CAPITALISM FOR TOTS

Posted in Rants on October 11th, 2010 by Ed

How does one explain a concept like banking to a small child? If your education was anything like mine, the first time you encountered the concept it was explained with very basic hypotheticals. Suppose Mary earns $100 and puts it in the bank. The bank has to hold onto her money for her, but they know that Mary probably won't want to take out the whole $100 anytime soon. So they loan $10 from Mary's money to Bob, and they charge Bob "interest." Bob pays back $11. Mary's $100 is safe and the bank has made $1. Capitalism for tots.

This oversimplification is an effective way to explain banking to a 6 year old (or, as I've seen in macroeconomics textbooks, concepts like reserve requirements to 18 year old). I think it underscores an important point that seems very far removed from the minds of most people who think about abstract things like "the housing crisis", bank bailouts, and foreclosures. When we borrow money – and I say "we" because I doubt many of us go without a credit card, an auto loan, a student loan, or a mortgage – the bank is giving us someone else's money. We think of it more often than not as The Bank's Money, but the bank has no inherent resources independent of what it can convince customers and investors to deposit with it. You already know this, but I'd be surprised if many people thought about it very often.

When I read about things like "strategic default" – defaulting on a mortgage when the value of the property collapses even though the borrower can afford to continue making payments – it is particularly important to keep the basics of lending in mind. While I am among the most enthusiastic critics of our financial system and the ethics of private enterprise in this country as a whole, it is difficult to understand how responding with equally dubious ethics will lead to better outcomes for any of us:

Jeff Horton, a 33-year-old Orlando, Fla., technology manager, is among those who recently decided to take the step. He told his lender that he's done making payments on the condo he bought in 2005 and the home he bought in 2007, because he wants to move from Florida and can't sell or rent the properties at a price nearly high enough to cover his payments.

Jeff Horton, a 33-year-old Orlando, Fla., technology manager, is among those who recently decided to take the step. He told his lender that he's done making payments on the condo he bought in 2005 and the home he bought in 2007, because he wants to move from Florida and can't sell or rent the properties at a price nearly high enough to cover his payments. "Life is too short," said Horton, who has mortgages totaling about $400,000 with Bank of America — about twice as much as he thinks he would get if he could sell the property. He says he has little choice because the bank has refused to refinance the mortgages or adjust original terms…"I felt guilty at first," said Horton. "It all stopped when I saw them take $90 million in executive bonuses. They take bailout money and do nothing for the little guy. They wouldn't do anything for me."

I applaud Mr. Horton's remarkable skill at rationalizing his selfish behavior. Nonetheless, to describe this approach as short-sighted would be an understatement. In whose interest is this "strategic" default? Mr. Horton won't be getting another loan anytime soon. The bank raises the cost of borrowing to everyone – including those credit cards Horton likely uses to make ends meet – to cover its losses on the defaulted loans. And if enough people engage in this behavior, the government has to step in, through either the political process or FDIC, to cover what depositors are owed.

I would prefer that We maintain the moral high ground in this crisis. Banks have only themselves to blame for their lack of ethics, abandonment of lending standards, and borderline sociopathic inability to accept responsibility for their actions. I understand that when people cannot pay a loan they are going to default on it. The question is, are we at a place as a society at which it's OK to blow off an obligation just because we no longer feel like repaying it? I have no sympathy for a bank that lends money to some yahoo who quite obviously has no hope of paying it back. That said, I have a difficult time mustering sympathy for a borrower who makes an investment – using someone else's money, mind you – and then expects to be absolved of the obligation when the investment loses its value.