When should deadbeats be forgiven?

When Americans fail to pay their bills, credit rating agencies and lenders report the loss on their books for seven years. For that period, a would-be borrower's past financial sin is right there on the credit report for any home or auto or student lender or credit card bank to see, and to cite in denying another loan, or charging more.

Does this make sense? It seems backwards -- money is the rare product that costs more for people who want it the most; higher rates make it tougher to pay lenders back.

True: lenders justify higher rates for questionable borrowers because it helps cover their losses.

But: What if the statistical caveat that "past performance is no guarantee of future results" actually applies -- not just to investment returns -- but also to loan payback?

That's what veteran Federal Reserve Bank of Philadelphia economist Leonard Nakamura suggests, based on what he found when he joined Swedish financial researcher Marieke Bos to compare what happened to defaulted borrowers after their records were scrubbed (they used variations in Swedish record retention time limits and extrapolated the results.)

Here's the working paper: http://www.philadelphiafed.org/research-and-data/publications/working-papers/2012/?utm_campaign=WorkingPaper&utm_source=2012/11/27&utm_medium=E-mail


- The longer you keep "credit arrears" marks on borrowers' records, the more money they have to borrow once their record finally gets clean -- which plunges them right back into debt.

-  About a quarter of debtors whose records are cleaned end up late again -- whether the debt is erased from their record immediately, or it's only erased years later. They re-default at just about the same rate.

That suggests to Nakamura and his research partner "that only a minority of the individuals who received an arrear may be inherently high risk." So "for many borrowers," failure to pay in the past isn't a useful predicter of who is going to default. (Revised)

Low credit scores, when applied to people who haven't defaulted on their payments for at least three years, actually "overpredict the probability of an additional default by these borrowers over the course of the next two years," based on testing of a sample of Swedish borrowers, Nakamura added. "It is possible that forgetting default does tend to make credit scores more accurate, rather than less." (Revised)

In short, "following a default it may be good to forget, because by improving an individual's reputation, forgetting increases the eincentive ot exert effort to preserve this reputation."

There are crude signs that quick debt forgiveness may actually have some association with better loan payment records:

According to a chart appended to Nakamura's paper, in famously indebted Greece, "negative arrears" remain on a debtors's record for a full 10 years after the debt is paid back or wiped out. In the U.S., where 1 in 11 people are late on their payments, the record stays ugly for 7 years. In debt-averse Germany, it's just 4 years. And in extra-solvent Finland, zoom, bad debts go right off the books when the consumer pays the debt.