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The New York Sun


Vilifying Lenders

September 18, 2007

By Edward Glaeser

Not so long ago, banks were routinely vilified for not lending to the less fortunate. Over the past 15 years, a revolution in credit has made it possible for millions of less wealthy Americans to borrow to buy a house or a car, or to go on vacation. The rise in subprime lending has made credit available to the many, not just the privileged few.

And so politicians now denounce the banking industry for lending to the less fortunate. Lenders that entrust their money to riskier borrowers are routinely called predators, as if velociraptors crowd creditors' cubicles. Presidential candidates promise to "combat" subprime lending, as if we need a war to ban loans to people without perfect credit scores. More worryingly, politicians have called for a moratorium on foreclosures, which would rewrite the rules of perfectly legal loans. This might help politicians look like they are doing something, but future borrowers will pay the price. Any response to the current crisis must recognize that to protect the rights of future borrowers, we must protect the rights of today's lenders.

Civilization has long vilified lenders; enforcing debt contracts is more the exception than the rule. Dante placed the usurers of Cahors in the same neighborhood of hell as the residents of Sodom. Exodus, Leviticus, and Deuteronomy each contain their own separate injunction against lending at interest. In one of the less coherent moments of the "Politics," Aristotle assaults charging interest. Martin Luther wanted to "put a bit in the mouth" of the Fuggers, the family banking dynasty. Europe's most powerful monarchs, like Philip II of Spain, routinely reneged on their debt. Expropriating lenders has been a favorite Marxist policy for generations.

While the spotty protection of creditor rights is bad news for less wealthy borrowers, it is a boon to social scientists who want to understand the economic impact of rule of law. A rich literature has used cross-national heterogeneity in legal systems to look at the impact of protecting creditors on the ability to borrow. In a recent paper, my colleague, Andrei Shleifer, examines a wide range of formal legal rules and the number of days it takes to enforce a simple debt contract across 129 countries. In the Netherlands, you can enforce a debt contract in 48 days. In Angola, debt enforcement takes almost three years. As it takes more days to enforce a debt contract, the share of private credit to GDP plummets. When countries improve creditor protection, private credit increases significantly.

As we respond to the current subprime mess, we need to follow the letter of the law, not the rhetoric of anti-banking populists. If lenders broke the law, then they should suffer the consequences. Foolish lenders that made foolish loans do not deserve a bailout. At the same time, we must not help distressed borrowers by expropriating law-abiding lenders.

To me, this suggests two courses of action towards the current foreclosure mess. First, we can consider small public grants to ease the distress of people who move because of a foreclosure. We should make sure that any recipient earns less than the national median and did not lie about his income on his mortgage application. Second, we should be open to regulatory changes that make it easier for bankers and lenders to renegotiate and avoid foreclosure. One possibility is for borrowers to move into shared appreciation mortgages that give bankers a share of future housing price appreciation in exchange for a lower interest rate.

Looking forward, we should mandate better disclosure forms that make the terms of a loan more obvious to everyone, but we should avoid laws that will enhance legal uncertainty facing lenders. For example, Senator Obama's Stop Fraud Act threatens lenders with up to 35 years of prison and $5 million fines if they use any "false or fraudulent pretenses, representations, or promises." Given the vagueness of the term "fraudulent pretenses," I would expect to see millions of borrowers use the threat of prison or the threat of a lawsuit to get out of paying back their mortgage. I would also expect to see lenders shun loans that can lead to such lawsuits. Perhaps, the law should be called the "Stop Credit Act." Senator Obama is on firmer ground in his calls for ex ante disclosure of a "home score" that will make it easier for borrowers to compare effective interest rates. The credit industry can be improved with clear ex ante rules, but vast ex post penalties based on vaguely defined misbehavior will make it much harder to borrow.

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