Necessary Roughness

CBS News reports that “lenders who handed out billions of dollars in loans failed, 85 percent of the time, to document that recipients were actually hurt by the terrorism attacks and therefore eligible for the aid under the law.”

Consider the natural state of things for a second. If the government didn’t back loans, would we still have loans? Absolutely! If you personally loan money to someone, you may not charge interest, but you expect to get the money back. You make a risk assessment of the person getting your money, usually based on your knowledge of that person’s behavior. If you lose your money, you may be angry and give them grief about it, but you wouldn’t be stupid enough to loan them more cash than what you need. The consequences are minor.

Banks only have the banking history of their customers, or if someone is new, they make the lendee co-sign with someone they have a history on. They make a risk assessment either on the lendee or the co-signer. If their money doesn’t come back, they go out of business. The consequence is basically a death penalty for the bank. They have incentive to spend their money to hire statisticians (actuaries) to find the people most likely to pay them the money back, with interest. It’s either that, or become the second coming of J. Edgar Hoover, and that’s expensive too.

Would banks have made loans after 9/11? Of course! The risk assessment would have changed some, surely, because a couple of towers worth of collateral and records had been destroyed. But when the government comes and says, “We’ll back the loan. We’ll be the co-signer,” things change. The bank has no death-penalty incentive to assess risk when passing out loans. The bank is free to give out money to whomever and just demand what doesn’t get paid back by lendees from the government. A normal co-signer has incentive to make sure the lendee pays up, because they will be sued if not. Not so with the Feds. In addition to not having to worry about going out of business, the bureaucracy measures success by how many people use its “service”, not by whether it gets the money back.

With the bank’s incentive to check gone and the co-signer/government’s incentive to check also gone, this 85% default rate—kiss that money of ours goodbye—should not be news to anyone. What should be news is that we have legislators and executives who couldn’t apply basic incentive analysis to see this would happen. I expect this level of performance or worse to come from the government-backed loans of Ohio’s State Issue 1 from the previous election.