A Thousand Years Problem
FEB 03, 2024
Usury is a thousands years old problem. There were many attempts to solve it, prohibition by law or religion, an upper limit on the interest rate to name a few.
Why is it still there?
This phenomenon is common across many industries. For instance, car manufacturers are better organized than their customers, enabling them to lobby for laws and regulations that benefit them at the expense of car drivers.
Information asymmetry is common in many industries. Sellers often know better the value of their product, as seen in the example of selling a "lemon" car.
But what does information asymmetry look like in lending?
Lenders have insight into the 'fair' price of a loan (i.e., the interest rate) based on specific parameters (such as the quality of the collateral, loan-to-value ratio, and the credit quality of the borrower).
Calculating such a price isn't straightforward—it requires the expertise of mathematicians and investment in sophisticated software.
Consider a scenario where a lender determines that the fair interest rate for a particular customer and loan structure is 5.1%, but they manage to issue the loan at 5.3%.
The seemingly minor difference of 0.2% is significant over time and across large sums.
For example, on a $500,000 loan over 15 years, this 0.2% difference can amount to nearly $10,000 for a single customer.
The lending process demands a significant time investment from the customer, leading many borrowers to accept the first bank's offer that seems reasonable and is willing to finance them.
Ideally, it would benefit customers to obtain a loan quote and then share this quote with another bank, a financial consultant, or even seek advice on an online forum.
Consider the process of booking a hotel or a flight: you select a hotel on an aggregator website and easily share the link with a friend to see if they would like to join your trip.
They can view the option without needing to re-enter all the search criteria. A similar system could greatly benefit borrowers, making loan options more transparent and comparable.
However, it serves the interests of established lenders to maintain high transaction costs.
This barrier discourages borrowers from shopping around for better rates and terms, effectively limiting competition and keeping prices (in this case, interest rates and lending fees)
higher than they might be in a more transparent and competitive market.
So, how to solve it? It's hard to fix the legacy legal code and politics, it's one step at a time.
While creating a centralized platform like Uber could pose its own issues with power concentration, one can attack the problem of high transaction costs and information asymmetry.
To solve the usury we need to think of it as a mathematical problem and to have the proper tools.
First, the loan parameters need to be "sharable" (or RESTful in IT vocabulary). This would allow for straightforward comparison and transparency.
Then one needs to have a free user-friendly price engine.
While such a tool could be open source, it doesn't have to since the fixed income mathematics is easy to check.
If you offer me an API, I better check your API (with my examples) than your code.
The price of the loan is its interest rate (EAPR). What are the factors impacting the price?
For simplicity, it's the clients solvency (e.g. probability of default), the quality of collateral, the structure of the loan (e.g. payment schedule) and some macro factors (e.g. interest rate curve).
None of it is shared with the client in a systematic and transparent way (piecewise at best). Who of the homebuyers can tell their probability of default?
Currently, we are not there in terms of transparency etc even on price and structure of the loan.
Once it's solved, we approach the factors (the second order).
This is how we solve usury. Even if just a part of it.