Westmont Magazine Borrower Beware, Lender Beware:
The Subprime Mortgage Crisis and Moral Reflections on Usury in the Scholastic Tradition
by Edd Noell, Professor of Economics and Business
The contribution of subprime mortgage lending to the ongoing credit crisis has received much attention in recent months. Abusive financial practices associated with these loans allegedly led to foreclosed homes, bank failures and bailouts, and mounting public debt. Media coverage has described in detail the declining economy, but few commentators have reflected on the ethics of the situation. Christian economists can make a contribution to the discussion of subprime mortgages with both economic analysis and moral reflection. How can we apply biblical principles to identify responsible lending and responsible borrowing? What can Christians do to protect the most vulnerable members of society who suffer disproportionately during economic downturns?
Typically, subprime borrowers earn low or unpredictable incomes and can’t make a down payment of at least 20 percent of the home’s value. Their total monthly housing cost exceeds a reason-able fraction, such as 30 percent, of the family’s monthly income. Many obtained adjustable-rate mortgages in which a low, teaser rate applied for 12 to 18 months before rising sharply. The question arises: How many lenders made full disclosure that favorable initial rates would increase significantly and result in substantially larger monthly payments?
On the other hand, why shouldn’t subprime borrowers be responsible for making full payments on loans they accepted? Many borrowers counted on rising prices to avoid owing more than their homes were worth. Others pursued subprime loans purely for speculative purposes. In addition, Congressional mandates and regulatory pressure encouraged lenders to make funds more readily available to low- and moderate-income borrowers, particularly first-time homeowners.
Sorting out the relative roles of personal responsibility and fraudulent practices in modern credit markets involves some peculiar challenges. Believers in the 21st century can gain insights on the thorny issues of irresponsible lending and borrowing from a surprising source: Medieval Christians. During the 12th-15th centuries, they wrestled with the evolving relationship of creditors and debtors in ethical treatises, confessional manuals and commentaries on Scripture, Aristotle and the Patristics. In particular, they sketched moral parameters for truthfulness in trade and discernment of fraud, deceit and economic compulsion.
In the history of Christian thought, this period stands out for its significant moral reflection on economic matters. With the onset of the commercial revolution in Europe, lending activity became more widespread as merchant banking emerged to challenge existing suppliers of credit. Scholastic thinkers such as Thomas Aquinas, William of Auxerre and Peter Olivi viewed lending through the lens of protecting the economically weak and reflected on its morality as apparent abuses of poorer borrowers became more evident.
Initially, the Scholastics forbade lending at interest, identifying it as usury, a mortal sin. They quoted the Old Testament to support this position, “If you lend money to My people, to the poor among you, you are not to act as a creditor to him; you shall not charge him interest” (Exodus 22:25).
In addition, they adopted elements from Roman legal tradition and Aristotle in developing their concept of economic justice. Roman law depicted bargaining between equals as the basis for establishing a current market price, identified frequently as the just price. This mutual consent became a key element in the legal code. Recognizing the potential for abuse, the Romans were among the first to regulate interest rates and set ceilings. Contracts covering the loan of interchangeable items measured by weight or number, such as grain, oil and money, required borrowers to repay only the exact amount of goods they received. An additional charge required a second contract, known as usura. Scholastics considered this payment problematic, in part because they affirmed the sterility of money.
Reliance on Roman legal tradition and technological changes gradually opened the door to accepting loans made at interest. As financial practices evolved with the commercial revolution in Europe in the 13th and 14th centuries, lending money at interest became more prevalent. The church struggled with the legitimacy of this practice, making a limited allowance for interest on the basis of late loan payments. Scholastics grounded their prohibition of usury in a variety reasons, one of which has continuing relevance: the potential for fraud and economic duress or compulsion.
Clerics in the church provided the laity with instruction about sin in specific professions, defining penance for economic sins such as theft and avarice. Examples of relevant economic transgressions included using false weights and measures and lending funds at interest out of greed, fraud or economic compulsion. Maillard of Paris stated that selling goods on credit for more than they were worth qualified as a sin.
Lenders commit fraud when they mislead borrowers regarding the terms of a loan. Borrowers can misrepresent themselves by disguising their intended use of the funds or their ability to repay. Such deceit involves withholding relevant information that the parties are obliged to disclose. For example, sellers must communicate the item’s value and function or buyers won’t know what it’s worth. Without that critical information, the exchange is uneven.
The absence of competition also created the potential for fraud according to the Scholastics. Lenders could exercise undue economic coercion by establishing a monopoly or other interference or manipulation of the market. In more isolated locations the lack of competitors and primitive communication also caused problems. Lenders often acted either as local monopolists or in collusion with each other. The resulting high interest rates inspired Franciscan and Dominican criticism of usury.
The Scholastics described the desperate position of people in poverty driven to borrow funds as a form of economic compulsion. In this way they began to qualify the place of consent so important for Roman law. Individuals who agree to pay usury don’t necessarily do so freely and willingly; they accept the terms because they need the loan.
Aristotle originated the notion that a voluntary action may actually result from a form of compulsion, and the Scholastics cited his concept. In Aristotle’s example, a ship’s captain faced with a severe storm must jettison cargo to prevent the vessel from capsizing. He does so voluntarily, but his motives are mixed. Aristotle focused on personal moral responsibility for actions performed under duress, while the Scholastics considered the morality of those who deliberately imposed duress on another, such as lenders who charged interest.
Aquinas observes that borrowing for necessity subjects the borrower to a “mixed force.” Those who need money have no choice but to pay the cost. In the 14th century Antonino of Florence noted that borrowers usually agreed to pay whatever the lender charged. Gerardo of Siena thought that usury was more voluntary than theft because the borrower consents. Yet the thrust of Scholastic teaching on the economic duress associated with usury underscores that it eliminates bargaining between equals, which is fundamental to just transactions.
Clearly stating the duty of Christian lenders or merchants toward those of little means was a consistent Scholastic theme: Lend freely and don’t take advantage of your neighbor’s need through usury. They recognized degrees of need and drew parallels with the product market where buyers must pay — and sellers must charge — the just price. Neither should take advantage of the lack of information or lesser bargaining position of the other. Otherwise the terms involve fraud or coercion as the transaction does not occur freely. There is no mutual consent. The issue of justice in exchange (commutative justice) in the product and labor markets occupies a significant part of Scholastic economic thought.
Fraudulent practices circumvented the ban on lending funds at interest by raising transaction costs for engaging in finance. A common illicit technique was inflating the total of the loan by adding the interest to the principal. Both parties knew that they were engaged in usury and fraud, leaving the door open for a defaulting borrower to take advantage of this arrangement by claiming to be the victim of extortion. The Scholastics emphasized personal accountability before God for those on each side of the transaction.
With the spread of merchant banking in Italy, by the 15th century the Italian Scholastics began to see the necessity of charging interest, and their discussion of the need to provide funds to the poor led to modest toleration of interest charges. Merchant bankers in Italy were in effect public money lenders. The most controversial of these lenders arose through the initiative of the Franciscan order. The poor could borrow from them by depositing a pawn and paying about 5 percent interest. The intent was charitable.
By the 16th century, the Protestant Reformer John Calvin reversed the direction of previous Scholastic thought. He affirmed the legitimacy of charging interest on loans but qualified his tolerance of usury by emphasizing the Deuteronomic ban on lending money at interest to the poor. Eventually, Christian thinking came to understand usury as excessive interest, a position expressed in modern interest-rate ceilings.
Modern economists can find fault with some Scholastic analysis, such as their less-than-convincing rationales for banning interest. Nonetheless, their insights on fraud, deceit and economic compulsion offer possible avenues for Christian reflection on the modern subprime mortgage crisis.
During most of the 20th century, low- and moderate-income borrowers faced insurmountable difficulties in purchasing a home. Ironically, usury laws capping interest rates kept them from getting loans since markets were likely to charge them steeper rates in light of the higher risk they presented. In the 1980s, legislation removed such caps and allowed interest deductions on mortgage debt, which made mortgage borrowing more attractive.
By the mid-1990s the volume of subprime mortgages accelerated, partly because investors began to buy securities derived from these mortgages. The Federal Reserve’s efforts to keep interest rates low in the early 2000s escalated the momentum. People with problematic credit could obtain adjustable-rate mortgages with favorable initial rates. Rising home prices contributed to the buildup of subprime mortgage loans.
In keeping with Scholastic thinking, Christians should examine both sides of the credit market. What about the practice of excessive borrowing and avarice? To what extent did speculators who sought to turn over houses take advantage of the increased opportunity to borrow easily in the subprime market? Shouldn’t borrowers beware of moral culpability?
The actions of lenders likely deserve more emphasis, particularly those taken toward the more vulnerable borrowers in society. To what extent were subprime borrowers misled in taking out loans with low prospects of repayment and little collateral required? Shouldn’t lenders beware of moral culpability?
Certainly evidence exists of alleged predatory practices by subprime lenders. Financial institutions targeted low- to moderate-income neighborhoods as sources of subprime borrowing, reversing practices that dominated until the late 1990s when lenders limited credit to this demographic because they were more likely to default. In addition, affordable housing lending goals for Fannie Mae and Freddie Mac spurred more of these loans.
Mortgage brokers had little incentive to insure that borrowers were creditworthy since they didn’t bear the risk of loss in the event of default. They became increasingly involved in loans to subprime borrowers, driven by the volume of loans generated. Less than scrupulous practices resulted.
Consider the directions managers gave to their mortgage brokers in recent years. “The loan application has to be packaged correctly” in order to secure the underwriter’s approval. In some cases this meant doctoring incomes on application forms or facilitating appraisal fraud. One mortgage broker used a dead husband’s annual income as the basis for a widow qualifying for a home loan. Others didn’t even verify incomes, ignoring subprime credit scores. Some brokers encouraged borrowers to refinance four times in four years despite all the transactions costs associated with frequent refinancing. Lenders offered pick-a-payment loans in which the lowest mortgage payment didn’t even cover the interest.
The problems of deceit and possible economic compulsion are obvious in these scenarios. They don’t necessarily entail borrowing out of economic desperation, but they do raise the specter of regret for taking a loan under pressure or misleading information.
Of course not all subprime loans are predatory. But the availability of capital allowed some lenders to take advantage of uneducated borrowers and pursue deceptive policies.
However, modern credit markets have largely functioned efficiently in allocating funds. Modern usury laws create credit market shortages and often make it more difficult for low- to middle-income borrowers to obtain loans. It can be difficult to differentiate between practices that are predatory and those that appropriately reflect the increased risk that lower-income borrowers present. Legislation increasing transparency in credit transactions is no doubt needed. Whether the government can sort out predatory practices from efficient credit rationing in the subprime lending market is uncertain, however. And the degree to which a legislative remedy should be paternalistic remains a live issue.
The application of the moral parameters surrounding lending in Scholastic thought to the modern context of subprime mortgage lending yields insights for Christian economists in understanding the nature of duplicitous practices in modern credit markets.
These medieval clerics responded with moral instruction to creditors and debtors focusing on what was sinful and what was not. They reflected on the ethical implications of changing conditions surrounding the availability of credit, particularly as apparent abuses of poorer borrowers become more evident.
While the Scholastics didn’t affirm that all usury was grounded in fraud or economic compulsion, their emphasis on the frequent presence of these factors in credit provision calls us to more carefully consider the extent to which lenders exploit ignorance and dire need and to reflect in general on the role of personal moral agency in credit markets. Should we not consider a significant amount of subprime mortgage lending to involve instances of mixed voluntariness? Or should we better understand that some low- to moderate-income mortgage receivers too often focus on present gain at the expense of future income and economic stability? For many Christians engaged in nonprofit economic counseling work in low-income neighborhoods, the latter point seems to ring true.
While modern Christian economists have no strong reason to reject the legitimacy of interest-taking, they should reflect more carefully on the relevance of Christian moral truths for the recent financial crisis. We would do well to ponder how the concepts of economic compulsion, fraud and avarice apply in discerning the role of both irresponsible lenders in putting people in houses they can’t afford and irresponsible borrowers who’ve speculated on movements in housing prices.
One possible extension of the Scholastic discussion of usury applies to microfinance lending. Should lenders charge interest on loans to subsistence borrowers in lesser-developed countries? Does the purpose of these funds for an entrepreneurial venture matter in our perspective on microfinance? To what extent is the degree of economic compulsion and possible supplies of funds from competing sources (profit and nonprofit organizations) relevant for the payment schedule, default penalties and interest rate charged? How might Christian economists evaluate the interplay between the subsistence borrower and the microfinance lender in terms of the place of bargaining and consent in a process moving toward economic justice?
Scholastics affirmed that a just price emerged as the “common estimate” of the market checked by means of the moral constraint of duty and conscience upon sellers and buyers alike. They extended Jesus’ commandment to “love your neighbor as yourself” to credit markets, encouraging individuals to limit their greed and meet the needs of their neighbors.
The full article is available here. Borrower Beware, Lender Beware