The harmful economics of usury laws: usury laws, regardless of their form, hurt consumers rather than protect them. By studying the Italian mortgage market, we see how any form of price controls is harmful to a society seeking to foster homeownership.
The basis of usury laws in mortgage markets
Price controls are an easy solution to a variety of economic and social problems--so easy that governments have turned to price controls since ancient times. The Old Testament deplores interest on any loans, based on the principle that charging interest constitutes abuse of the less-privileged.
Plato, too, condemned charging interest because it would produce and exacerbate disparity in the distribution of wealth, eventually destroying the stability of a society. Plato advocated protection of citizens against lenders--an argument that still makes its way into the contemporary discussion of consumer credit.
Roman society was one of the first to recognize and regulate the practice of charging interest, setting maximum rates for a variety of loans in tacit acknowledgment of the possibility of exploitation. Throughout much of Western history, governments have indeed felt it was important to restrict lenders, especially with respect to interest rates.
On various grounds--be they religious, political, philosophical or a mix of all these--government interference in credit markets has been even more pronounced than its attempts to control prices of commodities such as oil.
Although protection of the society's most vulnerable consumers appears to be one of the most noble and ethical purposes of government, economists nonetheless generally oppose price controls in any form. Economically speaking, the only meaningful purpose of usury laws is to protect the individual forced by desperation to borrow in a monopoly market--as in the case of regulating the price of bread in ancient times.
And despite the frequent use throughout history of price controls and usury laws, competitive markets have shown time and again that price ceilings cause shortages of supply and distort the allocation of resources. The mortgage lending sector is no different than that of bakers selling bread; the same laws of economics apply.
As individual consumers, when we purchase credit we do not want to pay more interest than necessary. Whether applying for a credit card or financing a new car or house, we want to pay the lowest price (i.e., interest rate) possible, just as with any other purchase. Price ceilings in financial services confine credit flow and ration customers out of the market, as can be seen in the consequences of poor risk management.
In the United States, for example, responding to a quick runup in mortgage interest rates in the late 1980s, the government pre-empted most state usury laws for first-lien mortgage loans. Nonetheless, 15 states controlled mortgage usury caps by overriding the federal pre-emption act of 1980. Most states followed Massachusetts or the District of Columbia, restricting interest rates solely on second-mortgage loans.
In January of last year, the Office of the Comptroller of the Currency (OCC) pre-empted state usury laws again in order to preserve its appropriate oversight over national banks in the instance of high-cost loans. Usury laws are still a considerable part of the American regulatory landscape, even though price controls are no longer the leading method of consumer protection in the U.S. mortgage market.
Regulation of Subprime Mortgage Products: An Analysis of North Carolina's Predatory Lending Law, a study on the subprime mortgage market in North Carolina conducted in 2002 by Gregory Elliehausen and Michael Staten for Washington, D.C.-based Georgetown University's Credit Research Center at the McDonough School of Business, identified a significant reduction in lending due to usury laws directed at predatory lending. Overall, the number of subprime mortgage originations declined 14 percent after the stealth usury law took effect in North Carolina. Even more drastically, first mortgages to lower-income borrowers declined 27 percent. Further research is needed to comprehend the full impact of usury laws directed at predatory lending in America's mortgage market.
The economics of usury laws
In economic theory, the mortgage market functions like any other market. The credit volume offered in the market will be a function both of buyers' willingness to buy (demand) and of sellers' willingness to sell financial services (supply).
In a competitive market, as borrowers compete for a limited supply of credit, they bid up prices and consequently drive up the interest rate. If you have doubts about the existence of constraints in the supply of credit, listen to Federal Reserve Chairman Alan Greenspan's recent recommendation to curb Fannie Mae's and Freddie Mac's asset growth. As prices increase, banks want to profit by offering more credit, thus increasing supply and helping to satisfy demand. This game of bidding prices up and down and increasing or decreasing volume of credit continues until borrowers and lenders eventually establish an equilibrium price, which balances the two factors of supply and demand.
When a usury law is introduced to this equation, it may have no impact on the credit market--or it may alter fundamentally the way in which price and supply are determined. Governments may set usury law rates above or below the market equilibrium, making price controls respectively ineffective or effective: ineffective if the regulation has no impact on the market price, effective if controls result in altering market prices from the level they would find in a free market.
An effective ceiling obviously alters the price of credit--the highest permissible rate becomes the rate of interest charged. Establishing a below-market interest rate by means of a usury ceiling will also bring about a decrease in the quantity of credit supplied. Factoring in lenders' costs, it is evident that when the interest rate is artificially held down, the amount of credit lenders' supply will be limited.
Nevertheless, the market will still try to clear and reach equilibrium; to that end, people invent many kinds of market subversions, such as barter, black or gray markets, "under-the-table" deals and so on.
As in any other business, if mortgage lenders do not recoup their costs and earn adequate returns, they will put their resources to work elsewhere. The ultimate impact resulting from price ceilings will also be affected by the elasticity of demand and supply. Beyond certain thresholds, price controls will not only create a shortage in the credit market, but will also reduce surplus consumer demand. Under the proposition of "protecting" citizens from abusive prices, usury laws therefore can greatly hurt society.
Mortgage lenders respond to usury laws with such measures as shorter loan terms, a focus on serving only low-risk segments and increases in fees not affected by usury laws. These steps concentrate the impact of price controls on specific borrowers. For example, imposition of more stringent standards for calculating loan-to-value (LTV) ratios and reduction of loan terms will reallocate mortgage credit toward consumers who can afford larger down payments or larger monthly payments--generally those with higher incomes. Without the flexibility of adding risk premiums into the pricing equation, banks will base their lending decisions more heavily on the individual profile of each potential borrower.
Credit thus is rationed away from low-income or high-risk consumers who might be willing to pay interest rates that are higher than the usury cap. Adding higher fees to offset restrictions on interest rates eliminates from the market those for whom such extra costs are burdensome. Conversely, those borrowers who pass stringent credit requirements will obtain access to more credit than they would at normal market interest rates. So credit is abundant for those who need it less, while it is scarce for those who need it most.
Even though a ceiling price may reduce the explicit price of credit via inflexible underwriting criteria and non-interest charges, usury laws may not result in lower overall costs of borrowing, even for those who are able to obtain loans. In addition, such laws may make it more difficult for customers to comprehend the total cost of borrowing, and therefore more difficult for them to make well-informed credit decisions.
The case of the Italian mortgage market
With the development of economic theory, governments have tried to find a middle-ground position on usury laws that would prevent abusive pricing while allowing markets to reach equilibrium. This is what I define as an "enhanced" or "stealth" usury law--a form of price control that aims to avoid credit-supply shortages. In competitive markets, however, no type of usury law works, not even economically adjusted ones. The mortgage market in Italy illustrates the bogus effectiveness of enhanced usury laws.
Total mortgage debt outstanding in Italy is currently around 12 percent of the nation's gross domestic product (GDP). In Spain this figure stands at 34 percent, in France at 24 percent; the Western European average is 43 percent, while the United States surpassed 70 percent. Although Italy's mortgage market has been growing for the past eight years at a compounded average gross rate (CAGR) of 10 percent, it is expected to slow to a CAGR of 6 percent over the next four years, according to a report issued by an association of Italian credit bureaus.
Although this is still a substantial growth rate, future growth is reducing its pace as the market reaches the maximum volume lenders are willing to supply. The prime market will saturate sooner than most banks expect, in my view.
Italy also has the lowest average loan-to-value ratios in Europe (63 percent in 2003 and less than 40 percent until 1998) and the shortest average contractual term--less than 15 years, as might be expected in a situation distorted by price controls. The high mortgage growth being experienced in the last five years is concentrated in a handful of local banks providing standard mortgage products to their existing prime customer base.
A very small number of foreign mortgage specialists has entered the market, such as London-based Woolwich plc and Abbey National plc. Besides unattractive usury laws, Italian regulation makes it complicated to obtain banking licenses.
Overall, Italy has a small mortgage market with conservative products, low internal competition and high barriers to entry, a slowing pace of growth and falling margins. The Italian mortgage market thus reflects all the economic impact of price controls described earlier, regardless of its enhanced usury law.
Italy's usury rate is updated every three months in a formula that essentially imposes a rate no higher than 1.5 times the previous quarter's average. One might expect that an increase of 50 percent on top of the market average would create room for the market to adjust itself, therefore allowing the market to reach equilibrium. Yet this is not the case.
The Italian idea of "softening" the usury law relies on phony logic. As the forces of demand and supply adjust themselves to reach equilibrium, market rates will increase at the maximum allowable rate every month, thus raising the market rate by legal increments of 50 percent. Every quarter, as the market pushes the price up closer to equilibrium, the usury rate would be revised upward. This adjustment, though regulated, would continue until supply and demand reach equilibrium.
This sounds like a good plan, but in the past four years not only has no pressure developed to raise the usury cap, but even more strangely, prices and margins have come down. Counterintuitively, margins have come down and so has competition. After a period of intense merger and acquisition (M & A) activity, currently only five big players dominate 70 percent of the mortgage market, offering a very narrow range of products.
In this scenario, the questions that arise are these: If latent demand for credit exists and prices can be increased progressively to foster the supply of credit for high-risk consumers, why do banks not take advantage of the situation by offering credit to high-risk consumers? Why do lenders not increase prices, pushing up the usury cap and in so doing enjoying meatier volumes and profits?
The answer is hidden in risk management. The economics of price ceilings are more complex in credit markets than in other industries. Such dynamic price controls may work in other industries, but for credit markets, risk management plays a fundamental role in setting prices and must be factored into the discussion.
Such dynamic price ceilings could work if the credit risk grew linearly. But in fact, credit risk grows exponentially, with consumers unevenly distributed among different risk profiles. Prices in the credit industry are (or should be) greatly driven by probability of default (PD) of each borrower. PD grows exponentially, causing diminishing returns to lenders and consequently inhibiting their incentive to raise supply to a level that achieves market equilibrium.
Selling to any riskier consumer segment would require quarterly price adjustments greater than 150 percent to cover losses. But pricing setting in Italy does not depend on the level of default; it depends on the average of previous market prices. Such price increase, of course, is not legal in Italy; thus a share of the market is left unserved.
Staying within the legal 150 percent quarterly cap is not sufficient to stimulate Italian lenders to increase their loan base. The Italian central bank would need to set the usury ceiling far higher--at 300 percent over the past quarter's average--to make the market move. Later on, a further increase in the cap may well be required in order to sustain supply and service the whole market. Can such a process still be called a usury law, or has it become free-market policy?
What to expect in a free-credit market
Several consequences are to be expected in a transition from a price-controlled market to a free market. Regulators and government must be aware of the changes this transition will entail, understanding that a free market ultimately will be beneficial to companies and to the larger society.
Credit will be democratized. An increase in the overall availability of credit will develop as lenders are permitted to adequately price for the nonprime segments. People with a less-than-perfect credit history, low-income families and young borrowers will gain access to credit.
Average interest rates will climb. Market average rates will increase as lenders move to higher-risk segments. Despite an initial sense of alarm, this increase is not necessarily a bad thing. Rate increases will be partially offset by greater competition for business, as the credit industry will become more attractive to new entrants, fostering rivalry among players and pushing down rates for all customers.
Borrowers will experience more credit problems, including a higher default rate. As consumers gain access to credit that was previously unavailable to them, it is natural to expect an increase in credit-related problems. Here, the best risk-management result may well be the one that leads to no sale. Deregulation also will expand opportunities for households with higher financial leverage at the margin. This higher financial leverage increases the household's exposure to financial shocks, and an increase in personal bankruptcies is to be expected.
Lenders' average losses will increase. As banks shift focus to higher-risk segments, absolute losses will increase. Conversely, however, lenders will be able to freely set risk-based prices, generating more substantial cash flows and increasing market capitalization and, ultimately, shareholders' value.
Let the market tell you what to do
A government's legitimate role in regulation of credit should be one of ensuring competitiveness and the free flow of credit, not developing creative price controls. In a competitive market, price controls should be removed from the government's toolbox, simply because they do not work--whether in the form of stipulated maximum or minimum prices or of upper and lower limits. Usury laws result in a reduction of the amount of credit available.
Low-priced credit is of no use to those who cannot meet the very strict requirements for obtaining it. When consumers cannot buy credit, lenders do not optimize their profits through lending, instead looking for returns elsewhere.
According to economic theory, a competitive market is sufficient to prevent financial institutions from charging abnormally high prices. In a freely competitive market, the market rate of interest will not exceed lenders' costs of supplying credit--including, obviously, a fair return on equity. It is when competition is restricted or absent that consumers may face unreasonable interest rates. The price reduction effect seen in Italy was not due to competition, but was a result of a sharp reduction in supply, leaving fewer people with lower prices.
Along with competition, information availability is the other essential requirement for doing away with usury laws. Knowledgeable, informed borrowers create pressure on lenders, helping to cultivate competition in credit markets and thus reducing prices more effectively than legal restrictions. In the United States, for example, in order to discourage unfair and predatory lending the government has passed a handful of federal laws including the Truth in Lending Act (TILA), the Fair Credit Reporting Act (FCRA), the Real Estate Settlement Procedures Act (RESPA) and so on. American lawmakers, without exclusively relying on usury laws, allowed freer flow of credit in the mortgage market while using mandatory consumer disclosures to prevent deception, misrepresentation and nondisclosure in lending.
Abusive lending practices may have thoroughly undesirable consequences to the wealth of nations, but pricing legislation is neither a form of prevention nor the remedy for such consequences. Free-market policy remains the best route to nurturing economic growth and development, as Mr. Smith himself would have argued back in 1776.
Leandro DalleMule is a global mortgage risk manager with Stamford, Connecticut-based GE Consumer Finance. He can be reached at firstname.lastname@example.org.
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|Date:||Jun 1, 2005|
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