Comment by roel_v | Hacker News Reader

Comment by roel_v | Hacker News Reader

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Some of the borrowers (for loans in the amount of x) default on their loan, and some (for an amount y) don't. Then you (where 'you' is the original lender) have on the books, under 'assets': (y + expected interest on y) - (x + expected interest on x). You don't know for sure yet how many will default, of course; but you can predict something from the socio-economic makeup of the borrowers.

Now, y gets smaller because some people pay off their loans in one go, to refinance somewhere else (the whole presumption is that only those who won't default will refinance); the expected interest becomes zero. But x stays the same. So y - x gets smaller. Hence, your number in the 'assets' column gets smaller; a write down that is counted as a 'cost' at end of year. You do get y in the assets column (the money that is paid back), but without the expected interest.

In other words: non-defaulters will keep serving their debt, earning the lenders interest. Defaulters have to be written down, including the interest. The less non-defaulters there are, the worse the overall portfolio will perform. If you estimate a performance of x at year t, and in year t + 10 it turns out that you need to revise the performance to (0.8 * x), then that 20% is a write down - i.e. a cost.

But y does not get smaller. Only expected interest on y gets smaller. y is the same (actually a little larger because money today is worth more than money tomorrow) and in the governments pocket. If the government was smart they would put the y in their pocket to use to offset the risk of x.

You're right, I didn't write it exactly enough. What gets smaller is (y + expected interest on y) because the expected interest goes to 0.

The whole thing to realize here is that the 'cost' is not an actual loss as in 'less money comes in'; it's a cost in the sense of 'this portfolio will perform less than we anticipated'. And if the interest that people pay is based on a certain overall performance, but now all of a sudden the performance needs to be adjusted downwards, then one might argue 'we were shooting for a 0-operation, but in the end we will have to spend money to make up for the good borrowers leaving'.

Here's another intuition that explains it: if the market is willing to finance the good borrowers at half the rate it takes to lend to everybody, regardless of their prospects of paying back; then only the bad borrowers will stay in the government-funded portfolio, reducing the performance that was originally estimated. Which is, if you've accounted for future earnings based on the original estimate, a loss when you have to write it down.

Worth noting that this is probably a less catastrophic write-down than a private lender would face in the same scenario, as these loans typically can't be discharged and the federal gov't can do all sorts of crazy things to recoup money on a default (garnish wages, taxes, etc.).

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