Monday, September 07, 2015

"Loan fairness" as redistribution


I've noticed an interesting desire, especially on the political left, to want to use loans as a means of redistribution. The idea is that lenders should be willing to make loans to poor people when the risk-return tradeoff is worse than for loans to rich people. This could mean, for example, loaning money to high-default-risk poor borrowers at the same interest rate as to low-default-risk rich borrowers. Or it could mean extending loans to poor people whose perceived default risk would previously have prevented them from getting loans. The notion that this is "fair" - or that lenders "owe" it to poor people to give them favorable lending terms - pervades such works as David Graeber's Debt: The First 5000 Years.

A more recent example is Cathy O'Neil's recent post on Big Data and disparate impact in lending:
Did you hear about this recent story whereby Facebook just got a patent to measure someone’s creditworthiness by looking at who their friends are and what their credit scores are? They idea is, you are more likely to be able to pay back your loans if the people you’re friends with pay back their loans... 
[This] sounds like an unfair way to distribute loans... 
[In the neoliberal mindset], why would anyone want to loan money to a poor person? That wouldn’t make economic sense. Or, more relevantly, why would anyone not distinguish between a poor person and a rich person before making a loan? That’s the absolute heart of how the big data movement operates. Changing that would be like throwing away money. 
Since every interaction boils down to game theory and strategies for winning, “fairness” doesn’t come into the equation (note, the more equations the better!) of an individual’s striving for more opportunity and more money. Fairness isn’t even definable unless you give context, and context is exactly what this [neoliberal] mindset ignores. 
Here’s how I talk to someone when this subject comes up. I right away distinguish between the goal of the loaner – namely, accuracy and profit – and the goal of the public at large, namely that we have a reasonable financial system that doesn’t exacerbate the current inequalities or send people into debt spirals. This second goal has a lot to do with fairness and definitely pertains broadly to groups of people.
I don't get the random swipe at "equations", but the rest all seems pretty clear, even if it is couched in vague terms like "context", "reasonable", and "pertains broadly to groups of people". The basic idea is simple: Society is more fair when lenders give poor borrowers favorable terms relative to rich borrowers.

Let's think about this idea.

One problem with the idea would be that following it might force lenders to accept negative expected returns, which would drive them into bankruptcy. But let's assume for the moment that this doesn't happen - that lenders can lend to poor people and make lower, but still positive, profit margins overall. Loan "fairness" would then act as a subsidy from lenders to borrowers - a form of redistribution via a tax on loan-making businesses.

Another problem would be a more subtle version of the first problem - the implicit "fairness tax" on lenders might reduce the amount that they lend overall, and thus hurt the economy. This would be an example of the "leaky bucket" of taxation, in which we trade efficiency losses for welfare gains.

But let's ignore that issue. Let's think not about efficiency concerns, but only about the fairness of this type of redistribution.

Obviously fairness is a a matter of opinion, but there are some things we can clarify. Who are the recipients of "loan fairness" redistribution? Answer: Poor people who ask for loans.

Some poor people ask for loans because they have businesses to start, or for standard consumption-smoothing reasons. If these people are currently subject to borrowing constraints because of asymmetric information - in other words, if they can't get a loan because lenders don't realize they can and will pay it back - then these borrowing constraints will be ameliorated by "loan fairness" redistribution. That seems like a good (and fair) thing to me.

Other poor people ask for loans that they are unlikely to be able to pay back. This might be because they don't realize that their chances of repayment are low. Or it might be because they don't really intend to pay the loans back. Both of these groups of people will benefit from "loan fairness" redistribution.

One effect of implementing "loan fairness" redistribution would be an incentive for more people to join the latter group. Once poor people realize that society's desire for redistribution has given them the opportunity to get loans on more favorable terms, some poor people - it's not clear how many, but more than zero - will certainly take advantage of this by taking out a bunch of loans that they can't or don't intend to pay back.

A final group will be those poor people who don't ask for loans. Some will probably have ideas of morality that tell them to work hard, save money, and "neither a borrower nor a lender be". Others will think it unfair to request loans that they know they are unlikely to pay back. Others will simply not need to borrow that much. These groups of poor people will not benefit from "loan fairness" redistribution, because they will not ask for loans.

This introduces what I see as a source of unfairness. Poor people who are honest, and who refuse to borrow money that they know they can't pay back, will suffer compared to poor people who are dishonest and will just borrow as much as they can without any intention of returning the money. I think one could probably find some evidence of this kind of behavior among poor-country governments that borrow money and then ask for loan "forgiveness".

That seems clearly unfair. But there also seems to be another source of borderline unfairness here. Poor people whose moral values prevent them from asking for loans will be disadvantaged relative to poor people who have no moral problem asking for loans. Morality-based redistribution sounds a little iffy to me in the fairness department.

So purely in terms of the fairness of "loan fairness" redistribution - without even talking about efficiency concerns - I see some big problems with the idea of opportunistically redistributing money to only those poor people who are willing to walk into a lender's office and ask for a loan.

A more intuitively fair method of redistribution might simply be to tax rich people and give the money to poor people. Crazy idea, I know.

40 comments:

  1. Jesus man, just say #Uber4Welfare. Miles, Roger, Scott - in what world do there guys agree and you don't?

    More generally, you should always expect the actual workable wonk ideas to come from tech guys from now on. it's just how it is... You are gonna LOVE govwhiz

    ReplyDelete
    Replies
    1. Anonymous10:04 AM

      Isn't Uber for Welfare just a benefit and minimum wage cut disguised as a novel idea? At the very least, I'm not sure how an idea that cuts benefits can act as a redistribution scheme.

      Delete
  2. Maybe the random swipe at equations is an early example of antimathinessness.

    ReplyDelete
  3. I think your assumption that this proposal is primarily about poor people is incorrect. Although most certainly, it is about people who have poorer parents and thus less rich friends in their social networks, it isn't about people who are themselves what we would consider to be poor at the moment. After all, lenders can and do already easily discriminate against poor people by asking them about their income on the loan application right now today. So, in reality, this really has little or nothing to do with access to credit by the truly poor. They largely do not have access to credit on good terms now and they largely would not have access to credit on good terms if creditworthiness were based on social networks as an input. So access to credit by the truly poor would largely be unaffected by allowing social networks to be an input into credit decisions. The same can be said about the truly rich, who will continue to have access to credit on good terms.

    You talk about redistribution, and I think that is exactly the right word. But this is not about creating more redistribution from rich to poor like various government programs do, but instead preventing a new sort of redistribution from certain middle class people to other middle class people. Allowing social networks to be used in credit decisions would be a redistribution of wealth and power from middle class people who have poor social networks to middle class people who have rich social networks.

    If information about friends on social networks is useful to lenders, it is because it is measuring something useful that is not asked on standard loan applications and credit checks. There could be a couple of things.

    (1) While a standard credit check does tell us something about someone's wealth (i.e. whether they are a homeowner), this information is very incomplete. Considering social networks might be a proxy for wealth. If most of your Facebook friends are creditworthy people, probably you are wealthier. If you are not friends with such people, probably you are less wealthy. Since getting information on net worth is expensive and guessing about it based on social networks it cheap, this would be a rational thing for lenders to do.

    (2) The likelihood that if you end up having personal trouble paying your loans based on your individual attributes and accomplishments, that you will have family (most likely parents) and friends (much less likely) who are able to bail you out. (Whether your parents are willing, is another matter. But if they do not have the means, then it is completely out of the question.) So, assuming you are more likely to have friends with good credit ratings if your parents are well off, this would act primarily as a probabilistic measure of how likely your parents are to bail you out if you get into trouble, with the probability increasing the higher the quality of your social network.

    (To be continued...)

    ReplyDelete
    Replies
    1. I think allowing companies to get more information on factor 1 is fine, but I don't think it is a socially good thing if they go about doing this by guessing based on social networks for reasons I will discuss briefly later. Allowing companies to measure factor 2 is, I think, not a good thing at all if we believe that it is unfair for people to be judged based on who their parents happen to be rather than based on their individual accomplishments. Now, it is true that co-signing by parents is possible under the status quo and that, in reality, a lot of benefits are derived from the simple act of having the right parents. But existing unfairness is not a justification for making that source of unfairness even worse.

      But my final objection to allowing this idea is what I think is the most powerful. Here is a thought experiment. If people knew that who they allowed to be their friend on a social network was an input into their creditworthiness, what would happen? I think quite predictably, people would dump their friends who they perceived to be poor while seeking out more friends who are perceived to be creditworthy. In other words, it would give people a very concrete economic incentive to seek to associate with those that are economically well off and disassociate with people who are doing less well. Granted, some people behave like this already. But I think having more people behave in such a manner would be a very bad thing and would have much deeper social implications than the loans in question.

      Delete
    2. Anonymous8:17 PM

      I think O'Neil's post kind of jumps from one to the other. She starts off discussing those who are friends with poorer people. (I think that's a fair criticism on fairness grounds; why should someone who escaped poverty and is on solid ground pay more just because they don't want to jettison old friends who are less well off? And it's a good example of 'exacerbating current inequalities' -- one more roadblock for those in poorer neighborhoods.) But the latter part of her post generalizes out of this into the question of simply loaning to poor people, which is more problematic.

      I don't get the "equations" thing. It's a blog called "Math Babe," after all. Plus, I never saw game theory as being overburdened with equations. Not sure that's really what she's thinking of.

      About your last point, maybe there's a business opportunity, a rent-a-rich-friend type of thing. Legal Tinder?

      Delete
  4. I think the idea is that poor people who are more likely to take out loans are somehow more worthy of aid than people who don't, either due to their taking out loans as a result of desperation or as a result of trying to actively better themselves (or both!). Also, poor people who take out loans are still poor people, so even if the redistribution isn't perfect, the idea is there's at least some redistribution being done.

    Good post, though. Excellent for this blog.

    ReplyDelete
  5. I read Cathy's post.
    I didn't read all of yours because into the pea brain popped the words, "Redlining".

    ReplyDelete
    Replies
    1. I thought of "redlining" also. I'm sure the banks argue that being forced by the government to make loans they don't want to cuts into their profits.

      But then they'll make all sorts of crazy loans to other banks who are making crazy leveraged bets on mortgage backed securities and the housing bubble.

      They'll give loans to Donald Trump even though he's been in bankruptcy before.

      Agree that there are better forms of redistribution but still.

      Delete
    2. I strongly doubt redlining is a significant issue. Banks want to make money. Arbitrariness in lending decisions cuts into the bottom line.

      "But then they'll make all sorts of crazy loans to other banks who are making crazy leveraged bets on mortgage backed securities and the housing bubble."

      -And then they become one of the 100-something banks that go bankrupt in 2006-11. Not fun.

      Delete
  6. Okay, let's talk about the non-theoretical - mortgages. Banks have been pressured since the 1990's to make more loans to poor people. Does that help or hurt the poor?

    Factoids

    1) Loans to under-qualified-by-normal-lending-standards home buyers are not distributed randomly, they tend to cluster in the least expensive - poorest - neighborhoods.

    2) The U.S. has a real estate boom and bust roughly every 10 years.

    Having a lot of people buy homes in your neighborhood should scare the hell out of you because that means in the next real estate bust your neighborhood will have more foreclosures than otherwise and home prices will fall more in your neighborhood than if all home buyers had been fully qualified.

    In the poorest zip codes in Phoenix, for example, home prices fell 80% during the real estate bust. It's insane! 80%!

    The lower lending standards for the poor caused prices to increase in poor neighborhoods more than otherwise during the boom and fall far more than otherwise during the bust.

    I wonder how many poor homeowners ended up far worse off buying a home than they would have been renting instead. These housing programs add instability to the net worth of the poor.

    If the poor had to meet market lending guidelines, 1) the poor would take longer to qualify for home loans, 2) but their likelihood for long-term home-ownership and, more importantly, long-term economic success would be a lot higher.

    ReplyDelete
    Replies
    1. Having a lot of UNDER-QUALIFIED people buy homes in your neighborhood...

      Delete
    2. The housing bust wasn't mostly subprime. This is a myth.

      Still because of the downturn and housing bust, many people lost their jobs through no fault of their own. It was "involuntary unemployment."

      And then they couldn't pay their debts. But that context doesn't matter to the cold equations of the banks.

      The banks themselves were bailout out and subsidized with low interest loans. Unfair redistribution upwards.

      Delete
    3. Anonymous12:11 PM

      Waah, waah, waah! Evil mean banks making people take out loans! And insisting on pricing them appropriately! Bring out the pliers and let's get medieval on them! Waah! Waah!

      Delete
  7. Very one sided. Some on the left think the poor deserve lower relative rates than they receive. Some on the right think lenders should be able to lend to the poor at any rate even when there is little to no chance of repayment. Why would a lender do so? When they expect to gain a sufficiently high return and/or collect enough on collateral to profit on it even when it eventually defaults. Some of us believe we should neither subsidize such loans nor allow them to be made. The right proclaims that will harm those willing to grant and accept them. The left asserts the harm caused by such loans exceeds that from granting them, only delaying the inevitable, increasing the damage, worsening inequality and social welfare.

    ReplyDelete
    Replies
    1. And some on the right support such lending to profit from it themselves, redistributing upward, and some support it to resist those very calls for redistribution.

      Delete
  8. Anonymous11:25 PM

    I am always disappointed with Cathy O'Neal's 'wonk' posts. She seems like a good mathematician/'big dataist' but once she ventures off that path she sinks in the path of a sophomore college sociology course. Lots of good feeling, little in terms of the logistics.

    ReplyDelete
  9. What does redistribution have to do with fairness? Don't see any connection.

    ReplyDelete
  10. I don't think O'Neill is really saying "We should lend more to the poor even if they're a higher credit risk and it entails greater losses". Rather, she's trying to portray it as a "win-win" - say that we should regulate the lending system to ensure more justice, while also thinking this is better because good borrowers are being excluded due to racism/sexism/etc. "Those bankers are irrationally discriminating against black customers because racism".

    ReplyDelete
  11. What about student loans? Democrats like Elizabeth Warren wanted to lower the rates the loan companies were making money off of, while Republicans didn't.

    ReplyDelete
  12. Disparate impact cases take into account legitimate credit criterion, like credit score and debt-to-income ratios. To show disparate impact the lender has to be doing something that tars good and bad credit risks with the same broad brush. The credit-worthiness of your Facebook friends would be an example of precisely that. Your Facebook friends’ probability of repayment is not a legitimate credit criterion because it is not something you have direct control over. If you build your prejudice into an algorithm it you don’t get to say, “I’m not doing it, the computer is doing it.” Algorithms shouldn’t automatically get a pass. That is the point of disparate impact -- the people discriminating are doing something that is impacting people differently, beyond that which can be explained by business justifications. It is a side effect and may not be something they are aware of.

    ReplyDelete
  13. Anonymous1:57 PM

    We can, of course,make this primarily about wealthy people. There is likely to be a selection bias by wealth: if you have ample current cash flow, there is seldom a reason to take out a loan. You're only reason to do so is to be able to declare bankruptcy in the form of a small company (see Trump, Donald).

    This was the old model of South Shore Bank: the wealthy often should be charged higher risk premiums and the poor often are more dependable and should pay lower risk premiums, and the disparity between actual risk and perceived risk is a political and not strictly risk-based assessment.

    ReplyDelete
    Replies
    1. Are you kidding me? Your first paragraph is just flat out wrong.

      From your second, I'd love to hear your definition of "often."

      Delete
  14. Anonymous11:17 PM

    A world run by actuaries will fail quickly.

    It will blow up in a fit of rage all at once. Because actuarial predictions carry positive feedback.

    ReplyDelete
    Replies
    1. Anonymous11:26 PM

      This probably blows right over the head of almost anyone interested in the technical aspects of this blog. Why?

      Humans are natural actuaries. The behavior is built into our psychological interactions.

      This explains a lot of human behavior, such as putting people on pedestals and admonishing those who have already been over admonished.

      However, humans have a counter acting force that tries to find a reason to ignore actuarial reality, and this is the saving grace of humanity in general.

      Actuarially, nuclear war should have happened already. But we don't want it to happen, so we've acted accordingly.

      Using Facebook for actuarial calculations is not fair or unfair, it will be deadly. Perhaps totally destructive. Mark my words.

      Delete
    2. Anonymous12:14 PM

      Does your tinfoil hat burn your scalp in the sun? Or do you solve that problem by remaining in your mom's basement all day?

      Delete
  15. Anonymous11:58 PM

    Actuarially-positive feedback is not an effective way to fight poverty, however. Being more generous with student loans is a good thing right now, because so many people are over indebted, but it wasn't a good thing when it replaced other forms of financial assistance.

    The worst possible policy in this respect was making student loans immune to bankruptcy. What a stupid idea! Really stupid!

    Taxing the rich and giving to the poor is not just superior to loan-based solutions, it actually works, while there's little evidence that the alternative works well in aggregate.

    As for Warren's proposal to lower student loan rates, it was a proposal for existing loans if I'm not mistaken. For new loans, I'm not in favor, but for existing loans? Of course! If I could wave a wand, I'd mark all existing student loans to zero interest.

    And no, I don't have any of these loans and nobody I'm really close to does either. This is purely an ethically-based economic idea, and it is the perfect idea for policy. I admire Warren for suggesting something like this (her suggestion was not quite so extreme).

    ReplyDelete
  16. Anonymous12:04 AM

    By the way, the reason I rarely ever post comments on a blog anymore is that it is obvious that few people want to engage in conversation, or if they do, they just aren't on the same page. It is only really effective as a means of communicating with the blog owner.

    ReplyDelete
  17. Anonymous4:10 AM

    The word you are looking for is cross subsidy

    ReplyDelete

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  24. Omg somebody make him stop. Or preferably, go away.

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  25. This issue tends to go in cycles. Before the housing bubble, there was a big push for low-income lending from HUD to Fannie/Freddie.

    There is a lot of cognitive dissonance on the left on this issue. There is also a big push to crack down on "abusive" payday lenders. "The poor" seems to use payday lending primarily for liquor purchases (http://economistsview.typepad.com/economistsview/2015/08/the-effect-of-payday-lending-restrictions-on-liquor-sales.html also http://dealbook.nytimes.com/2014/12/25/dipping-into-auto-equity-devastates-many-borrowers/)

    So, "fairness" really seems to mean "lending" for an "approved" purpose, like a car or house. Unless you borrow more than you can afford for the car or house, in which case the left also wants to crack down on Subprime! Lending.

    So, the left wants to crack down on borrowers making bad financial decisions, while also making sure they have access to loans (at below the rate which would compensate the lender for the probability of default - e.g. at a subsidized rate).

    I am 100% in favor of eliminating "deceptive" lending and fees, but the current regulatory environment is driven by two contradictory objectives: Using banks/lenders as enforcers of "good" "approved" behavior while at the same same subsidizing access to low income loans. Sure, you can "incent" good behavior, but you cannot 100% eliminate bad behavior, and a lender is not the appropriate way to do that (truly bad behavior like borrowing for alcohol or drugs by someone with a real addiction just gets driven underground). And, subsidizing low-income loans will cause some bad behavior (because: some people are poor because they make repeated bad financial decisions).

    Here is a somewhat different idea: If the goal is to make sure poor people have access to affordable stuff (cars, houses), make it so that those things can be built cheaper. Cheaper lending does not really fix the affordable stuff problem. If the goal is to get people to make smarter financial decisions, subsidize access to financial advice, and promote education in high school (also access to addiction treatment). Restrictions on lending does not fix the bad decisions problem either.


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    C.E.O---

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  28. 1. Its not clear to me, how not paying the loan back is a great deal for anybody (including the person not paying the loan back - presumably they will be now blacklisted from future loans). Or is some sort of debt forgiveness part of the deal?
    2. Yes, on the general point, I think proper redistribution is better than hidden redistribution (not least because a proper redistribution - which means to me a basic income sort of policy - increases the ability to take out and pay back normal loans).

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