Aquinas and the Financial Crisis
Gabriel Martinez, Ph.D.
Ausurer: some sort of medieval person, maybe a character from Shakespeare, greedy and hopelessly out of date. Many people know that while the Catholic Church frequently declared usury a mortal sin, the prohibition on charging interest on loans was relaxed over the centuries, so that now very few people give it any thought. Most of us have no qualms with collecting interest from our money market mutual funds or our high-yield savings accounts. The Scholastic thinking on usury also seems outdated.
The traditional teaching had two kinds of conc erns. The first is that money (unlike land or trees or animals) does not produce fruit on its own, so asking for a return on lending money is against the nature of money and therefore unjust. The second concern was to deal with situations in which a lender took advantage of a borrower and his desperate need.
Most pe ople believe that the current, modern economy provides abundant occasions for money to be, indeed, very fruitful. While the ancient and medieval world were
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economically stagnant, the modern world is characterized by economic growth, and a cleverer allocation of money can help propel that growth. The concept of lucrum cessans , developed by the Scholastic followers of St. Thomas Aquinas, justified the charging of interest as a compensation to the lender for having missed out on some profitable business opportunity. A key distinction has been the difference between interesse and usura. Charging interest can be justified by the opportunity cost, by the cost of managing the transaction, and as a compensation for possible loss. But charging the borrower above and beyond what is necessary to compensate lenders for their costs would be considered usura , and economists would often associate such behavior with some breakdown of perfect competition in the financial market.
The second concern—that of a lender taking advantage of a borrower—has not disappeared in the modern economy. Thomas Aquinas taught that loans to the desperate or impoverished are not truly voluntary. Such lenders take advantage of their market power to make loans in unfavorable terms that borrowers have no choice but to accept, meaning that their consent is invalid: economic compulsion makes the loan null and void, or at least morally suspect. Consumption loans are
more likely to be made to the poor, and more likely to be exploitative, than loans for business (which finance productive assets).
Consider a lender that provides inaccurate information under the shape of “advice,” concealing that the low initial rate will increase over time. Or one that uses high pressure tactics to make an informed decision hard to make, hiding fees or a balloon payment. Or someone who takes advantage of the borrower's desperate need to get a far-above-market interest rate. Or someone who targets borrowers with low education or little access to information, maybe aiming to take over the collateral. A sophisticated example: “equity stripping” through repeated loan flipping, where a lender encourages an unsuspecting borrower to refinance repeatedly, charging high fees and points each time, removing equity from the borrower's home and leaving them deeper in debt.
Predatory lending was a significant component of the 2008 financial crisis. The crisis was a complex event, but it started out as crisis of the subprime market.1 Now, not all subprime loans are predatory, but predatory loans are typically subprime.
1The Federal Reserve’s ultra-low interest rate policies encouraged borrowers to seek high-risk investments while a flood of savings from the rest of the world (and securitization) provided financing. Government encouragement of home ownership (especially the Community Reinvestment Act) and de-regulation (especially of hedge funds) provided the opportunity. Rising health care and education costs, with flat median household earnings, provided the encouragement.
With exceedingly low credit scores, due to a history of late payment, high debt levels, or limited credit experience, a subprime borrower may not be able to provide evidence of regular income or of assets for collateral. This borrower is a bad credit risk: there is a high likelihood that the loan will not be paid back. In the year 2000, a subprime borrower had a 7 percent default rate (versus 1.4 percent for prime borrowers).
How does such a borrower get a loan? Maybe the loan officer expects to earn thousands of dollars in fees and so prompts the borrower for a statement of a desirable level of income. The borrower may be offered an extremely low “teaser” interest rate and even be told, “Pick your payment! We realize your income is very low, too low to qualify for the loan. No problem! How much can you afford every month?” In the fine print: the rest will just be added to the loan, which grows rather than shrinks.
As many as half of subprime loans may have been made to people who could have qualified for prime loans. One analysis suggests that at least one-quarter of subprime loans had features of predatory lending (such as mandatory arbitration, excessive fees, or prepayment penalties). Many loans to subprime borrowers were second-lien loans on top of their primary mortgage, increasing their exposure and risk of default: home equity loans or lines of credit became
very popular in the run-up to the financial crisis. The share of consumption financed by using one’s house as an ATM tripled between 1991 and 2006.
Before the early 1990s, established financial institutions barely made loans to borrowers who were unlikely to repay. Beginning in 1993 (coinciding with a push for expanding homeownership and stricter enforcement of the Community Reinvestment Act), the subprime mortgage market began to grow, reaching $65 billion in 1995, $332 billion in 2003, and $1.3 trillion in 2007.
On the eve of the financial crisis, one in eight mortgages (and one in four new mortgages) were subprime. But subprime mortgages accounted for over 50 percent of all foreclosures during the 2006–2008 period. In fact, 25 percent of subprime loans originated in 2007 (versus 4.9 percent of prime loans) were in default within a year. Three-quarters of subprime loans originated over 2002-2007 were securitized, meaning that the loan originator who
collected the fees bore none of the risk imposed on the borrower. The securitizer passes the risk off to a larger financial institution which, after packaging and slicing the loans into tranches, passes the risk off to investors protected by diversification.
“If you lend money to any of my people with you who is poor, you shall not be like a moneylender to him, and you shall not exact interest from him." (Ex 22:25). The medieval
Scholastics recognized degrees of need and the necessity for borrowers and lenders to agree to a just price, which could include compensation for possible loss or missed opportunities. But they condemned taking advantage of the other’s lack of information or weak bargaining position (due to lack of competitors or options). Indeed, people accept predatory terms because, out of ignorance or desperation, they need (or believe they need) the loan.
It is tempting to believe that medieval concerns about abuse in finance are as out of date as Old English. But when it comes to today’s lending and credit markets, we can learn much from the wisdom of the Scholastics.
Gabriel Martinez, Ph.D.
Gabriel X. Martinez earned his Ph.D. in Economics from the University of Notre Dame. He has taught at Ave Maria University since 2002, with an emphasis on macroeconomics, international economics, financial institutions, and Catholic social teaching. He has written extensively on a wide range of subjects including international financial crises, Catholic social teaching, economic education, and John Henry Newman. He has been published in prestigious journals and professional outlets such as the Cambridge Journal of Economics, Catholic
Social Science Review, International Review of Economic Education, and Faith & Economics. He lives in Ave Maria, Florida, with his wife and six children.
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