Wednesday, December 19, 2012

“It's a Wonderful Life,” but It's the 21st Century

Some things don't change. Some do.

The last two postings discussed a number of timeless financial management lessons one can learn from “It's a Wonderful Life.”  However, some things change.  Generally, what changes is how to accomplish things that make sense rather than the things one should try to accomplish.   
What hasn't changed is the first rule of investing: “don't lose the capital.”  For banks loans are investments.  The most important thing in lending is to get paid back.  Now, all investments have risk, and some loans will default.  Yet, starting with a loan that one expects will default makes no sense.  That hasn't changed.

In the November 19, 2012, WALL STREET JOURNAL, there was an article entitled “For 'Credit Invisibles,' A Market Takes Shape: FirmsDevising New Methods to Score the Previously Shut-Out.”  It addressed a topic that is highly visible in “It's a Wonderful Life.”  Specifically, the issue it addresses is that without debt it is hard to get a loan.  Nothing demonstrates that one will pay back the loan better than paying back loans.
In the movie “It's a Wonderful Life” the solution is implied rather than explicitly stated.  One should recall that many of the customers to whom Bailey Building and Loan lends aren’t strangers.  As George explains to his customers during the run on Bailey Building and Loan, their money has been lent to their neighbors. 

In fact, a loan to a friend of George’s, Ernie the cab driver, plays an important role in the movie.  Potter uses it as an example of why Bailey Building and Loan should be closed down.  It results in George responding with one of the most memorable parts of the movie, a speech that is often quoted. He points out that the majority of people at that point in time had no credit histories.

Experian Information Solutions Inc., the large credit bureau, estimates there are 64 million credit invisibles in the U.S.  The term “credit invisibles” refers to those who can't access loans based upon their credit score.  The credit score has become the replacement for George’s firsthand familiarity with the borrower.  That there is a segment of the population that does not have access to credit is not new.  What is new is that it is no longer the majority of the people referenced by George in “It's a Wonderful Life.”  The estimate of 64 million is a lot of people, but it doesn't represent the majority referenced in George's speech.
So while the portion of the population may have changed, the issue is the same.  As is pointed out in “It's a Wonderful Life,” more important than that firsthand familiarity with the borrower is “character.”  George makes explicit reference to it at one point.  

The issue for a lender isn't whether the borrower is a friend (or whether they're in the majority).  The issue is whether the borrower has the character to pay back the loan.  As the WALL STREET JOURNAL article points out, “some of those consumers [the credit invisible] are worth the risk.”  In a world that is fair, people with the character to pay back their loan should have access to credit.  The article goes on to describe some of the steps being taken to try to identify those consumers who have the character to pay back the loan.
It's interesting that some of the proposals to address this issue involve looking at things like rent and utility payments.  Of course those would have been known to Bailey Building and Loan.  But, to harken back to the theme of this year’s first postings on “It's a Wonderful Life,” one finds that there always advocates for bad financial management.  For example, the WALL STREET JOURNAL article states: “Consumer advocates have objected to the proposal, saying it may penalize low-income customers who occasionally skip payments.”  One has to wonder how people can consider themselves a consumer advocate when they are advancing the notion that people who are having trouble paying their rent and utilities should get into debt. 

A substantial portion of the “credit invisible” has gotten there because of previous experience not being able to manage credit.  That's a major difference between the issue currently faced by financial institutions trying to make lending decisions and Bailey Building and Loan.  Bailey Building and Loan was mainly dealing with people who never had credit.  By contrast, the article in the WALL STREET JOURNAL highlights a very different issue.  It notes that many of the people who are credit invisible have tarnished, incomplete or nonexistent credit files."  As one of the people interviewed for the article says, “when you have bad credit, it's hard to ever get credit again.”
Lest the difference be misunderstood, George makes explicit reference to the fact that one of his customers experienced financial difficulties.  He uses it as an example of why they should want to keep Bailey Building and Loan going.  He points out that Potter would have evicted the customer.  So, the difference is partially quantitative, but one should doubt that George is referring to problems that resulted from previous use of credit.  In the 1920s and 30s, such problems were not common among much of the population.

So, let's inventory.  Both in the “It's a Wonderful Life” and now, banks have to deal with the issue of how to identify those with the character to repay a loan.  Now banks have access to extensive records on previous debt payment that weren't available in the 1920s and 30s.  But those records only go so far in identifying creditworthy customers.  There is still a substantial portion of the population that should be able to manage credit but who do not have access to credit.  It's currently a much smaller portion than it was 20s and 30s, but it is, nevertheless, a substantial number of people. 
The reason why credit is denied to many people is no longer just lack of previous credit experience.  An issue that is much more important now than it was in the 20s or 30s is how to address the people who have previously failed in their credit management experience.  Further, there is now a substantial group of “consumer advocates” who seem more interested in getting people into debt than in the well-being of consumers.

While many things have changed, one thing remains important.  As the WALL STREET JOURNAL article states about efforts to address the issue: “Those efforts could offer a reprieve to millions of Americans who have been denied credit, not to mention deliver a windfall to banks scrambling to find new sources of revenue.”  Improvements in the ability to identify individuals with the character to repay their loans have tremendous benefits both to the individuals involved and to banks.  What is often overlooked is that missteps in identifying the individuals with that character have tremendous cost.
Comparing “It's a Wonderful Life” to current issues surrounding how to identify individuals who will repay their loans highlights one aspect of the issue.  It makes it quite obvious that the issue is timeless: it has always existed.  It also isn't unique to developed economies. 

Much of the world experiences the difficulty of identifying individuals with the ability and character to repay their loans in a way that is similar to “It's a Wonderful Life.”  Consumer credit markets are new in many parts of the world, and credit bureaus, and the associated credit files, don't exist.  When it comes to access to consumer credit, a substantial portion of the world's population exists in a state similar to George Bailey's customers.
In many respects in the developing world the situation is the inverse of the US.  The US is trying to figure out how to identify those worthy of credit after a period of excessive ability of credit.  In the developing, world the problem arises from the total absence of consumer credit.

Given the difference in the issues being addressed, it isn't too surprising that lenders in the developing world are seeking approaches that avoid the reliance on credit history.  For example, is developing analytic techniques that focus on measuring the financial responsibility of a consumer from information other than his or her previous credit history.  In developing economies where consumer credit markets don't exist, such techniques are vital.
If there is any doubt that the problem is the same (i.e., judging the character of the borrower) it should have been eliminated by the founder’s presentation at TEDxWallStreet.  The presentation, entitled “How Facebook, Twitter, Google+ and LinkedIn will change Finance” is quite explicit about the nature of the problem.

A good deal of The Hedged Economist’s career focused on how to use information in lending decisions.’s approach is intriguing and represents a significant effort to return to character lending.  It has the potential to provide tremendous benefit to consumers in developing economies. So, a disclosure that The Hedged Economist is an Angel investor in should not be surprising.

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