How Does Trust in Borrowers Work?

$215,000,000,000,000.

Yeah, that’s hundreds of trillions. That’s the size of the market for debt in the world. This is the amount of money lent out (most of it created based on other debt or existing value). This is money lent from one person or company to another in the hope that the borrower will pay it back (with some additional interest). I’d like to focus less on why this is so large or how we got here and more on why people trust our existing mechanisms enough to lend out this much to others.

The Primary Method of Assurance is Reputation

If you live in the US and you’re an adult, you’ve heard of the FICO (Fair Isaac Co.) score. You’ve also probably heard of the major credit reporting agencies (Experian, Equifax and TransUnion (and how some of them have lost your personal data)). FICO, however, is its own company and project. They rely on the reporting agencies for their data, who source their information from your bank, lenders, and whatever other sources they can acquire. The score is industry and credit type specific, ranging from FICO became dominant in the 1990’s when Fannie Mae and Freddie Mac endorsed it as their go-to credit score system. There is also VantageScore (built by the reporting agencies), which is focused on consumers with small credit histories. The makeup on the FICO scores is as follows:

• Payment history (35% of the FICO score)
• Debt/amounts owed (30%)
• Age of credit history (15%)
• New credit/inquiries (10%)
• Mix of accounts/types of credit (10%)

In the Nordic countries, France, Spain and other European nations, only negative events from your loans are reported, resulting in a list of negative events (like a blacklist) as your record rather than a mixture of positive and negative.

Germany uses Schufa, a private firm that handles the credit scores of at least 66 million people.

The UAE has a credit score system run by Al Etihad, which is wholly owned by the government. It is a recent system as Riba or usury is not allowed by the Qur’an but charging interest is often not considered the same and therefore allowed sometimes.

China has built in reputation on loans into their Social Credit System, resulting in the possibility for delinquent borrowers to lose rights such as air or train travel. It could also play into aspects of the Social Credit System such as publicizing your credit score on dating apps or banning your children from going to top regional schools. The Chinese market has a poor reputation among major lenders for repayment based on a history of delinquency of sometimes extreme nature. Examples include ‘ghost collateral’ or ‘missing collateral’ where companies borrowed based on collateral they claimed to have and had promised to multiple lenders at the same time. When they defaulted on their debt, the promised collateral was nowhere to be found. This is likely why the measures to enforce repayment through reputation and in turn rights is so heavy handed.

Another Method is Collateral

Collateral, a property offered up as a way of backing up the borrower’s guarantee to repay a loan, is another way lenders can feel assured they will have their money returned. If the borrower fails to repay the loan, the property promised can be confiscated by the lender and either kept or sold off to make up for the lost loaned money. The lender will have a lien (from Latin for ‘bind’) against the borrower’s property. The collateral can be the borrower’s, the property being built or purchased with the loaned money, or someone else’s property with an interest in getting the borrower the loan. This kind of loan is called a secured loan. The reputation backed loan is an unsecured loan.

As you will read in the WattWatt Medium What is Backing Bitcoin?, central banks minting new currency use this form of loan to create new money and put it into the economy through the banking system. In order for the Federal Reserve to give a bank $1,000, they must purchase $1,000 worth of US Treasury bonds (or mortgage backed securities now, as you can read in my other post) and in turn they can create $1,000 new US Dollars and pay with them. The Fed now has to keep these bonds locked up as collateral for the loan they are taking from the unlimited bank account the Federal Reserve controls.

We Can Be Even More Creative- Cash Flow

Although it’s another form of collateral if you think about it hard enough, current or even future cash flow can be used to assure the lender that the borrower will repay the loan. So a business may borrow $10,000 and assure the lender, through a written contract, that if they don’t repay the loan, the lender has a right to pull money out of the accounts of the borrower’s business as soon as it enters there from paying customers. This happens to individuals as well and it’s called garnishing your wages. This brings in your employer, who is holds the money that will later be your wage, to withhold your wages before they are paid to you and first pays some of it to the lender you failed to repay. In most places this is supposed to, by law, only be used as a method of last resort for collecting loaned money. It is without a doubt an effective method of collecting the unpaid amount of a loan but consumer protection agencies will side with the borrowers to protect them from harm.

Potential Faults in This System

The existing system is effective enough to facilitate the amount of money lent at the top of this article. Like any human invention, however, it comes with a long list of faults we can work at, including:

• Trust in the credit agencies, whether private or public
• Accuracy of whether the factors taken into account and their weights in the final figures can account for risk of non-payment
• Accuracy for consumers with little existing credit history
• Accounting for consumer risk profile versus the bonus system at a lending firm that may encourage irresponsible lending deals
• Trust in the government and its legal system to enforce confiscation of the collateral in the case of default
• Conflicting factors in the credit score like political affiliation or personal behavior that may not have any effect on repayment risk
• Not everyone is the same and some people may go outside the bounds of a credit system intended for 95% of the population and not the unusual 5%
• If the system doesn’t serve borrowers well, they may exit it and use underground markets that may be less efficient for both sides
• The reputation system often requires consumers to have a long history of debt, which doesn’t necessarily correlate with repayment risk
• Credit rating agencies will always hold their self interest over those of their consumers, leading to issues like being dinged for requesting them to show your rating to a bank you’d like to borrow from or losing your personal data needed for tracking your credit history
• People have radical life events that nobody could have planned for, this level of nuance is missing in existing major credit scoring

I’d like to give credit to Bloom for their writing on credit scoring. Potentially WattWatt will rely on their system to profile lenders on the WattWatt Lending Portal and lower the risk for lenders.

Projects reinventing lending, besides WattWatt, and focusing on credit scoring, include:

• Celsius, collateral backed borrowers borrowing while locking up tokenized collateral that can be collected by the lender. The higher the collateral relative to their loan, the lower their interest rate. Not a new credit score per se but with a similar outcome (or perhaps an improved one).
• Aire, focused on building credit profiles for consumers with limited credit histories.
• Grameen Bank, the bank to the poor, focuses on microcredit to individuals wholly lacking the ability to borrow from traditional bank. I recall specifically how in Mr. Yunus’s book he brings up how the costs of the paperwork and due diligence alone would cost more than the potential profit of the loans to impoverished people in Bangladesh, such as Jobra where Grameen initiated operations. While these people absolutely would have valuable use for the money, such as having the money to purchase a day or two worth of bamboo for their furniture making business, the banking system was not modeled correctly to serve them. Grameen Bank’s model is based off ‘Solidarity lending’, where small groups in an area collectively borrow and in turn encourage each other to repay based on a set list of incentives incurred by the lender. All members of the group are also responsible for unpaid loans (joint liability).
• UltraFICO, built by Experian, Fincity and, of course, FICO, is focusing as well on consumers with limited credit. It requires its consumers to open up their bank account data and other personal information for the firm to build the score.