Dienstag, März 10, 2009

Redlining, Subprimes and Irony...

Oh the irony.

Let's step back and repeat something I've touched upon here.

Let's go back to the establishment of the subprimes.

Back in the 1960s, you had a generation of people who seem determined to find where the wrongs in society were and to correct them. Yound, idealistic, some did some good things.

Others, well intentioned, did some awful things.

For those who decided to get involved in local community politics, the asked why some areas were blighted, apparently permanently so, whilst other areas with not dissimilar incomes thrived and did well. It's a sociological problem, one of urban development, and at least some found out, by asking people living in those areas, what a partial reason for this was: it is called redlining.

Simply put, redlining means that a bank or other lender simply decides that a geographic area - outlined in red on a map, hence the term - was fundamentally a high-risk area and that the bank either would simply not make loans to that area or, if loans were to be made, these loans would command a significant risk factor. While this is fairly sound commercial practice, it was interpreted as how capitalism was exploiting the poor, either refusing them access to capital or, even worse, punishing them for being poor by raising their costs. It's the same reason that you don't find the best stores in low-income neighborhoods: risk is greater there for theft and vandalism, which reduces the potential profit to be made, and stores operating there tend to be higher priced and lower quality (since things are going to be damaged, no sense in investing in something of higher quality when it will be vandalized). These are legitimate commercial decisions, but are, of course, politically distasteful.

Hence the Community Reinvestment Act, the original one: it made redlining very difficult. It didn't stop it, since the banks continue to do geographical analysis to determine which areas are in demand and which ones aren't, which areas are perhaps underpriced and could be targeted for development work, and other commercial considerations based on physical location.

Redlining was generally condemned and amongst the activist left actively demonized.

Which is why this from the WSJ is so wonderfully, wonderfully ironic.

Redlining back in the 1960s had everything to do with the ethnic makeup of neighborhoods and with mortgages, i.e. long-term financial investments. Yes, there was a time when mortgages really were considered to be long-term investments.

Now let's pop back to the current day: redlining is back, back big, and is, just as it was back then, a commercial consideration that has real repercussions.

But now it's not mortgages, but credit card lines of credit. Not debt as such: lines of credit:

...home price depreciation has been a more reliable determinant of consumer behavior than FICO scores. Hence, lenders have reduced credit lines based upon "zip codes," or where home price depreciation has been most acute. Such a strategy carries the obvious hazard of putting good customers in more vulnerable liquidity positions simply because they live in a higher risk zip code. With this, frequency of default is increased. In other words, as lines are pulled and borrowing capacity is reduced, paying borrowers are pushed into vulnerable financial positions along with nonpaying borrowers, and therefore a greater number of defaults in fact occur.

Welcome to the brave new world of redlining: zip code redlining for credit lines of risk.

What are the implications for this?

And fourth, along with many important and necessary mandates regarding fairness to consumers, impending changes to Unfair and Deceptive Acts or Practices (UDAP) regulations risk the very real unintended consequence of cutting off vast amounts of credit to consumers. Specifically, the new UDAP provisions would restrict repricing of risk, which could in turn restrict the availability of credit. If a lender cannot reprice for changing risk on an unsecured loan, the lender simply will not make the loan. This proposal is set to be effective by mid-2010, but talk now is of accelerating its adoption date. Politicians and regulators need to seriously consider what unintended consequences could occur from the implementation of this proposal in current form. Short of the U.S. government becoming a direct credit-card lender, invariably credit will come out of the system.

Lovely: Washington is interfering with the markets once again. The article is complete accurate: if risks cannot be repriced, then there will be no money lent. Period.

Over the past 20 years, Americans have also grown to use their credit card as a cash-flow management tool. For example, 90% of credit-card users revolve a balance (i.e., don't pay it off in full) at least once a year, and over 45% of credit-card users revolve every month. Undeniably, consumers look at their unused credit balances as a "what if" reserve. "What if" my kid needs braces? "What if" my dog gets sick? "What if" I lose one of my jobs? This unused credit portion has grown to be relied on as a source of liquidity and a liquidity management tool for many U.S. consumers. In fact, a relatively small portion of U.S. consumers have actually maxed out their credit cards, and most currently have ample room to spare on their unused credit lines. For example, the industry credit line utilization rate (or percentage of total credit lines outstanding drawn upon) was just 17% at the end of 2008. However, this is in the process of changing dramatically.

Without doubt, credit was extended too freely over the past 15 years, and a rationalization of lending is unavoidable. What is avoidable, however, is taking credit away from people who have the ability to pay their bills. If credit is taken away from what otherwise is an able borrower, that borrower's financial position weakens considerably. With two-thirds of the U.S. economy dependent upon consumer spending, we should tread carefully and act collectively.

Amen to that.

What is happening here? Simple: the bankers/credit card companies are commercial entities that must manage their risk. If risks cannot be repriced - which is, fundamentally, what happened with the subprimes - then these entities will not be interested in taking those risks on: you can't blame them for that.

In the interest of protecting consumers from having changes in their risk profile result in higher risk premiums, the government - in its infinite wisdom - is going to stop those who carry the risk from charging higher risk premiums.

Which will throttle the credit card system.

Which will reduce liquidity for the individual consumer.

Which will move us closer and closer to a cash society, one that lives not on a leveraged cash flow, but only on the cash flow. No more using your credit card for large purchases: save up and pay cash. No more using your line of credit as a puffer zone for unexpected large expenses: better have that money saved up and put in some sort of fast-access short-term account. No longer can you simply drive to the airport and get on the next plane on a Saturday evening if you receive news that a loved one is dying and you need to get there before they die: wait until the banks are open (because you can't get the amount of money you need from your ATM).

No more using your line of credit as a deposit for renting cars, or to avoid the risks of carrying large amounts of cash for a long trip. Unless, of course, you have a job earning a salary in the top 5%, have no outstanding loans, have a proven track record of repaying loans, and really don't need it in the first place.

Talk about unintended consequences: a progressive policy, aimed at protecting consumers from those evil and nasty commercial companies who just want to rip them off, has the effect of forcing all of us to become financial ... conservatives.

Oh, the irony.

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