April 25, 2016 By FTI Consulting
For at least as long as humans have been recording history, we’ve been borrowing from one another. And, even without the benefit of spreadsheets, financial models, and advice from our accountants, we’ve long understood that loaned money comes at a price.
The price of lent money, and the fairness of that price, has occupied us for millennia.
Usury laws are frequently cited as the one of the oldest known forms of financial regulation – they enjoy mention in the Old Testament and, for those willing to dig into potentially less familiar documentation, can be found in ancient Vedic texts dating to 2000 BC.
Historically, in civilizations both ancient and modern, as much as governments desire to see their constituents participate within regulated economic spheres (observable economic activity is taxable economic activity, a fact not lost on any governmental authority, ever) they have also sought to protect borrowers from predatory lenders for reasons moral, ethical, and economic.
While there is substantial room for reasonable people to disagree about what constitutes a “predatory” interest rate, at a certain point it is becomes a mathematical truism that rates can be so prohibitively high that the opportunity to repay the debt effectively ceases to exist. In a sense, one could argue that loans at these rates are not really loans at all, as they are being made without any meaningful expectation of repayment.
This is self-evident in the corporate credit markets, where there is no such thing as “corporate” usury laws. They don’t exist, because they simply aren’t necessary: at the institutional level, even in the riskiest debt markets, as interest rates move much beyond 15%, borrowers and lenders alike know companies are unlikely to survive this kind of interest burden without going bankrupt or having to dramatically restructure.
To this point, in the last three years, if we were to survey all corporate debt denominated in US dollars (well over 8,000 bond issues total) we would discover that the single highest coupon is 14.75%.
The US consumer, however, is not so lucky – there is almost no ceiling, regulatory or otherwise, on the interest rates that will be attached on the credit products they use every day to manage their finances.
Using my new home state as an example, currently in California, the maximum interest rate a loan may bear without being considered usurious is 10%. Beyond this amount, a lender may find themselves subject to both significant civil penalties and criminal liability.
But while the State of California would happily prosecute me for lending to my neighbor at a rate over 10% a quick survey of the terms of my credit cards, bank overdraft rates and fees, or for the less fortunate, fees paid to payday and other non-bank lenders, will reveal an astonishing range of interest rates beginning in the teens and making their way to almost 30%.
This is because California, as is true of most other states, exempt a host of providers of consumer credit from compliance with their usury laws, and notably, these providers are the very institutions that provide the average consumer with every one of their loans, credit cards, credit lines, and checking and savings accounts.
This is a fascinating disconnect.
Providing American consumers with access to credit is a national priority and has been for a century. The very fact that mortgage interest is deductible from income for federal tax purposes is one of the most transparent examples of public policy seeking to manipulate economic choices one could point to, not to mention the formation of multiple GSE’s to provide liquidity in the mortgage market.
The domestic economy is enormously sensitive to consumer behavior and activity, and so the federal government actively manages interest rates and money supply, attempting to moderate demand by tightening credit, or, as has been the case since 2008, to stoke demand by easing credit supply.
But the onset of the financial crisis of 2008 revealed significant structural weaknesses in the incumbent system of providing consumers with access to credit, while at the same time providing an opportunity for nontraditional, technology-driven competitors to suggest where the future of consumer credit may lie.
Given how critical access to consumer credit products not just to families looking to operate in the modern economy, but to the basic health of the national economy, it is well worth thinking carefully about the multiple, quiet revolutions taking place in credit that my dramatically alter the way in which credit is provided, and who will be providing it.
It can be fairly argued that “modern” consumer credit, as understood and practiced by lending industry incumbents, isn’t meaningfully modern. “Modern” consumer financing, the extension of credit to finance typical household purchases, funding retailers’ inventories, the ability to resell debt obligations, and the formation of specialty financing companies, all of these elements were in place at the turn of the 20th century.
Over time, the mainstream consumer finance business benefitted from the application of technology in that it is, ultimately, a data business. More data about more transactions could be accumulated, reported, analyzed, and distributed, and in a sense the business was able to industrialize itself.
Assembly lines formed. Consumers were analyzed and segmented by their relative risk. Based on this analysis, credit products could be offered to individuals in any particular risk segment. These loans (whether credit card balances, auto loans, mortgages, or other financings) were in turn pooled, securitized, tranched, rated, and sold by aggregators on to institutional investors.
Foundational this system, of course, is that the initial analysis of the risk that consumers might default on a given loan – the methodology of credit scoring – is accurate. The consequences of this are vast: from accurately understanding the risks of lending, to how credit products are priced, and whether or not credit is available to the appropriate people in the first place. There are huge cost implications to consumers, and huge costs for the economy.
A hard-won lesson of 2008 was that maybe it isn’t. More importantly, though, is to ask whether or not the data sets that have been relied on by the entire industry for decades to score credit risk can be relied on going forward.
That is to say, are we even asking the right questions in the first place?
A number of recent entrants in the consumer credit space are intent on demonstrating that the answer is no.
And if they’re right, it means that a key pillar of the national economy, which represents over $3.2 trillion in outstanding balances, is at best improperly understood.
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