury laws as paternalism for the *lenders*, not the borrowers (as is usually argued), but there are so many problems with usury laws, I don’t think their benefits outweigh their costs. Debt booms are the price of a free society and a free economy. I’m not saying we shouldn’t regulate banks and insurers, but arbitrary caps on pricing are almost never a good solution for any market. Trying to use regulation to increase transparency and then letting competition reign strikes me as a much more efficient solution.

  8. Nemo

    I don’t believe for a moment that you’re puzzled by the distinction between the prime rate, leverage, and interest rate spreads, Nemo.

    I appreciate the sentiment.

    I am actually a proponent of anti-usury laws; I am just not convinced they would have made any difference in the current crisis. All those no-income-verification no-down-payment Option ARMs did not carry usurious rates by any reasonable definition of the word… The housing bubble got to the point where lenders were counting on home price appreciation and not the borrower’s willingness or ability to repay, and I do not see how anti-usury laws would even have slowed that down.

    The Harper’s piece was interesting, but I think it is another case of a guy who has had a particular axe to grind for decades and is now trying to use the crisis to publicize his cause. I happen to agree with his cause — 20% credit card offers and 200% payday loans are simply preying on the poor and stupid — but I am skeptical that this has any particular relation to the current crisis.

  9. Lord

    Access to credit is no benefit when paying for it impairs the future. Denial of credit is no loss when lending cannot be repaid.

    If only good lending was made, rates would have been even lower than they were. Bad lending was used to increase them above what they otherwise would have been. So, no, the problem was not low rates, but not low enough rates, not rates that could actually be repaid. Rates were in fact too high, rates that could never be repaid.

  10. albrt

    Actually, Nemo, most subprime loans were usurious, but the terms were disguised.

    The stereotypical subprime loan put a person in a house he or she could not afford using a prime credit 5% 30 year fixed rate loan.

    The subprime loan had a teaser rate of 2% and a permanent rate of 8%, and charged lots of fees up front, which were rolled into the principal, plus a large prepayment fee at the back end.

    The borrower cannot possibly pay 8%, so he or she MUST roll the loan in one year, thus incurring the prepayment fee plus new origination fees far exceeding the annual dollar cost of the nominal 8% permanent rate. All paid out to the bankers at the time of refinance and rolled into the new loan.

    Funny thing, though, when you lay it all out like that it becomes really obvious that this system could not possibly last more than 3 or 4 cycles. I wonder how all those ultra-smart, ivy league, New York bankers were fooled?

  11. ndk

    I am actually a proponent of anti-usury laws; I am just not convinced they would have made any difference in the current crisis. All those no-income-verification no-down-payment Option ARMs did not carry usurious rates by any reasonable definition of the word… The housing bubble got to the point where lenders were counting on home price appreciation and not the borrower’s willingness or ability to repay, and I do not see how anti-usury laws would even have slowed that down.

    Now that’s the Nemo we know and love. :D

    I don’t think anybody is making the argument that usury laws would’ve prevented this particular crisis, just that it’s an interesting anecdote coming from a father of capitalism from a different era. Egregious payday lending, as you point out, is the most gruesome example of such lending that is largely predatory and detrimental to society as a whole. I still can’t believe it’s legal, but I guess if it’s not above ground, it’s the loan sharks…

    It’s much more interesting and challenging to ponder how to bar banks from real estate speculation using us mirror-foggers as vehicles. In a sense, making secured loans against collateral they believe will be money good is kinda the entire goal. Seen any creative ideas you can point me to?

  12. Anonymous

    Nemo -

    I think its more to Smith’s point that banks will chase risk if it pays, and its important to put limits on that to make sure capital is distributed more wisely. That could be usury laws, or stringent accounting and regulated markets for derivatives.

  13. gregg

    I happened upon an article written by Martin Armstrong over the weekend (I’ve learned since he a bit of controversial figure). Anyway, he mentions the lifting of usury laws as one of the causes of our current problems:

    This Depression was set in motion by (1) excessive leverage by the banks once more, but (2) the lifting of usury laws back in 1980 to fight inflation that opened the door to the highest consumer interest rates in thousands of years and shifted spending that created jobs into the banks as interest on things like credit cards. As a percent of GDP, household debt doubled since 1980 making the banks rich and now the clear and present danger to our economic survival. A greater proportion of spending by the consumer that use to go to savings and creating jobs, goes to interest and that has undermined the ability to avoid a major economic melt-down.

  14. Anonymous

    Whether interest rate limits would have limited banks is questionable, as they are quite capable of charging low interest rates and high administration fees. It is interesting that this is yet another tidbit of information pointing to alarm bells ringing whilst approaching this debacle.
    If william black is to be believed then recent administrations have deliberately hindered any actions which could have addressed recent problems.Her are some quotes from William in an interview with Bill Moyers.


    The FBI publicly warned, in September 2004 that there was an epidemic of mortgage fraud, that if it was allowed to continue it would produce a crisis at least as large as the Savings and Loan debacle. And that they were going to make sure that they didn’t let that happen. The Justice Department transfers 500 white-collar specialists in the FBI to national terrorism but then, the Bush administration refused to replace the missing 500 agents.
    Brooksley Born a regulator tried to do the right thing to regulate one of these exotic derivatives that you’re talking about. We call them C.D.F.S. And Summers, Rubin, and Phil Gramm came together to say not only will we block this particular regulation. And it’s this type of derivative that is most involved in the AIG scandal.

    bill moyers interview

  15. Ken

    Oh, please. The banks aren’t profitable now, when they’re paying 0.1% on deposits and charging 22% on credit card loans. If you cut back the latter rate, they’ll all go under.

  16. Anonymous

    Many of the most important advances in our economy come from taking big risks. Think of an R&D company or a small business owner. Their future income stream is less certain, so a lender must be compensated with a higher rate. That doesn't mean that their economic contribution is less, we need people out there taking those chances.

    The other problem with usury laws is inflation and constantly changing interest rates. Fixed rate usury laws (which we use to have) become totally irrelevant when those things are volatile.

  17. Yves Smith

    Anon of 12:53 PM,

    R&D should not be funded by debt, period. Taking a loan means you need to pay interest on a regular basis. When will the R&D pay off? Years down the road, if ever. So the borrower either overborrows and pays interest out of his overfunding, or tries to become a Ponzi until (if he is lucky) his R&D pays off.

    The cash flow timing is too uncertain, and there is an open question as to whether the borrower can make good. The very fact that you suggest that R&D be funded by debt illustrates how our culture has grown accustomed to borrowing for uses that should be funded out of retained earnings or equity investors.

    As to a small business owner, if you look, the credit card lending to them has not been secured by the business, but by looking at their personal credit history, and the debt is guaranteed personally.

    And 9 out of 10 new businesses fail. They are not good risks. BTW, the traditional sources of funding for new businesses is owner savings, friends and family, and more recently, credit cards.

    Established businesses are a different story if the have a base level of predictable earnings or assets they can pledge.

    Usury rates could easily be set as a percentage over Treasuries. That is even how Smith expressed them, as a premium over the best borrowing rate.

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