Thermonuclear Lending; Would You Like to Play a Game?

Posted Friday, August 1, 2014 in Finance

You're starting to sweat. The lending agent is looking at a computer screen you cannot see while you anxiously await. You've stepped into the office of your local bank in the hopes of applying for a home loan with little to no downpayment. You may not know your credit score but because of some missed payments when times were tough your score classifies you as “subprime.” But there's good news! The lending agent has input all kinds of information into their risk analysis system and has determined that they can give you a loan, albeit with a hefty interest rate.

All is good right? Wrong. Now five years later you're nowhere near paying off the home and will likely pay more than twice the original price. With the recent loss of your job you are unable to make payments that were just barely affordable before. The bank moves to forclose on your home in a move to void your well overdue loan. What could have brought you to this point? Certainly the bank would prefer to have the full repayment of your loan. Why would they have sold you a loan product that you couldn't afford?

As Leonhard (2011) points out, contract law in the US is such that it's in the best interest of both parties to look after their own interests. Seems reasonable? Maybe in a system where each party is equally adept to determine what's in their best interest. However, Leonhard (2011) argues that this dynamic pushes the well financed to do everything in their power to increase their own self-interests at the cost of the other party. For the lending agent this can mean pushing the limits of lending contracts to get an ever increasing return on high risk loans.

There looks to be no signs of change either. Watkins (2011) points out that the ones engaged in these high risk lending practices were fairly insulated from the effects of the financial crisis. That means there's not much hope for your local super bank to radically disengage a self-interest-first approach to lending. But here's the point. The interests of both parties is best served through trust. The ingredients are a lending agent that has an accurate indicator of high risk customers and a borrower with an accurate knowledge of the product being sold. A social contract, if you will, between two informed parties can be formed when each party shows their hand but also knowing when to quit when your opponent is betting the shirt off their back.