June 23, 2024

The Correlation Between Incomes And Default Rates

The Marginalization Of Risk

The massive number of loan defaults that has put the entire banking industry on the brink on insolvency did not happen by accident.   Banks recklessly extended credit, even to low income borrowers who obviously had the least ability to service their debts.   What may have seemed like a virtuous circle of increased consumer consumption and  higher banking profits has turned into a debt disaster for both borrower and lender – consider the Democratization of Credit.

WSJ -The recession has forced a financial reckoning for Americans across the income spectrum. The pressure is especially acute for the low-income Americans who relied on borrowing for daily expenses or to gain the trappings of middle-class life. Shifting credit practices over several decades had enabled them to live beyond their means by borrowing nearly as readily as the more affluent.

But the financial crisis and recession have reversed what some economists dubbed the “democratization of credit,” forcing a tough adjustment on both low-income families and the businesses that serve them.

“We saw an extension of credit to a much deeper socioeconomic level, and they got access to the same credit instruments as middle-class and mainstream Americans,”…

The financial crisis has forced lenders to be especially cautious with the riskiest borrowers, a category that low-income families often fall into because their debt tends to be higher relative to income and assets.

Some are turning to wherever they can for credit. A publicly traded pawnshop chain, EZCorp., reported a 37% rise in revenue in the second quarter. “With credit limited and other options disappearing, there are people looking for somewhere they can get emergency cash,” said David Crume, president of the National Pawnbrokers Association.

Cash-strapped workers have long obtained advances through “payday loans,” available at storefront lenders for fees that equate to high annual interest rates. Even that move is not so easy now.

“More customers are walking in the door, but turndowns are up,” said Steven Schlein, a spokesman for the payday-loan industry’s trade group, the Community Financial Services Association of America.

The Journal article also includes a chart showing that the combined delinquency and default rate for lower income groups dramatically exceeds that of higher income groups.  Are lower income groups inherently a poorer credit risk or did lenders create the conditions for default by recklessly granting credit in excess of a borrower’s ability to repay?

The Journal article perhaps should have more appropriately been titled “the marginalization of risk”.   Banks failed miserably in executing their basic mission – lending prudently based on a borrower’s ability to service the debt.   Regulators failed miserably by allowing banks to make inherently unsound loans.  Did the bankers really believe the income numbers supplied by borrowers who “stated” their income?  What were the regulators thinking when they allowed banks to lend money without considering a borrower’s income, such as with “no doc” loans?

The long term adverse economic consequences of reckless lending are now obvious – the bigger tragedy is that it was allowed to happen in the first place.