Thursday, January 7, 2010

Why strategic defaults will be good for loans sharks

Felix Salmon asks: Does predatory lending rise when other forms of credit contract. …I’m not at all convinced that tightening rules on credit has that effect. Indeed, it seems to me that payday lenders and the like positively thrived during the credit boom — much as India’s moneylenders have thrived and grown even as microfinance institutions in the country have done likewise.

So is there less predatory lending now, from loan sharks and payday lenders and the like, than there was in Damon Runyon’s day?

Firstly, I think predatory lenders thrive because there are bad credit people. People who go to predatory lenders are people shunned by banks, whether the economy is in credit expansion or contraction.

A credit contractionary environment isn’t necessarily what it takes to make them thrive (although in this environment, when many people are becoming worse credits, predatory lenders will thrive even more.)

Very usually, in a bad economy, people who otherwise may not need money, will find a need to borrow money because cash is running low (maybe they lost a job, or their livelihood is doing badly). Because people in this condition are now considered higher risk (whereas in a good economy, they may have had stable sources of income), people who absolutely need the money will go to alternative lenders. There are pawnshops and other various lenders who lend money on pawned collateral. They are not necessarily predatory lenders.

The worst credit people, however, the ones without collateral to pledge at all, are the ones who go to predatory lenders, the ones who charge loan shark rates. Loan sharks exist because they often are the only resort for people who have no other lifeline left.

That is why I am perplexed that Felix seems to be encouraging the notion of strategic defaults. If defaults become at all more common, it makes a whole bigger swathe of the population bad credit. The logical consequence will be that it won’t be long before we forever say good-bye to any notion of regular banks providing credit to anyone. This will be a bonanza for predatory lenders.

Those who do not have any assets, and absolutely need the money, will have no other choice but them. And if the notion of strategic defaults gathers steam, we will likely see a scenario of more defaults leading to more underwater mortgages leading to more defaults, which means more people needing money who have no assets of any value.

So I see a disjoint between him encouraging strategic defaults, and then wondering why we have a lot of loan sharks. A better way to fix the mess here.


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