History, Impacts and Regulation of Consumer Credit
Winter, 2014
Mondays from 6:00 p.m. to 7:40 or 7:50 p.m.
David Lander
314 345 4713
dal@greensfelder.com
OFFICE HOURS: every couple of weeks from 5:00 to 5:50 p.m.
Purpose of the Course:
1. Understanding how and why consumers borrow beyond their capacity to repay;
2. Understanding how and why lenders lend beyond the borrowers’ capacity to
repay;
3. Deciding how to regulate consumer lending/borrowing against that backdrop
Rules for the Course:
Class Participation will count 25% of the grade;
Missing three classes will reduce your grade by one level;
Missing more than three classes will result in failure in the course;
Excuses will only be considered if they affect three absences.
Students who need accommodations because of a disability should contact the disability
services coordinator for the School of Law, Shannon Stinebaugh Morse, Assistant Dean
of Student Activities and Leadership. Dean Morse's office is in Room 1082 of Student
Services suite and she can be reached by email at stinebsm@slu.edu or by phone 314977-2728. Confidentiality will be observed in all inquiries.
Class 1 January 7, 2013
First Hours: Introduction: The Dilemma of Regulating Consumer Finance,Reducing the
harm without reducing the benefits. Understanding the landscape:
Second Hour: A Very Brief History of Consumer Credit in the United:
Survey of Consumer Finances – Fed Three year study.
Class 2: Credit Card Lending, Before and after the Crash;
Class 3: Student Loans and Home Mortgages
First Hour: Student Loans
Second Hour: Home Mortgages: Part One
Class 4: Home Mortgages: Part Two
Class 5: Sub Prime Lending including Payday and Car Title Loans Predatory Lending
Payday
Car title
Tax refund anticipation
Other – housing –auto – credit cards
Class 6: The Supply of dollars to lend and various surveys
Class 7 : Understanding the micro and macro sociological, political and anthropological
impacts of increased/decreased consumer debt/credit.
Class 8: Understanding the micro and macro economic impacts of increased/decreased
consumer debt/credit.:
Class 9: Understanding consumer borrowing/lending from the behavioral economics or
economic psychology points of view.; and intro to consumer finance issues;
Who helps consumers in financial distress? Who trains those helpers? What are the
goals?
Class 10
Financial Distress
Financial Literacy, Disclosure and Counseling of Consumers in
Class 11
Price Controls
Class 12
Prohibited Transactions and the Bureau
Class 13
The ultimate consumer protection – the Bankruptcy Discharge
Bankruptcy ; discharge of unsecured debt; treatment of secured debt .
means test; chapter 13; nondischargability – student loans – credit cards
Class 14
Consumer Credit around the World
Exporting Consumer Credit around the world – or Not.
Brazil, China, Canada
HISTORY, IMPACTS AND REGULATION OF
CONSUMER CREDIT- DEMAND AND SUPPLY
Introduction to this book and this course
1. Understanding the landscape: The Dilemma of Regulating Consumer Finance;
Reducing the harm without reducing the benefits.
2.
A Very Brief History of Consumer Credit in the United States
3.
Installment Debt and Auto Debt
4.
Credit Cards
5.
Student Loans
6.
Debts Secured by the Borrower’s Home.
7.
Sub Prime Loans
8.
Surveys of Consumer Behavior, Finances and Sentiment
9.
Sources of the Dollars that are lent
10.
Economic Impacts of Consumer Finance – Micro and Macro
11.
Sociological Impacts of Consumer Finance- Micro and Macro
12.
Behavioral Economics
13.
Introduction to Regulation of Consumer Finance and
Financial Literacy Education, Disclosure Requirements and Distressed Debtor
Counseling
14. . Price Control
15.
Prohibitions
16.
Bankruptcy – The Ultimate Consumer Regulation
17.
Consumer Finance Around the World
Required Reading: Course EBook
(Years ago we used Credit Card Nation by Robert Manning but it became dated; then we
used portions of Financing the American Dream by Calder, but it stops many years ago.
Then two years ago we used Borrow by Louis Hyman which is excellent, but now we use
these materials supplemented by the various readings. Most readings are short enough
not to have a copyright problem; most longer readings consist of a cite to the web
materials that are generally available to all for free. Please note that there are several
longer readings which are long excerpts and may present copyright concerns.
Introduction to the book and the course
Every society struggles with its construct of rules regarding borrowing by and lending to
consumers. As we will see if the door is open too widely there will likely be damaging
consequences to consumers, to lenders and to the economy and society as a whole. If the
door is not opened widely enough a different set of damaging consequences will likely
occur.
Many people think that one major cause of the crash of 2007 was that the door to
consumer credit had been open too widely too long in the US. In the late 1990’s the
regulators in South Korea decided to provide wide open credit card credit to borrowers
without regard to credit history; the result was a short term boom for the economy and a
short term happy buying sprees for many consumers; not long after the consumers
became overwhelmed with debt and the lenders became overwhelmed with bad credit and
the economy skidded to a halt because consumers shut down their buying.
In Brazil in 2012 the government opened the door to auto financing in order to give a
shot to the auto production and auto sales industries and shortly thereafter the economy
and society suffered a reaction similar to that in Korea and the United States, although
on a much smaller scale.
If the door is open too narrowly in a country in which consumers wish to borrow then the
economy will be less strong than it would otherwise be and the consumers will be
unable to maintain a life style that they could afford. For example younger consumers
might have to delay the purchase of a car or a house or a large appliance until later than
necessary. Moreover, financial institutions will be less profitable and investors will
receive lower returns on their investments.
As we will see at the end of our study when we consider the consumer credit in various
other countries, there are societies where consumers do not wish to borrow.
Our focus will be ninety per cent on the US. In the last part of the course we will
examine the various types of consumer credit regulations and the roles of lawyers but
before we do that it is crucial to examine the history and impacts of consumer borrowing
and consumer lending
We begin with an overview of the course in order that can understand where each of the
chapters fits into the overall scheme. We then proceed to a very brief history of
consumer lending in the US; then to a look at several specific types of lending to
understand how they developed and what they are;
1.
installment lending such as car loans and furniture loans
2.
credit card lending
3.
student loans
4.
home mortgages
5.
subprime as a separate species, both tax refund antic, title loans payday and subprime types of car, home
The author believes that we need to understand the impacts of more or less consumer
lending and borrowing so we spend one class looking at the economic impact of
consumer lending and borrowing, on individuals and their families as well as on the
overall economy; then one class to look at the sociological impacts. We all know that
some consumers make what turn out not to be wise decisions on borrowing; some borrow
too much, some too little and some just right. We spend one class looking at how
consumers make such decisions.
All of this information forms our knowledge base as we consider how much and how
little to regulate, and what types of regulation will do the most good and the least harm.
Each type of regulation protects against certain vulnerabilities in the consumer or against
certain harms in the financial offering. We will consider the role and efficacy of financial
literacy education and disclosure information in combatting the unevenness of the
relationship between borrower and lender and the lack of knowledge and information of
some consumers. We next look at price controls, prohibiting certain financial products
and finally we look at discharge of consumer debt in bankruptcy The last chapter
provides a look at how consumers and lenders have acted and might act in various
countries around the world including Canada, Brazil, South Africa, Indonesia, China,
India, Turkey, Poland and Germany. We then consider what consumer regulatory regime
might best fit each of those populations or cultures.
Although our inquiry is mostly from the perspective of the borrower, it is necessary to
understand the supply of funds to lend and the motives and techniques. To understand
consumer borrowing in the 1990’s and early 2000’s it is essential to understand
securitization and the pressure for higher returns. For that reason we will focus regularly
on issues related to the supply of funds that the market is lending.
Chapter 1
The Dilemma of Regulating Consumer Finance. Reducing the harm without reducing the
benefits. Understanding the landscape:
Welcome to your job as public policy maker in the office of the consumer credit
regulator. Your test is to learn everything you need to know to determine the optimal
regulatory scheme for consumer lending, then to decide how much and what kind of
regulation is best. Your first assignment is to figure out what you need to know to decide
how much and how to regulate consumer lending and consumer borrowing.
These materials are intended to help you on your quest by providing you with:
an understanding of how and why consumers borrow beyond their capacity to repay;
an understanding how and why lenders lend beyond the borrowers’ capacity to
repay; and a methodology for deciding how to regulate consumer lending/borrowing
against that backdrop
We begin by considering the opinions of four scholars of consumer borrowing behavior
in the United States and who each have a different slant on the situation. opinion.
As you read through the materials think about the following issues
What do we need to know to decide how much and how to regulate consumer lending
and consumer borrowing?
To what extent does the regulation of consumer credit reduce
the amount of credit or the availability of credit to selected populations?
If so is that a reason for not regulating?
Why do lenders lend?
In his pioneering book Financing the American Dream, the author Lendol Calder asserts
that there is something in the American character which pushes consumers to choose to
borrow more than they can easily afford and then simply work harder to keep the house
of cards from falling. He calls this a defining American value and hears American
consumers happily singing “ I owe, I owe, it’s off to work I go.
In her book, The Overspent American, Juliet Schor believes that American simply want
to have luxuries so much that they overspend to purchase them. In our chapter on
behavioral economics we will look more closely at the various theories behind the
choices consumers make when they spend and borrow beyond the rational limits of what
they can afford.
Please consider these themes as you read an article that Ms. Warren wrote years ago. Mr.
Wallace’s article was written when America was deciding whether to throw out the
controls that had limited interest rates for a hundred years or more. There were many
many pressures to take that action and his is the clearest explication of the value of
keeping those limits.
The Immoral Debtor
1995 or so
Professor Elizabeth Warren
Harvard Law School
Cambridge, MA
INTRODUCTION
Every piece, of legislation is an answer, a solution, to a problem that Congress, has posed
and then responded by changing some law. The answer may be right or wrong, too much
or too little, but it is an answer nonetheless.
The bankruptcy bill is no exception. On April 20,2005, when George W. Bush signed
into law a bankruptcy bill that had been pending in Congress for eight years he declared
that he was addressing “a problem.”2 Because the bill was written by credit industry
lobbyists,3 shopped to their friends in Congress, and supported by tens of millions of
dollars in lobbying and campaign contributions (including the president’s own single
biggest contributor), it might easily be dismissed as just one more piece of highlyfocused, special interest legislation, an answer to nothing except payoff for big-dollar
contributors. But that would be a mistake. The powerful financial industry that drove
this bill defined a problem. Their supporters in Congress took up the call and agreed to
make changes to the bankruptcy system that they claimed would answer that problem.
The problem they described had substantial national resonance. It was plausible enough
that it provided political cover for a large number of both Democrats and Republicans to
support the bill. Despite the fact mat Senator Hatch’s own Utah constituents would be hit
the hardest in the nation, he could tell a story that permitted him to support the bill.
Despite the fact mat Senator Biden had overt presidential aspirations that he could
advance only with the support of millions of middle class working people, he could tell a
story that permitted him to support the bill. The list is long: traditional supporters of
women faced down women’s groups; traditional supporters of minority groups faced
down the Leadership Conference on Civil Rights; and traditional supporters of union
workers, faced down union groups. Money may have been the unseen force, but money
alone does not make it safe to vote contrary to the interests of constituents and
supporters—unless there is a good cover story. In, the case of bankruptcy, many senators
and representatives could ignore the groups they usually called on for help because they
now had a powerful story to tell. They voted for the interests of credit card companies
and subprime lenders, but they did so under the cloak of moral rectitude.
The story is as simple as it is harsh: Middle class America is riddled with spendthrifts,
irresponsible people consumed by appetites for goods they don’t need, people who think
little of cost and who take their responsibilities to pay their debts lightly, people who file
for bankruptcy rather than repay their lawful debts. The bankruptcy bill was more than a
giveaway to the credit card companies; it was a public, moral judgment against those who
go broke.
The story isn’t about a few bad debtors. A few debtors could be snared by the existing
version of 707(b). Indeed, if the problem were limited to a few people who stepped out
of line, then the response would need to be sharply confined and pinpointed to the
specific activities that signaled abuse. A story about a few bad debtors would not support
the kind of wholesale reform that the credit industry wanted. Although the credit
industry could be forced to admit from time to time that even their own inflated numbers
about “can pay” bankruptcy filers were under 10 percent, the repeated language of both
industry representatives and their political supporters was about irresponsibility,
profligacy and immorality in vague, but powerful numbers. It was about untold numbers
of people who routinely overspent with little care for the consequences.
The bankruptcy bill was a way to strike back at the Immoral Debtors. It was an answer to
the breakdown in the American culture that has produced record filings. By offering a
harsh and punitive response, it attempts to meet immorality head-on, to fix the problem of
irresponsibility and over-spending nationwide.
The difficulty, of course, is that if the problem is misstated, then the solution is also
misstated. If, in fact, families are filing for bankruptcy for reasons other than
unrestrained profligacy, then a punitive solution may visit enormous pain on these
families. Instead of being punished for their immorality, they may be punished for events
beyond their control, for having relatives who had no money to bail them out in times of
crises, or for plain old bad luck. Moreover, if the problem is misstated, then the statutory
solution may have unanticipated effects that reverberate throughout the economy. The
real problem goes unaddressed, while the proposed solution actually makes things worse.
The Public Version of Why America Needs Bankruptcy Reform
The story of American failure did not originate with the bankruptcy lobbyists. As
American families have sunk deeper in debt, they have endured non-stop criticism from
multiple quarters. To be sure, lobbyists and powerful politicians have set upon families
in financial trouble, chiding them for their profligate ways. But economists and
sociologists have added credibility to the story, describing families’ collective lust for
goods they could easily forgo. The popular media echo the themes of irresponsibility.
The accusations are sharp, the assertions are confident and unambiguous, and the tone of
condemnation is unmistakable.
Cornell University economist Robert Frank claims that America’s newfound “Luxury
Fever” forces middle-class families “to finance their consumption increases largely by
reduced savings and increased debt.” Documentary film maker John de Graaf and Duke
Economics Professor Thomas Naylor explain in Affluenza: The All-Consuming
Epidemic, “It’s as if we Americans, despite our intentions, suffer from some kind of
Willpower Deficiency Syndrome, a breakdown in affluenza immunity.” They assert that
Americans have a new character flaw—”the urge to splurge.” Economist Juliet Schor is
often cited as documenting irresponsibility, as she explains that American families are
buying “designer clothes, a microwave, restaurant meal, home and automobile air
conditioning, and, of course, Michael Jordan’s ubiquitous athletic shoes, about which
children and adults both display near-obsession.
The popular press sounds the same notes. Newsweek ran a multi-page cover story about
Americans drowning in debt. The reason for families’ distress? “Frivolous shopping is
part of the problem: many debtors blame their woes squarely on Tommy, Ralph, Gucci,
and Prada.” Money magazine laid blame on the family home. “A generation or so ago ...
a basic, 800-square-foot, $8,000 Levittown box with a carport was heaven. ... By the
1980s, the dream had gone yupscale. Home had become a 6,000-square-foot
contemporary on three acres or a gutted and rehabbed town-house in a gentrified ghetto.”
The drumbeat shows no signs of letting up. Critics heap scorn on how Americans buy
food, clothes, cars, shoes, appliances, and vacations.8
And what have Americans gotten for all their spending? Professor Schor cites
“competitive spending” as a major, contributor to the deterioration of public goods” such
as “education, social services, public safety, recreation, and culture.” Professor Frank
sums it up: “The dogged pursuit for more’’ accounts for Americans’ “overload, debt,
anxiety, and waste.” When it comes to money, Americans’ profligate spending has dug
them into a hole from which they may never recover. Or so say the critics.
The step from social critique to political action is short. The bankruptcy bill received
widespread support in Congress, carefully couched in tones of moral condemnation for
their spending binge. Senator Oren Hatch, R-UT, a senior spokesman of the United
States Senate, points an unwaivering finger at families. He explains that millions of
Americans are bankrupt or near-bankrupt because “they run up huge bills and then expect
society to pay for them.” He is joined by federal Judge Edith Jones, once-rumored to be
a potential Bush appointee to the Supreme Court. She asserts that “[b]ankruptcy is
increasingly seen as a big ‘game,’ with the losers being those who live within their
means, while the bankrupts pursue more interesting and carefree lives.”
Judge Jones and her co-author Professor Todd Zywicki make the connection even clearer
in explaining why bankruptcies are on the rise: “if debt ‘causes’ bankruptcy, it is only
because overspending and an unwillingness to live within one’s means ‘causes’ debt. In
short, one can simply re-characterize the ‘debt causes bankruptcy’ thesis as
‘overspending causes bankruptcy.’” In case anyone missed the point, they drive it home:
“Bankruptcy is now too frequently a choice, fostered by irresponsible spending habits
and an unwillingness to live up to commitments.” Professor Zywicki testified before
Congress that: “We have ‘defined bankruptcy deviancy downward’ such that it has
become a convenient financial planning tool rather than a decision freighted with moral
and social significance.” He explained that the bankruptcy bill offered a way to correct
that moral lapse, a tool to change the ways of the Immoral Debtor.
The deep entanglement of the power of campaign contributions and advancing an
ideological viewpoint was explored by Princeton political scientists Steven Nunez and
Howard Rosenthal. They analyzed the intersection of ideology, campaign contributions,
and voting in Congress, using the example of a credit industry supported amendment to
the bankruptcy laws. Nunez and Rosenthal posit that support for the bankruptcy bill
among Republicans was; largely a matter of ideology. Among Democrats, who might be
less inclined to support the dominant view that human misfortune was largely a matter of
just deserts, they identified enough vote buying through campaign contributions to
conclude that “after controlling for ideology, we find that campaign contributions are
significantly correlated with voting.” But even Nunez and Rosenthal saw the importance
of keeping the public on board for any legislative change: “if public opinion tilts toward
a view that it is necessary to discipline a minority of profligate, strategic debtors, then the
industry bill should attract broad support . . . .”
In other words, money counts, but the story counts too.
The Family Balance Sheet
The idea of the Immoral Debtor, the over-spender whose uncontrolled appetites impel
him to run up debts that can easily be discharged in bankruptcy, gets a big boost from
current economic data on the family. First, families have more to spend than a generation
ago. Family income, adjusted for inflation, has taken a big jump in a single generation,
the typical two-income family today earns nearly 75 percent more than their one-income
parents earned a generation ago.
But incomes haven’t risen because men are making more money. In fact, adjusted for
inflation, the wages of fully-employed men have remained essentially flat. Instead, the
rise in income can be attributed almost entirely to the decisions of millions of mothers to
enter the workforce. Over the course of a few decades, the change has been nothing short
of revolutionary. Mothers have entered the workforce in record numbers, doubling the
number of earners in typical middle-class families from one to two.
As recently as 1976 a married mother was more than twice as likely to stay home with
her children as to work full-time. By 2000, those figures had almost reversed: The
modern married mother is now nearly twice as likely to have a full-time job as to stay
home. Mothers are going back to work much sooner after their children are born. A
mother with a three month-old infant in 2001 was more likely to be working outside the
home than was a 1960s woman with a five-year-old child. The transformation can be felt
in other ways as well. In 1965 only 21 percent of working women were back at their jobs
within 6 months of giving birth to their first child. Todays that figure is more than three
times higher, topping 70 percent.
In other words, families have more money to spend, but, they picked up that extra income
by sending two people into the workforce. Without both parents pulling in paychecks,
today’s family has no more to spend than they had a generation ago. They need both
husband and wife at work to secure a place as middle-income earners.
Even as family incomes have risen dramatically over the past generation, American
families have decreased the amounts they put away. Family savings in the U.S. have
decline markedly from the early 1970s to the early 2000s, with families putting away a
shrinking fraction of their take-home pay.
Families are spending an ever-larger fraction of what they earn. They spend now, saving
less either for future purchases or as insurance against hard times.
Increased income has not saved the family balance sheet for the median earning family.
The reversal in spending patterns—spending more than they earn—has taken a terrible
toll. Today there are five times more families filing bankruptcy than in the early 1980s.
Home foreclosures have more than tripled in less than 25 years. Nearly half of the
families with credit cards report that they have no money to make more than a minimum
monthly payment on their outstanding credit card bills. One in every three families in the
U.S. with an income above $35,000 reports owing medical bills that they cannot pay.
Financial distress documented by these numbers hits hard in the middle class. It is
homeowners—people who once saved money for a down payment, who showed that they
had steady enough incomes to make monthly payments and who survived the most
rigorous credit screen imposed in consumer financial markets—who lose their houses to
foreclosure. It is people in the middle—not the richest or the poorest—who accumulate
the most debt on their credit cards. It is middle class families seeking relief in the
bankruptcy courts.
These data compose a deeply disturbing picture. Tens of millions of American
families—middle class people with decent educations and respectable occupations—are
living on a financial cliff. Some will hang on, and others will plunge over as they deal
with the anxiety of unplanned emergencies and unpaid bills.
How They Spend
If families are making more money than ever and in financial trouble, surely the critics
are right: Over-consumption is rife in the land, and Immoral Debtors are running wild.
But despite the steadfast assurances of the politicians, intuition and anecdotes are no
substitute for hard data. The story of the Immoral Debtor is advanced as fact, but without
any numbers. It might be worthwhile to look at some actual data on spending.
And yet, when it is all added up, including the Tommy sweatshirts and Ray-Ban
sunglasses, the average family of four today spends 21 percent less (inflation adjusted) on
clothing than a similar family did in the early 1970s. How can this be? What the
fingerwaggers have forgotten are the things families don’t spend money on anymore. No
more rushing off to Stride Rite to buy two new pairs of sensible leather shoes for each
child every three months (one for church and one for everyday) plus a pair of sneakers for
play. Today’s toddlers often own nothing but a pair of $5 tennis shoes from Wal-Mart.
Suits, ties, and pantyhose have been replaced by cotton trousers and knit tops, as
“business casual” has swept the nation. New fabrics, new technology, and cheap labor
have lowered prices. Discounters like Target and Marshall’s have popped up across the
country, replacing full-price department stores of a generation ago. The differences add
up. In 1973, Sunday dresses, wool jackets, and the other clothes for a family of four
claimed nearly $750 more a year from the family budget than all the name-brand
sneakers and hip T-shirts today’s families are buying.
If Americans are not blowing their paychecks on clothes, then they must be overspending
on food. Designer brands have hit the grocery shelves as well, with far more prepared
foods, high-end ice creams, and exotic juices. Families even buy bottles of water, a
purchase that would have shocked their grandparents. Besides, who cooks at home
anymore? With Mom and Dad both tied up at work, Americans are eating out (or
ordering in) more than ever before.
The Immoral Debtor critics have it right, but only to a point. The average family of four
spends more at restaurants than it used to, but it spends less at the grocery stores—a lot
less. Families are saving big bucks by skipping the T-bone steaks, buying their cereal in
bulk at Costco, and opting for generic paper towels and canned vegetables. Those
savings more than compensate for all that restaurant eating—so much so that today’s
family of four is actually spending 22 percent less on food (at-home and restaurant eating
combined) than its counterpart of a generation ago.
Outfitting the home? Affluenza authors rail against appliances “that were deemed
luxuries as recently as 1970, but are now found in well over half of U.S. homes, and
thought of by a majority of Americans as necessities: dishwashers, clothes dryers, central
heating and air conditioning, color and cable TV.” These handy gadgets may have
captured a new place in Americans’ hearts, but they aren’t taking up much space in our
wallets. Manufacturing costs are down, and durability is up. When the microwave oven,
dishwasher, and clothes dryer are combined with the refrigerator, washing machine, and
stove, families are actually spending 44 percent less on major appliances today than they
were a generation ago.51 Furniture may now be leather and super-sized, but spending has
shrunk for it as well—a 30% decline in a single generation.
What about cars? At first glance it would seem that the family car might just shatter the
case against the Immoral Debtor. Cars now come jam-packed with automatic gizmos that
no one had even dreamed of a generation ago. And cars cost more than ever. In the
words of a Toyota salesman quoted in Affluenza, “People’s expectations are much
higher. They want amenities—power steering, power brakes as standard, premium sound
systems.”52 At last, a big-ticket item that that proves that Americans are indeed
indulging themselves with lavish extravagances they can ill afford.
Families are also buying safety devices that didn’t even exist in the, early 1970s. Every
time I strap my new granddaughter into the car I am reminded of what I did when her
mother Amelia was a baby. I tucked her in a wicker bassinet, which perched on the back
seat of our Volkswagen Beetle. I was somewhat unusual—not because I failed to use so
much as a seat belt to hold my seven-pound daughter in place—but because I opted not to
hold her in my lap, where a simple fender bender would have transformed her into a freeflying projectile.
By and large, families have spent prudently on their automobiles, or at least as prudently
as they did a generation ago. And the money they are spending is paying off: The rate of
child auto fatalities has declined steadily since the mid-1970s, thanks at least in part to
safer cars and better car seats.58 For all the criticism hurled at car manufacturers (and car
buyers), it is important to note that families drive stronger, safer cars that last a lot longer
than they used to.
That is not to say that middle-class families never flitter away any money. A generation
ago no one had cable, big-screen televisions were a novelty reserved for the very rich,
and DVD and TiVo were meaningless strings of letters. So how much more do families
spend on “home entertainment,’’ premium channels included? They spend 23 percent
more—an extra $170 annually. Computers add another $300 to the annual family
budget.59 But even that increase looks a little different in the context of other spending.
The extra money spent on cable, electronics, and computers is more than offset by
families’ savings on major appliances and household furnishings alone.
The same balancing act holds true in other areas. The average family spends more on
airline travel than it did a generation ago, but it spends less on dry cleaning. More on
telephone services, but less on tobacco. More on pets, but less on carpets.60 When the
numbers are all added up, increases in one category are offset by decreases in another. In
other words, there seems to be about as much frivolous spending today as there was a
generation ago.
Whether families are spending more than they should by some moral notion—consuming
too much of the world’s resources or buying things they could easily live without—is not
at issue here. These data give us no clue about the right amount of spending. But the,
data give us a powerful look at why families are not going broke. Here the data are solid
and on point: There is no evidence of any “epidemic” in overspending—certainly nothing
that could explain a 255 percent increase in the foreclosure rate, a 430 percent increase in
the bankruptcy rolls, and a 570 percent increase in credit card debt.61 A growing number
of families are in terrible financial trouble, but no matter how many times the accusation
is hurled, Prada and HBO are not the reasons.
Where Did the Money Go?
They have more money and they aren’t spending themselves into oblivion on designer
water and DVDs, so how did middle-class families get into so much financial trouble?
The answer starts, quite literally, at home.
It would be possible to pile cliché on cliché about the home, but restraint forces me to
settle for this observation: The home is the single most important purchase for the
average middle-class family. To the overwhelming majority of Americans, home
ownership stands out as the single most important component of “the good life.”62
Homes mark the lives of their children, setting out the parameters of their universe. The
luck of location will determine whether there are computers in their classrooms, whether
there are sidewalks for them to ride bikes on, and whether the front yard is a safe place to
play. And a home will consume more of the family’s income than any other purchase—
more than food, more than cars, more than health insurance, more than childcare.
As anyone who has read the newspapers or purchased a home knows, it costs a lot more
to buy a house than it used to. (Because the overwhelming majority of middle-class
families are homeowners, this discussion focuses on the costs of owning, rather than
renting.) What is easy to forget, however, is that today’s home prices, are not the product
of some inevitable demographic force that has simply rolled its way across America.
Quite the opposite. In the late 1980s, several commentators predicted a spectacular
collapse in the housing market. Economists reasoned that the baby boomers were about
to become empty nesters, so pressure on the housing market would undergo a sharp
reversal. According to these experts, housing prices would reverse their forty-year
upward trend and drop during the 1990s and 2000s—anywhere from 10 to 47 percent.
The Immoral Debtor diehards are clearing their throats, eager to interrupt to explain why
housing prices shot up despite expert predictions. If they cannot sustain their claim, that
families are spending too much on frivolous purchases, these critics can simply adjust
their chant to declare that Americans’ materialistic and shallow motivations have driven
housing prices up. Money magazine captures this view: “A generation or so ago . . . a
basic, 800-square-foot, $8,000 Levittown box with a carport was heaven. . . . By the
1980s, the dream had gone yupscale. Home had become a 6,000-square-foot
contemporary on three acres or a gutted and rehabbed town-house in a gentrified ghetto.”
Where did so many people get this impression? Perhaps from the much ballyhooed fact
that the average size of a new home has increased by nearly 40 percent over the past
generation (although it is still less than 2,200 square feet).67 But before the Immoral
Debtor group declares victory, there are a few more details to consider. Those data tell us
only where real estate developers are aiming new home construction, that they have
decided that McMansions are more profitable than Levittowns.
The wealthy may be living in spacious digs, but those new homes are not snapped up by
middle-class families. The proportion of families living in older homes has increased by
nearly 50 percent over the past generation, leaving a growing number of homeowners
grappling with deteriorating roofs, peeling paint, and old wiring. Today, nearly six out of
ten families own a home that is more than twenty-five years old, and nearly a quarter own
a house that is more than fifty years old. 68
As millions of families sent a second earner into the workforce and pushed up total
family income, one might expect that they would spend less on housing as a proportion of
total income. Instead, just the opposite has occurred. A growing number of middle-class
families now spend more on housing relative to family income. Over a generation, the
average family increased the number of rooms in their homes by 7 percent, but their
mortgage expenses took a leap of 69 percent at a time that other family expenditures fell.
As food, clothing, home furnishings, and the like remained steady or fell, families across
America were loading up on mortgages like never before to buy those homes.
The impact of rising mortgage costs has been huge. The proportion of families who are
“house-poor,” that is, who are spending more than 35 percent of their incomes on housing
has quadrupled in a single generation.3 Today it takes two working people to support a
mortgage in most metropolitan areas. For example, the average police officer could not
afford the mortgage for a median priced home in two-thirds of the nation’s metropolitan
areas on the officer’s income alone. The same is true for elementary school teachers.
This phenomenon is not limited to high-cost cities such as New York and San Francisco.
Without a working spouse the family of a police officer or teacher is priced out of a
median home even in more modestly priced cities such as Nashville, Kansas City, and
Charlotte.
So what does all this have to do with educating middle-class children, most of whom
have been lucky enough to avoid the worst failings of the public school system? The
answer is simple—money. Failing schools impose an enormous cost on those children
who are forced to attend them, but they also inflict an enormous cost on those who don’t.
Even over-consumption critic Juliet Schor acknowledges the growing pressure on
middle-class parents. For all that she criticizes America’s love affair with granite
countertops and microwave ovens, she recognizes that parents’ motivations are not
always so crass:
Within the middle class, and even the upper middle class, many families experience an
almost threatening pressure to keep up, both for themselves and their children. They are
deeply concerned about the rigors of the global economy, and the need to have their
children attend “good” schools. This means living in a community with relatively high
housing costs.81
In other words, the only way to ensure that a beloved youngster gets a solid education is
to spring for a three-bedroom Colonial within an hour-long commute to a job in the city.
Newer, more isolated suburbs with restrictive zoning also promise a refuge from the
random crimes that tarnish urban living. It may seem odd that families would devote
more attention to personal safety—or the lack thereof—when the crime rate in the United
States has fallen sharply over the past decade. But national statistics mask differences
among communities, and disparities have grown over time. In many cities, the urban
centers have grown more dangerous while outlying areas have gotten safer—further
intensifying the pressure parents feel to squeeze into a suburban refuge. In Baltimore and
Philadelphia, for example, the crime rate fell in the surrounding suburbs just as it
increased in the center city. The disparities are greatest for the most frightening violent
crimes. Today a person is ten times more likely to be murdered in center city
Philadelphia than in its surrounding suburbs, and twelve times more likely to be killed in
central Baltimore. The overall odds may remain low, but it is the comparative story that
drives parents to distant suburbs.
Perhaps the strongest evidence of parents’ Herculean efforts to buy homes where their
children will be safe and go to good schools is the differential changes in housing prices.
The federal government has not reported the data for the full thirty-year period examined
here, but even in the confines of a fifteen year comparison, the relative increases in
housing costs for parents and non-parents have been quite different. Wherever they
started in 1989, housing prices grew for parents at a rate three times faster than for those
who have no minor children at home.
Families have been hit hard by more than mortgage costs. The rising cost of health care
has taken a terrible bite out of the family budget. If we focus on only the healthy
family—an unrealistic assumption, but one that makes the point even sharper—medical
costs are up dramatically. For the families lucky enough to have an employer who
contributes to their health insurance program, the costs of keeping a family covered have
risen dramatically. In one generation, the out-of-pocket cost of employer-subsidized
health insurance has jumped by about 90 percent. Of course, median earning families are
not all spending this amount. Some are lucky enough to have employers who pick up the
entire tab. For a growing number, however, the employer offers no assistance, and the
family either buys on the open market or gives up on health insurance altogether. In
recent years, the number of middle class families with no health insurance has grown
precipitously.
Adding It Up
The Immoral Debtor story dominates any discussion of the financial condition of
America’s families, but when all the plusses and minuses of changes in family spending
are added up, a very different picture emerges. Families are spending less on ordinary
consumption and more on the basics of being middle class. These data tell a story of
middle class families clipping coupons and buying pasta in bulk, while they hemorrhage
money to pay the bills for their mortgages, their health insurance, transportation,
chlldcare and taxes.
The changes in income and in expenses have transformed the family budget. A
generation ago, the median family kept one parent at home and put one into the
workforce. Today, the median family puts both parents to work, but their basic expenses
have outrun even the addition of a second worker. Even with two people in the
workforce, the new family budget still leaves families trailing their one-income parents
from a generation ago.
The new family budget is notable first for the sharp dissonance between earning and
spending. The two-income family of the 2000s has less money to spend on every
consumption good—food, clothing, appliances, furniture, life insurance, vacations, etc.—
than the one income family of a generation ago. They now have two people at work, but
less money for spending.
But the new family budget is notable for another reason: It is far more deeply leveraged.
A generation ago, the one-income family committed about 54 percent of its pay to the
basics—housing, health insurance, transportation and taxes. In effect, the one-income
family spent about half its income to make the nut—the basic expenses that do not vary if
someone gets sick or loses a job. Today, the basic expenses consume 75 percent of the
family’s combined income. Their nut—the amount that they must pay in good times and
in bad—is-fixed at 75 percent of their income. With 75 percent of income earmarked for
fixed expenses, today’s family has no margin for error. There is no leeway to cut back if
one parent’s hours are cut or if the other gets laid off. There is no room in the budget if
someone needs to take a few months off work to care for Grandma, or if a parent hurts
his back and can’t work. The modern American family is walking on a high wire without
a net; they pray there won’t be any wind. If all goes well, they will make it across safely,
their children will grow up and finish college, and they will move on to retirement. But if
anything—anything at all—goes wrong, then today’s two-income family is in big, big
trouble.
The expenses laid out here are averages, and plenty of families manage to pay less (or
more). But the alternatives families have pursued in an effort to make ends meet bear
some scrutiny. Consider childcare. Government statistics show that the average amount
a family of four spends on after-school care is lower than the $4,350 cited above. The
number reported here is calculated based on reports of families who pay for their
childcare, but the government “average” includes children who have a grandmother or an
older sibling who watches them for free. That is a great way for those, lucky families to
save some money, but it doesn’t do a bit of good for the typical family that has to rely on
paid childcare. For them, paying less money means getting less quality, such as an
unlicensed neighbor who parks several children in front of her television or an
overcrowded center with barely passable facilities. The cost of childcare is also on the
march. From 2000 to 2003 alone, the cost of childcare increased 19%.
There are other ways families could save money. Families could also cut their health
insurance expenses. They could drop those costs to zero by following the model of
millions of other middle-class families who simply live without health insurance and pray
for the best. Or they could give up the house and move into an apartment in a marginal
neighborhood. There are always options, but for families with children, these options
signal that their middle-class lives are slipping away.
Even if they are able to trim around the edges, families are faced with a sobering truth:
Every one of those expensive items—mortgage, car payments, insurance, tuition—is a
fixed cost. Families must pay them each and every month, through good times and bad
times, no matter what. Unlike clothing or food, there is no way to cut back from one
month to the next. Short of moving out of the house, withdrawing a child from
preschool, or canceling the insurance policy altogether, the families are stuck. Fully 75
percent of their income is earmarked for recurrent monthly expenses.
If all goes well, many families will squeak by. They will even get a breather in another
five years or so, when their children are old enough to be left alone after school. But the
spending hiatus will last for just a few years, until the older child heads off to college. At
that point, the family’s budget will be squeezed harder than ever as they search for the
money to cover room, board, and tuition for the local state university. If they are lucky,
they will have set something aside during the intervening years, and they will find a way
to put their kids through college. And when they hit their mid-to late fifties, these
couples might begin to think about putting something away for their retirement (about
thirty years later than a financial planner would recommend).
And so go the lives of the families with “affluenza,” “the urge to splurge,” and other
clever variation on rampant materialism. Lobbyists and politicians may cling to the idea
that these families over consume, but they can do so only with a deliberate disregard for
the data that tells a very different story.
Over the past decade, returns to investors on credit card debt have outstripped every other
form of lending—even after all the bad debt and bankruptcy losses are counted. A multibillion dollar wealth transfer has, in fact, taken place, but not the one the credit card
industry claims has occurred. Families that have lost jobs, families that have no health
insurance and families that have split apart following divorce or death of a spouse have
paid billions to credit card companies and their investors. And just to clarify the classdriven point, it is worth noting that across the U.S., half of all families have not one
dollar of savings put aside for their retirements and 73% of all families have not one
dollar in the stock market. It is a fair assumption that paying dearly for consumer credit
has not created a wealth transfer within the middle class, but rather a transfer from
working families to upper income families. The credit industry has good reason to spend
money to protect the income flow from debtors to shareholders.
The Immoral Debtor story is good for the financial services industry and for a Congress
that does their bidding. In the world of statutory regulation, reality matters less than the
perception of reality. The Immoral Debtor story keeps would-be reformers at bay, and it
blunts the criticism of the industry leveled by consumer groups and advocates for the
elderly, for racial minorities and for women. After all, who wants to organize to defend
deadbeats who are the cause of their own destruction?
What Happens to the Families
The story is powerful, but at some point reality asserts itself. Congress can cut off access
to bankruptcy. Credit industry spokesmen can assert that the people in trouble are the
profligate and irresponsible. But that won’t help families who have cut out lattes and
who don’t go to the mall every weekend; they still can’t make their mortgage payments
or find the money for health insurance. And it won’t help families avoid job losses,
illnesses, accidents or family break ups. In other words, Congress can pass the laws, but
if the laws have little to do with why families are in trouble, then people will still go
broke.
But those are complex changes, and change requires a consensus that something is
wrong. So long as Americans can be persuaded that families in financial trouble have
only themselves to blame, there will be no demand to change anything. One cost of the
Immoral Debtor story is that it helped bring us a bankruptcy bill that will fall hard on
good people. A second cost is that the story is one more roadblock to prevent getting on
with the difficult business of making America once again safe for middle class families.
Please also read the following excerpts from a 1976 article by George J. Wallace.
THE USES OF USURY: LOW RATE CEILINGS REEXAMINEDt
GEORGE J. WALLACE*
The problem which is becoming acute is that the market as it is does not produce a
distribution of income and power which satisfies the ideas of modern justice.
Kenneth Arrow 1
INTRODUCTION
Apparently spurred by the drafting and promulgation of the Uniform Consumer Credit
Code2 and by decisions such as Wisconsin v. J. C. Penney Co.3 critics of low consumer
credit rate ceilings have loudly and persistently called for their repeal.4 Not long ago the
National Commission on Consumer Finance5 considerably strengthened that call by
presenting empirical data tending to show that low ceilings bind more low income than
high income individuals.6 The main argument made by the critics is that low ceilings, if
effective, reduce the availability of consumer credit to those with low incomes. Reduced
availability interferes with the freedom of those denied credit to buy what they want with
discretionary income.7
Rate ceilings have also been charged with being ineffective, reducing competition and
efficiency, and discouraging economic growth in the state that harbors them.8
Although there have been a few rumblings in response, the critics charges to date remain
basically uncontested.9 My aim is to suggest that the critics' position, stripped of its free
choice and efficiency verbiage, is extraordinarily narrow. Low rate ceilings, if properly
used, are potentially effective and beneficial regulatory tools. Of course, like most
regulatory tools, they also have their costs. But the critics-apparently influenced by the
conviction that, as a normative matter, the theoretical free market shows the best way to
structure debtor-creditor relationships-have focused only on the costs. This article
attempts to readjust the uneven balance. Although those who ultimately set the guidelines
for credit policy in a state or the nation must determine by their own values whether the
costs outweigh the benefits, they cannot do so wisely when the relevant factors have been
only half-way explored.
Low ceilings are often opposed as governmental interference with the workings of a
market pricing system. In part I, I approach the dispute over low ceilings as a distributive
question and argue that there is no a priori reason to suppose that the market system's
answer to distributive questions is more ethically justifiable than that provided by
governmental intervention. In part II, I identify four advantages that appear to provide
some ethical support for certain types of low ceilings advantages that at the least require
careful consideration before a decision is made to adopt high ceilings. My primary
purpose is to suggest the lack of balance in any analysis of rate ceiling policy that
considers only efficiency and freedom to use credit. I therefore develop each of these
advantages with sufficient clarity to underscore its relevance to the choice of high or low
rate ceiling policy, but my purpose does not require that I examine each concern in
sufficient depth to establish it against all adverse criticism. The first advantage of low
ceilings, the protection of high risk consumers from the psychic and material hardship
associated with default, suggests the desirability of a moderately low rate ceiling
affecting all types of consumer credit. Because this type of regulation is of current
interest in state and national legislatures, part III subjects such regulation to the full
analysis suggested in part II. After exploring the ethical basis for low ceilings, I conclude
that a substantial argument can be made in their favor, even though the available
evidence on several crucial points is incomplete. Because the other advantages of low
ceilings are of less current interest, the lengthy analysis they require can be saved for later
articles.
III.
EVALUATING LOW RATE CEILINGS AS PROTECTION AGAINST
EXCESSIVELY RISKY CREDIT
Proposals for reform of economic institutions, such as the moderately low rate ceiling
examined here, require evaluation in terms of the ethical values they promote or
disrupt.74 That evaluation can best begin by examining two hypothetical credit systems,
one with low, one with high ceilings, drawn so as to clarify the basic ethical position that
underlies advocacy of low ceilings for protective purposes.75 Thereafter, several
complications likely to be encountered in the real world will be considered.76 In all this,
a certain degree of generality must be tolerated, particularly given the limits of the
empirical information on the impact rate ceilings and other regulatory proposals might
have.77 But the basic issues can at least be identified and the tentative prognosis made
that across-the-board low rate ceilings hold considerable promise as ethically justifiable
protective tools.
A. The Hypothetical Credit Systems18
The two systems are in all respects the same except for rate ceilings. Both have a package
of restrictions on creditor collection practices equivalent to those proposed by the
National Commission on Consumer Finance.79 The costs of administering the regulation
of consumer credit are likewise assumed to be the same. The first system, however,
utilizes a-rate ceiling low enough to interfere significantly with the borrowing ability of
high risk customers-perhaps a mean rate ceiling80 of twenty percent81
that would apply across the board to all consumer credit markets.82 The assumed effect
of this ceiling is to restrict credit availability so as to save those denied it a substantial
risk of psychic harm caused by the threat of occurrence of default and its aftermath.
Under these assumptions, the reduction in borrowing ability necessarily produces an
increase in protection. Because there are substantial restrictions on creditor collection
practices, rate ceilings only serve as a specialized method of protection designed to
protect the highest risk borrowers. The second system has a high ceiling like that
recommended by the Uniform Consumer Credit Code,83 producing a mean rate ceiling
of thirty-one percent.84 This system, then, offers an increase in borrowing ability to high
risk debtors at the price of less protection, while other variables are held constant.
The assumptions underlying these two alternatives have avoided several important
questions about the impact ceilings will actually have in the real world. After briefly
examining these questions, they can be set aside until we have explored the ethical basis
for lowered ceilings. Then they will be treated at greater length.
The first question is whether there is a strong relationship between lowered ceilings and
reduced psychic harm resulting from default. Even though the connection between
lowering ceilings and barring some high risk consumers from some credit is quite well
established,85 we do not understand well the relation between rate . ceiling levels, default
and psychic harm. Despite the time and money the National Commission on Consumer
Finance spent, its staff did not seriously inquire into the psychic impact of default. 86 It
did not do so presumably because of greater concern with the question of availability of
credit a factor of overriding significance only if the problem is to be analyzed solely in
terms of freedom of choice. 87 Although Professors Caplovitz and Jacobs have given us
evidence of significant psychic impact associated with default, the evidence is not related
to particular rate ceiling levels.88 If we can assume that the psychic harm they document
occurs with regularity in most defaults, credit with a high risk of default should carry a
high risk of psychic harm. But we still do not know enough to judge at what risk level
that harm reduces to acceptable proportions. The analysis in this part can therefore only
suggest that lowered rate ceilings are likely to have merit; it cannot determine with
precision that they do.
Second, whether a lowered ceiling will be completely effective in removing high risk
credit without seriously interfering with socially acceptable credit must be determined.89
A lowered ceiling will certainly exclude from the market some of the highest risk credit.
But there may still be "leakage" in retail markets, for example, unless rather extensive
regulation is
combined with the lowered ceiling.90 Lowered ceilings may also restrict socially
acceptable credit unless the market works with absolute perfection.91
The third question is whether there will be a seriously adverse impact on the competitive
structure of the credit industry in the low ceiling
system. Lowered ceilings will certainly interfere with pricing in the market for credit, and
they may ultimately drive out all but the most efficient operators,92 thereby reducing the
potential for competition. High ceilings might not have this disadvantage.
Fourth, there may be some alternative regulatory program which could
provide similar protection yet not carry the disadvantages of the low ceiling system.
Because a quite different ethical question would be posed if protection similar to that
produced by a low ceiling were obtainable without high cost in freedom to borrow or in
efficiency, the availability of such an alternative must be explored ..
Finally, we know practically nothing about the net transaction costs produced by credit
rate regulation.93 A lowered rate ceiling might r quire extensive enforcement,
particularly if an illegal loan market began to develop. Furthermore, an attempt to restrict
the ability of retailers to cover some of their credit extension costs by raising the prices of
goods sold would increase enforcement costs.94 On the other hand, regulatory costs
could just as well turn out to be higher under the second hypothetical system because the
greater volume of high risk credit associated with higher ceilings could result in greater
default collection. And there might be greater resort to bankruptcy and welfare than in the
lower risk system.
Each of these questions raises an important difficulty with lowering rate ceilings for
protective purposes. The issue that must first be settled, however, is whether there is
some ethical justification for such ceilings.
B. The Ethical Position Favoring Low Ceilings
The controversy whether protection justifies restrictions on borrowing ability and
freedom of action caused by low rate ceilings revolves around a classic ethical question.
To what extent is it proper to limit an individual's freedom of action in order to protect
that individual? A universally acceptable resolution has never emerged,95 and I do not
suggest that I have found one. Nonetheless, an examination of the precise effect lowered
ceilings would have on freedom of action will reveal a degree of infringement to which
only the most extreme libertarians could object.
1. The Purpose of Low Ceilings Reexamined and Refined
I have already urged that a lowered ceiling can be used to improve a society's overall
distribution of benefits and burdens among its members.97 At this point, it is necessary to
specify the distributive improvement that might be achieved. The protection from a high
risk of default afforded by a lowered ceiling is not expected to transfer wealth in the same
direct way as a welfare payment.98 A lowered ceiling, by protecting the debtor family
from a threat to stability and psychic harm,99 should, however, help maintain a minimum
standard of existence sufficient to preserve the dignity of the individual. Proposals for
various minimum standards are usually justified as a means to promote equality and to
satisfy the basic conditions for assuring the citizen the ability to exercise and enjoy
freedom. The low ceiling system hypothesized can therefore be viewed as an attempt to
equalize in part the distribution of such important social goods as family stability and the
ability to enjoy and exercise freedom.100 Of course, the contribution a low ceiling
system would make toward securing these goods is only a partial one, but it may
nonetheless be an important complement to other programs with the same objectives.
2.
The Apparent Infringement on Freedom I: Who Is Hurt by Low
Ceilings?
Lowered ceilings would limit credit to three identifiable classes of borrowers, and only
the third class could rationally complain that its freedom of action was being impaired.
The first class consists of those who would not use high risk credit if they fully
understood the extent and seriousness of the risk involved. The evidence indicates that
consumers understand
little about the terms and conditions of the credit they purchase.101 On the other hand,
they probably do understand that if they fail to repay, serious consequences will follow.
But a large group of high risk debtors may well fail to comprehend their own degree of
risk. No one tells them, as they might, "Eight out of fifty of your class will have serious
trouble repaying; two or three out of one hundred of your class will default and be
subjected to repossession." 102 A National Commission study provides some evidence
that the size of this group of unaware borrowers may be substantial and that the members
of this group may not object to the elimination of high risk credit. Of those who were
denied high risk credit by a legislative change in Maine's small loan laws, thirty-six
percent indicated that they were pleased to be rid of the "burden" of the finance company,
and another twenty-seven percent "felt about the same" without credit as with it.103
A second class of those who would be affected by lowered ceilings is composed of those
people who are simply not competent to run their own affairs. Although I suspect this
class to be rather small, few would object to protecting those who fall within its bounds.
104 Those who have advocated high rate ceilings have usually argued that the creditor
has a strong self-interest in identifying members of this class of borrowers and refusing to
extend them credit.105 Outside of certain peculiar submarkets,106 this incentive no
doubt exists and is quite strong. But the problem is that a creditor's ability to distinguish
members of this class is limited by the cost of obtaining the necessary information and by
the difficulty of ever knowing fully the subjective motivations, intelligence and fortune of
another person. In fact, there may be more than a few members of this class who are not
filtered out by creditors.107 They might be protected by a lowered ceiling.
The disadvantage of the lowered ceiling is to the third class: those who are intelligent
enough to handle their own affairs and willing after intelligent consideration to run the
risk of high cost, high default credit, but who cannot in fact obtain credit from an
alternative low risk source.108 To this class of borrowers the interference with the ability
to arrange their own lives is not so insignificant as to be fairly ignored. Use of credit to
purchase durable goods may sometimes produce a net savings to the consumer.109
Moreover, consumption behavior is a frequently practiced form of individual expression
in this society. By purchasing certain goods on credit, an individual may hope to enjoy a
more satisfying mixture of amenities and necessities than he could otherwise acquire.
The critics have always denounced low ceilings because of the kind of interference with
freedom which would fall on the third class. As the critics have framed the problem, low
ceilings are undesirable because they obstruct personal liberty (in choice of lifestyle) for
an improper purpose, paternalistic intervention.11° This argument focuses on the
interests of the third class rather than of the first and second classes, and it has therefore
misstated the issue. In fact, the ethical question is whether, despite the protection
provided the first two classes at no real loss in liberty, the infringement of the personal
liberty of the third class is so unacceptable as to require that lowered ceilings not be used
as a tool of social policy. The argument in response may begin from an ethical premise
quite similar to the one underlying the critics' position. Although the state ought not to
limit personal liberty solely for a paternalistic purpose, it properly may infringe on it in
order to help and protect others.111 This statement of the relation of the individual to the
state is a familiar feature of utilitarian philosophy, 112 and lowered ceilings are
consistent with it. Their use for protection would not be for a paternalistic purpose. They
are designed to protect the first and second classes whose liberty is not decreased by the
protection, although at the expense of the third class.113
Alternatively, one may begin from the premise that some infringement
on personal liberty by the state is acceptable when the infringement is slight, affects
economic rather than political rights, and improves the distribution of benefits in the
society. If we accept this position, as many others have, 114 the question becomes
whether the infringement caused by lowered ceilings can fairly be called minor. There are
several reasons why it can be. First, although low ceilings limit somewhat the ability to
buy major durable goods on credit, the alternative ways of spending the money involved
might be thought adequate to compensate for the loss. The payments that would have
gone to repay the debt with interest could be spent on lower priced items or saved.
Although some advantageous opportunities for example, the possibility that a washing
machine bought on credit would result in net savings to a large family will no doubt be
lost, the alternatives will be adequate in most cases, such as when use of public
transportation would be cheaper than driving a private car purchased on credit. Second,
lowered ceilings do not interfere with the restricted individual's ability to express himself
through a wide range of purchase behavior on a cash basis. Third, if credit were not
available, equally valued new outlets for expression other than purchase behavior might
emerge as substitutes. And, finally, the shape our consumption desires take appears to be
influenced to some degree by social pressures, and particularly by the cumulative effect
of massive advertising.115 The resulting purchase behavior is therefore an amalgam of
individual preference and social conformism.116 As a result, restrictions on purchase
behavior are not wholly restrictions on individual freedom of choice.
The foregoing analysis demonstrates that the interference with individual liberty
occasioned by lowered ceilings will not be nearly as burdensome as some have thought.
In addition, it is clear that our society already tolerates numerous forms of protective
legislation that interfere significantly with an individual's ability to spend wealth in
precisely the way he wants. The Consumer Product Safety Commission, for example,
has the power to ban unsafe products• from the market, even though some who realize
they are unsafe may want to buy them.117 Thus, I am not persuaded that low ceilings
must be rejected out of hand simply because they would somewhat compromise the value
of individual liberty. The conclusion does not directly follow, however, that such
ceilings are justifiable. At most, low ceilings for the protective purposes I am advocating
would be set so as to restrict borrowing by only a small portion of the
population. The dominant society would still be able to use credit freely. The exclusion of
the poorest members of society from the dominant culture might therefore be
exacerbated. For the third class of borrowers, those who want to use risky credit, the
restriction on freedom to borrow caused by low ceilings is actually a decrease in the
ability to participate in the dominant culture. Although the lack of empirical evidence
prevents accurately assessing how serious this widening of the gulf between rich and
poor would be, the potential for harm is great enough to demand that the widening be
seriously examined.
3. The Apparent Infringement on Freedom II: Inequality
The unavoidable conclusion from what has. gone before is that any infringement on
freedom of action caused by low ceilings involves a question more of unequal economic
treatment for the disadvantaged than of a significant infringement on liberty. Insofar as
the critics have based their attack on the argument that low ceilings interfere with
freedom, they may be fairly charged with mislabeling the basic issue. Low ceilings can
be justified as an attempt to promote equality by preserving the basic dignity of the
debtor and the debtor family. Conversely, high ceilings arguably permit high risk debtors
to share in some degree the consumption opportunities of the more fortunate—although,
of course, at higher interest costs. Two mutually exclusive schemes of social
organization, the low and the high ceiling systems hypothesized, both seek to justify
themselves as methods for promoting equality. The type of equality that each seeks to
promote, however, is different. Low ceilings promote equality by seeking to avoid
catastrophes that would destroy stability, self-esteem and family life. The focus is on
conserving the little property and security held by high risk debtors, most of whom
presumably fall in the lower ranks of wealth. High ceilings promote equality by
expanding the opportunities of the same group, at the attendant cost of increasing the
risks, and potentially the rewards, of that group. The basic issue in the controversy over
low ceilings, then, is the ethical problem of determining which type of equality should be
given priority.
4.
The Priority of Protection
A strict utilitarian would resolve the priority problem just posed in favor of the alternative
that produced the greatest good for the greatest number.118 So analyzed, the decision
might be thought best resolved by a
surrogate for majority vote of the borrowers involved.119 The relevant empirical
question would then be whether the first and second classes described above were greater
in number, or perhaps in intensity of opinion, than those in the third class, the group most
disadvantaged by low ceilings.
There is a pragmatic objection, however, that may be raised to basing
resolution of this problem on strict utilitarian grounds. The utilitarian test for priority
raises difficult, and possibly unresolvable, questions. How can we determine the greatest
good in a conflict of this nature when the answer immediately turns empirical and fades
into interpersonal comparisonsutility, as it must? How can we decide satisfactorily
whether the first and second classes are numerically larger than the third; whether the
feelings on the question held by the first and second classes are stronger than those of the
third? The only satisfactory answer may be that we cannot avoid such questions.120 But
if the manifest defects of the market as a device for resolving such questions lead us to
reject its verdict, as I have argued we must, l21 then informed intuition and belief seem to
be the substitute with which we must be content. As I argue below, the lowered ceiling
position has, on the present state of the evidence, as much intuitive appeal in utilitarian
terms as does that of its critics.122
Another approach to wealth distribution questions, recently urged by
Rawls in a special form, suggests that some of these difficulties with utilitarianism can be
avoided.123 If the criterion of choice between conflicting policies should be, as Rawls
suggests, to select whichever program favors the least advantaged group of society, the
controlling question is apparently narrower than that involved in a strict utilitarian
judgment. Arguably, the least advantaged groups affected by low ceilings are the first and
second classes, while the third class is by comparison the most advantaged. The first
class, composed of those who now use high risk credit but would not if they understood
the degree of risk they run, seems easily viewed as less competent and less secure than
the members of the third class, composed of those who would willingly take on the risk
of default in light of the potential rewards. The few studies made of the relation between
personality and attitude toward risk-taking support this view. 124 The fact that the second
class seems clearly more disadvantaged
than the third adds additional support to this justification for low rate ceilings.
Yet this approach, particularly in the concrete application here, has its
difficulties. The principle itself, if applied without limitation, would lead to a complete
equalization of wealth. 125 Rawls therefore surrounds its application with several
significant restrictions, but they are unfortunately so abstract as to make the application
of his analysis here at least as difficult as a strict utilitarian examination of the
problem}26 Moreover, the approach here requires a determination of which class is the
least advantaged. Deciding that question solely on the attitude of a class toward risk is
arguably far too narrow a focus, although it may be the best solution available.127 The
role of informed intuition about the state of the real world is thus just as important to this
analysis as it is to a strict .utilitarian analysis.
Despite these difficulties, the principle that society should generally favor the least
advantaged in making a wealth distribution choice has strong appeal. The choice between
a low ceiling and a high one is a choice between hurting the first and second classes on
the one hand or the third class on the other. The first two classes seem the most
deserving, unless either they are very small in comparison to the third or the protection
from psychic harm provided by lowered ceilings is insignificant. To be sure, the basic
ethical argument underlying this position may be viewed as only a special application of
utilitarianism in which the greatest good is thought to be found by identifying the least
advantaged class and designing social programs that are most likely to aid it. 128 But
regardless of -;whether the argument draws its greatest ethical force from utilitarianism
or some version of Rawls' contractarianism, it plainly, offers an ethically supportable
ground for advocating low ceilings, absent countervailing
considerations. Such considerations, however, must be thoroughly examined before any conclusions• can be reached.
Third, an alternative program that would provide equivalent, or nearly equivalent,
protection at less cost in anticompetitive effects, administrative costs, or other relevant
factors wo4ld clearly be preferable. Although efficiency may be subordinate to ethical
concerns when determining the proper course for distributive policy, the choice of the
method used for accomplishing the social objectives must be directed by cost minimizing
considerations.160
IV. CONCLUSION
Recently, there has been much criticism and little defense of low consumer credit rate
ceilings. The result has been an unbalanced view of the issues involved. An overview of
the potential of lowered ceilings suggests several uses that appear to deserve thorough
consideration before a state or the nation elects a high ceiling policy. Furthermore, close
examination of one use-protecting high risk debtors from the psychic harm associated
with default-suggests that a moderately low ceiling applied to all forms of consumer
credit provides a significant improvement in the distribution of benefits within society.
There will, of course, be those who disagree. When considerations of social policy turn
on the degree of psychic harm which one or another class must bear, empirical evidence
can only help uncover the right decision, it cannot identify it with certainty. A conclusion
in favor of a particular alternative must instead turn on the exercise of careful judgment,
informed by the available evidence and shaped by the relevant ethical considerations. My
•purpose has been to show those who set rate ceiling policy that a reasonable judgment
can be made to use lowered ceilings for protective purposes. A fair evaluation of the
empirical evidence and relevant ethical considerations supports, on balance, lowered
ceilings instead of the high ceiling alternative generally proposed.184 Of course, those
who assess differently the real world-the workings of the credit industry, the motivations
of credit users and the effectiveness of government regulation-will dispute this
conclusion. The available empirical evidence certainly does not preclude differences on
this basis, and I would prefer more evidence correlating default harm with high risk credit
before advocating wide adoption of lowered ceilings.185 But in my judgment the most
reasonable conclusion is that the psychic harm caused by default will have great impact
on high risk debtors if they do borrow and default, while losing the benefits of credit and
suffering pain and embarrassment when it is denied will have a relatively slight effect.
Differing interpretations of the evidence should not be exaggerated, however. The
disagreement over rate ceiling policy arises from a basic difference as to the ethical
considerations which should be brought to bear on the decision. In this respect, the
argument for lowered ceilings appears to rest on stronger grounds than that advanced by
its critics. The ethical justification for lowered ceilings begins from the premise that any
program designed to improve the distribution of benefits and burdens in the society must
at a minimum favor those who are the least advantaged. Lowered ceilings appear to
satisfy this criterion. They will protect two classes of debtors, both of which now use
high risk credit but are unaware of the risks they run when they do so, at the expense of a
third class which seems likely to be better off than the others. 186 In contrast, the ethical
position of those who oppose lowered ceilings remains obscure. On the surface the critics
argue that low ceilings will intolerably impair individual liberty and must therefore be
rejected. Yet close analysis demonstrates little, if any, impairment of the liberty of the
two classes of debtors who are to be protected. Although the freedom of the third class to
use credit is in fact impaired, any program to improve distribution will probably encroach
somewhat on the freedom of others to do what they want. Few will disagree that some
limited encroachment on freedom is acceptable if a significant improvement in
distribution results.
Some critics have also premised their position on a version of utilitarianism. They argue
that high ceilings will maximize the sum of social satisfaction, but they fail to inquire
whether those less well off at the
start are those who end with the greatest improvement.187 A high ceiling program would
favor the third class of debtors-those who are aware of the risks of high risk credit and
want to use it-all the expense of the first two classes. It is difficult to see how social
conditions are improved when the effect of a program is to worsen the lot of the least
advantaged classes affected. If the critics have an ethical justification for high ceilings
which rests on a different foundation, they have failed to explain it. .
Reformers have tended to decide questions of social organization involving the
marketplace by an easy reliance upon the standard wisdom that an unregulated market, on
balance, will produce the best result. Thus, they first suggest solving a social problem in
the marketplace by increasing the conformance of the real market to the intellectual
model of the unregulated market. Yet defining the best social organization is an ethical
question, and the ethical underpinnings of the results of the unregulated market seem
increasingly out of tune with the ethical views of the dominant culture. When the market
exposes individuals to risk of severe physical or psychic harm, ethical concerns will
likely reject reliance on the unregulated market. The Consumer Product Safety
Commission's authority to ban unsafe products is one demonstration of this rejection.188
Therefore, it is no surprise that a close examination of the consumer credit system leads
in a similar direction. Rate ceilings will be, in effect, a ban on unsafe credit. What should
surprise is the failure to notice the similarity between banning unsafe products and
banning unsafe credit. But the model of the unregulated market seems to hold an almost
magic fascination; unfortunately, the magic tends to bewitch rather than clarify. Although
economic analysis helps identify a reform program's cost and benefits, it also tends to
obscure the relevant ethical questions. The only antidote is to inquire continually whether
the market will reach an ethically justifiable result. When that question is asked about
consumer credit, the answer suggests lowered rate ceilings, inconsistent though they may
be with the very essence of an unregulated market.
Edit Elizabeth’s piece
Add Something by Julia Schorr
Chapter 2 A VERY BRIEF HISTORY OF CONSUMER CREDIT IN THE US
This chapter provides a brief history of consumer credit in the United States up until
1978.Prior to the crash there were extremely limited sources of information on this topic.
Perhaps the best is Lendol Calder’s “Financing the American Dream.” Louis Hyman’s
“Borrow, the American Way of Debt” is an excellent example of the more recent work in
this area and is particularly useful because it focuses on the history of the supply of
dollars to lend as well as the borrowers. Later individual chapters on credit cards, home
mortgages and subprime will fill out the story of their history and will carry the story to
the present time.
1880 – 1930
Although the history of consumer credit goes back further, we begin in the nineteenth
century. The largest early credit program of all was the homestead movement wherein
the family “bought” the land and was required to do work on the land within a fixed time
to keep it. Financial institutions and certain wealthy individuals were also willing to
finance the purchase of farm land. Closely related was the growth of farm equipment
lending. This was most often provided by the seller or manufacturer of the equipment
and was an example of “useful,” or healthy borrowing. A similar example is the credit
extended by the Singer Sewing Machine Company. The early sewing machines were
manufactured for industrial use and were too large and expensive for individual
consumers. Singer and others soon realized they had a bonanza if they could make
smaller units and find a way for consumers to “afford” them. This caught on and became
extremely profitable when Singer found a way to provide a credit or financing vehicle.
Once again, this was an example of credit about which the borrower could be proud. On
the other extreme were the loan sharks who were always there and always ready to
finance the consumer need for ready cash.
As we move forward into the twentieth century more and more merchants of various
types sell items on credit or keep an account for the consumer in order to retain their
business. At the beginning of the twentieth century, as more immigrants arrive in the
United States, and as cities continue to grow, several different types of borrowing/lending
trends intensify.
The accounts being kept at merchants grow and add a credit price to a “cash price;
eventually this will become the “time price differential” but at this early stage it is simply
a way for the merchant to keep the customer and realize a profit for the credit sale. In
addition there grew up in poorer sections of urban areas stores that sold only on credit
and that employed route men both as salesmen and as collectors.
A second major development is the short term balloon method of financing a home
purchase. The demand for home mortgage financing grows but the provider of the
financing wants to keep their commitment short term. One way of doing this is to make a
series of three to five year loans at a fixed interest rate. Both parties assume that the
loans can be refinanced at the “going” interest rate at the end of the term and the system
works well so long as there is not significant change in the market or economy or interest
rates which makes the refinance problematic or impossible. The explosive growth of
these short term balloon mortgages was a major factor leading up to the depression of the
late 1920’s.
When Henry Ford and others started the manufacture and sale of automobiles in the
United States in the early part of the twentieth century their initial sales were for cash to
wealthy consumers or businesses. Just as in the case of the sewing machine,
manufacturers they soon realized that if prices could be reduced and if financing could be
made available the potential market for their product would expand enormously.
Prices came down as some used cars became a factor in the market and as the assembly
line became more efficient. Those developments brought in more buyers but the number
of cash buyers even at those reduced prices was severely limited. It became clear to both
General Motors and to Ford Motors that auto financing was the key. Because Henry Ford
was opposed to buying on credit Ford Motors went very slowly down this route. General
Motors had no such reservations and created a financing arm and increased its market
share and the its potential customer base extraordinarily and auto finance followed farm
equipment finance and sewing machine finance.
Neither of these developments satisfied the need of the consumer who wanted some cash
to live or to finance something other than a house or a car or a sewing machine or a
tractor or something that a merchant would sell “on account.” Credit for consumables
was hard to come for the person who did not wish to deal with a loan shark. In a reverse
of the installment sale these folks increasingly turned to the pawn shop where they could
bring something they already owned, receive a small loan and perhaps buy the item back
at a higher price when they had the wherewithal. Pawn shops grew rapidly in number
and in importance.
In the early part of the twentieth century a number of businesses within the American
mercantile mainstream began to try to meet this need for cash. Initially there was moral
resistance to this growth; then a number of non-profits organization that purported to be
a friend and counselor to the potential borrower entered the foray and advocated for laws
that restricted cash lending to well-meaning non-profits. As this development began to
be problematic an important report was issued by ERA Seligman that seemed to give the
society stamp of approval to the small loan industry. This marked the rebirth of that
industry which was shortly followed by legislation allowing them to operate profitably
and attract capital.
1930 – 1950
A widespread credit market emerged in the 1920s. The players in the market were large
manufacturers, who allowed their customers to pay for goods in installments. This
practice was pioneered by the General Motors Acceptance Corporation in 1919, and other
manufacturers followed. These programs required a down payment followed by monthly
payments for a prearranged time period. Customers were approved for the programs on
the basis of their meeting minimum income requirements rather than their personal
reputations.
Pawns shops continued to thrive in the post war period and various types of small loans
have come and gone and come again, this time in the guise of payday loans.
The onslaughts of the Depression and World War II stopped the growing flow of
consumer credit on its heels. The housing finance arena which looms so large over all
other types of consumer credit changed rapidly. Refinancing the short term balloon loans
became impossible; that coupled with the millions of home buyers who lost their jobs and
became unable to make their monthly payments swelled the number of foreclosures into a
true crisis on both a human and economic basis. The government tried a number of
programs to halt the foreclosures and provide the refinancing or finance home purchases.
Some of these marked the intensification of government involvement in the financing of
single family homes that continues today.
As the Depression gave way to World War II the government became concerned about
inflation, the factories turned from automobiles and consumer appliances to war
munitions and the need for consumer credit decreased.
The end of the War changed that in many many ways. Returning white male veterans
more often moved from the cities to the suburbs; department stores grew in importance
and competed for buyer loyalty. Pent up demand for automobiles, consumer appliances
and furniture was extraordinary and so the consumer credit tapper was ready to be turned
back on and expanded significantly.
Historically the dollars that were lent to consumers came from several sources.
One memorable example was the bank accounts in the Bailey Building and Loan in
Bedford Falls. Individual put their money in savings accounts and the financial
institutions lent that money out to folks to buy their homes. Small loan companies fond
their dollars either from the owners’ capital investments or from their own borrowing at
rates lower than they charged to their borrowers. The government involvement in the
home financing arena led to a new source, investments by third parties that were seeking
a high return. This could come in the way of stock purchases in the lender or in the
development of special purpose entities that purchased the loans from the original
lenders. As we will see in the chapter on “where does the money come from: form the
Building and Loan to Securitization, the shift in ownership of the loan and the
concomitant shift in risk will have important implications.
Government financing of homes in the suburbs created heft liabilities for the returning
veterans and their spouses; most government sponsored and non-government lending
sources provided a long term fixed rate mortgage which became the bedrock of U S
financing until late in the twentieth century. As we now know, the shift back to short term
balloon loans will have dire consequences during the next crash; indeed it will be a
significant cause of that crash. This financing will also be done in a manner which is
racially discriminatory since most of these suburbs will not allow a family of color to
own a home within its borders.
The growth of the department stores during this period and their fierce competition for
customer loyalty led to their issuing and urging customers to use their branded credit
card. As we will investigate in the chapter on credit cards non store cards took control of
this market for thirty or more years, but recently this same store loyalty thirst has
reasserted itself.
In the middle of the twentieth century, certain companies offered credit cards, similar to
modern credit cards. The first was the Diners Club card in 1949, followed by bank cards
in the 1950s. The cards entered into widespread use in the 1960s. The concept of the
credit card removed the responsibility of credit verification from the seller. Instead, the
issuing agency allows the consumer a certain limit that it believes he can and will pay
back. This kind of credit is called revolving credit, as opposed to the installment credit
that manufacturers and retailers offered. That chapter will explain in greater detail exactly
how, during the late 1960’s and the 1970’s the Visa and Mastercard systems became
established and developed a strong hold on the consumer borrowing world.
Return to the Payday Lending in America featured collection.
A hundred years ago, when a mass market for consumer credit did not yet exist,
underground purveyors of consumer credit began to emerge, and a variety of problems
ensued. “Salary lenders” offered one-week loans at annual percentage rates (APRs) of
120 percent to 500 percent, which are similar to those charged by payday lenders
today.[i] To induce repayment, these illegal lenders used wage garnishment, public
embarrassment or “bawling out,” extortion and, especially, the threat of job loss.[ii]
State policy makers undertook an effort to suppress salary lending while also seeking to
facilitate the expansion of consumer credit from licensed lenders. One key change was a
targeted exception to the traditional usury interest rate cap for small loans (all original
colonies and states capped interest rates in the range of 6 percent per year).[iii] The 1916
publication of the first Uniform Small Loan Law permitted up to 3.5 percent monthly
interest on loans of $300 or less. Two-thirds of states adopted some version of this law,
authorizing annualized interest rates from 18 to 42 percent, depending on the state.[iv]
Subsequently, a market for installment lenders and personal finance companies
developed to serve consumer demand for small-dollar credit.
By the middle of the 20th century, a mass-market consumer financial industry was
emerging. Consumers were gaining access to a wide range of credit products, including
mortgages to purchase homes and credit cards to purchase goods and smooth household
consumption. State laws started to become inadequate to regulate national lenders. A
series of federal banking-law developments in the 1970s and 1980s eased regulations on
federally insured depositories, mortgage lenders, credit card lenders, and other financial
companies, giving them broad rights to disregard state usury interest laws.[v] As this
deregulation proceeded, some state legislatures sought to act in kind for state-based
lenders by authorizing deferred presentment transactions (loans made against a post-dated
check) and triple-digit APRs.[vi] These developments set the stage for state-licensed
payday lending stores to flourish. From the early 1990s through the first part of the 21st
century, the payday lending industry grew exponentially.[vii]
Today, the landscape for small-dollar credit is changing and several federally chartered
banks, most of which have not previously offered these loans, have expanded their roles
by offering “deposit advance” loans. These bank products share many characteristics of
conventional payday loans, including triple-digit APRs and lump-sum repayment due on
the borrower’s next payday. Further, a growing number of companies are providing loans
online. These lenders pose challenges for state regulators, as national banks are typically
exempt from state lending laws and online providers, who tend to incorporate offshore,
on tribal land, or in states without usury caps, often evade state authority.[viii]
Though federal law remains mostly silent about payday lending, this situation is
changing. The Talent Amendment to the 2007 defense authorization bill sought to protect
military families from payday lending. This federal law enacted a first-of-its-kind, 36
percent interest rate limit on payday loans provided to military service members and their
immediate relatives. Moreover, the Dodd-Frank Wall Street Reform and Consumer
Protect Act of 2010 created the Consumer Financial Protection Bureau (CFPB) and
provided the new agency with the authority to regulate payday loans generally.[ix]
Until the late nineteenth century, credit markets were limited to the local sphere. In 1800,
more than 90 percent of Americans lived in rural communities. Shopkeepers knew the
residents of their towns: they knew who could repay debts and who could not. On the
basis of their personal knowledge, they sometimes chose to issue credit to reliable
customers.
Industrialization and Urbanization
The system of credit advanced by local retailers grew weaker throughout the nineteenth
century. The causes were twofold. First, industrialization gave rise to large companies
that eclipsed local shopkeepers. The owners of these companies did not know the
communities in which they operated, so they could no longer base credit on reputation.
Second, the small rural communities gradually consolidated into cities. Urbanization
meant that each store had a much larger clientele, so keeping track of customers and their
debts became more difficult.
The modern credit market depends on scoring methods that have been devised by credit
reporting agencies to quantify each individual's reliability. These scores limit the access
that people have to the credit market: loans and credit card approvals are based in large
part on the credit agencies' reports. The agencies began with the founding of the Retail
Credit Company (now Equifax) in 1899. Its founders realized that business owners had
little time to keep track of their customers. Moreover, each business took a risk on each
new customer. Businesses were willing to pay for a directory of consumers that rated
their trustworthiness. The company began locally and expanded. Today, four major
agencies operate in the United States: Equifax, Experian, TransUnion and Innovis.
Notes and Questions:
Question #1
Thinks about the “sources of the money that is lent and borrowed.
Who supplies those dollars (the “product” being “sold”)?
Who actually make the loan or credit extension?
What is each of those parties looking for?
Consider the role that each of these “providers” of borrowing dollars has played over
history.
Family
Loan shark
Retailer/clothing
Retailer/furniture
Retailer/ peddler
Pawn shop
Charity
Car sales or credit
Builder and Loan Associations
US Government
BANKER
Question # 2
Think about the following factors as limiting or expanding factors regarding the amount
and ease of borrowing/lending.
Law usury rules or not;
Difference between cash sales and credit sales;
Cultural climate;
Moral climate etc
Economic climate;
Repayment potential
Purchasing climate
Other
QUESTION #3
What did people need / want to buy that they may not have had cash for and were they
credit worthy?
Why did consumption increase so sharply after WW?
Consider the effect of post WW2 suburbanization on consumer credit;
What role did department stores and their willingness or unwillingness to provide credit
have?
Chapter 3 Auto and Installment Debt
FROM BORROW BY LOUIS HYMAN
CHAPTER TWO
EVERYBODY PAID CASH
FOR THE MODEL T
(1908-1929)
The second most expensive purchase most of us ever make is a car, and when Americans
think of cars, we think of Henry Ford. Though fewer of us today drive Fords than
Hondas, Henry Ford's name is forever linked to the automobile. Yet the auto loan, which
makes buying cars possible, has nothing to do with Henry Ford, despite being invented at
just about the same time as his car company, Ford Motor Company. Indeed, Henry Ford
fought tooth and nail not to sell his cars through installment credit and in the process
nearly destroyed his company. Where did auto loans come from, if not from the father of
the car? And why did he resist helping his customers buy his cars?
Before 1919, nearly all cars, including the Model T, were sold for cash. As one General
Motors executive remarked, the car had "given us all something worth working for."1 It
was the ultimate luxury good, giving purpose to the savings of millions of Americans.
The best-selling car in the United States and the world was the Model T from Henry
Ford, whose innovative production techniques transformed the car from a hobbyist curio
into a mass-market love affair.
Before Henry Ford, the automobile languished as a hobbyist's gadget, a rich man's
plaything. Usually the Germans Karl Benz and Gottlieb Daimler are credited with its
invention in 1885, and by the 1890s many varieties of car proliferated in Europe. In the
United States alone there were around 2,500 automobile companies. But none of these
start-ups managed to transform cars into a mass-consumption item. Hand-tooled and built
one by one, they were expensive oddities. A few guys got together and made cars piece
by piece. The parts were never interchangeable. Each one required a great deal of skill to
produce, and the prices of the cars were unbelievable.
In the United States the story was largely the same as in Europe. In the 1890s, there were
already about thirty companies building cars. By 1909, the low-volume, high-price model
of automobile production was standard for the nearly three hundred American automobile
companies. All except for one: Ford Motor Company.
The introduction of the Model T in 1908 changed U.S. industry forever. But the Model T
was not the first car Ford worked on. The company had started in 1903. What happened
in those first five years? Models A, B, C, F, K, N, R, and S all came and went as Ford
struggled to find the right car for the American market. He aimed for a car that would suit
not only a high-end novelty audience but a mass market as well. He wrote in 1906 that
"the greatest need today is a light low-priced car with an up-to-date engine of ample
horsepower, and built of the very best material."2 Ford sold the initial Model Ts for $850
but by 1924 dropped the price to only $290, which is amazing considering the rising
inflation of the period. Quality was key, but so was price. How to reconcile the two?
Ford dropped the production time of a Model T from twelve and half hours in 1908 to
less than thirty minutes by 1914. The car stayed the same while the machines used to
produce the cars constantly improved. In 1915, Ford Motor Company celebrated its
millionth sale.
Ford always thought of himself as a mechanic first and a businessman last. While
"business men believed that you could do anything by 'financing' it," Ford "determined
absolutely that [he] never would... join a company in which finance came before the work
or in which bankers or financiers had a part."5 Ford, more than anything else, was a
builder of cars, He liked to know how they worked. He liked to improve them. Selling
cars was great, but that was secondary to building a quality machine. Once you had a
great machine, he would say, the only thing left to decide was its price,48
Though Ford remained in the hands of the original mechanics who built cars, by 1920
GM, through a series of corporate intrigues, had passed into the control of the Du Font
Corporation, famed for its ability to organize finance as well as production. So on the one
hand there was Ford Motor Company, headed by one man, who believed in nothing but
production, and on the other hand there was a vast corporation, drawing on the
organizational resources of many different men and predicated entirely on profit.
For the auto industry to continue the breakneck growth of the 1910s, new ways to sell
cars would have to be found. Though Henry Ford saw finance as antithetical to
production, General Motors saw salvation in finance. Then, as now, most Americans
bought their cars in the summer. Yet for factories to be run profitably, they had to be run
24/7, even in the winter. Who would pay for the storage of all the excess production?
Once production began to seriously outpace seasonal demand, GM hit upon a clever idea.
GM would finance dealers' purchases of cars from the factory. Then the automaker
wouldn't have to deal with the excess inventory, and dealers would have stock on hand
for any potential customers. If you think the dealers got the raw end of the deal, you
would be right. They had to pay for cars that could not be sold until the summer, while
GM got the interest on the financing, plus the profitable operation of the factory. But a
dealer had little choice in the matter, since GM could easily stop selling its cars and
simply find another dealership that was willing to play ball.
One of Du Font's vice presidents, a finance expert named John Raskob, set up a new
subsidiary corporation to handle this new financing plan, General Motors Acceptance
Corporation (GMAC). Though originally created to handle wholesale dealership
financing, GMAC eventually realized that consumers had financing problems of their
own. Though dealers were loath to go into debt to deal with GM's excess inventory
problem, consumers clamored to borrow. In the first few years of the 1920s, small
finance companies across the country recognized the opportunity and began to offer
consumers the option to borrow against their rising wages. Recognizing the possibilities
to be found, in lending to consumers, GMAC expanded beyond just lending to dealers.
Still, by 1924, GMAC provided about 5 percent of the total annual profit for GM and its
subsidiary companies. Whereas the General Motors Annual Report for 1919 describes the
primary purpose of GMAC as "to assist dealers in financing their purchase of General
Motors' products," by 1927, the GMAC annual report describes "providing] credit to the
consumer of goods as its most important func¬tion."11 Though we might think of GM's
shift to financing as a relatively recent phenomenon, its long road from a manufacturing
company to a finance company began nearly at its outset. By 1927, GMAC's annual gross
revenues totaled more than $40 million, and its assets totaled more than $300 million.
In 1926, GMAC connected high finance with consumer finance for the first time. To
maintain its growth, GMAC issued its first 6 percent bond in February 1926. The investment bank J.P. Morgan sold the bonds, raising $50 million in cash.12 Begun only seven
years earlier, GMAC had assets of $275 million, or 30 percent of General Motors
proper.13 The successful 1926 bond issue was followed in 1927 by another $50 million
sale, giving GMAC the capital it needed to grow.14 Ford, in contrast, relied on its own
pro fits—called retained earnings—to fund its growth. In 1926, it dispersed 62 percent of
profits to stockholders and reinvested an ample $64 million in its operations. Automobile
companies, in particular, did not tend to rely on loans. Car companies tended to fund only
2.3 percent of their capital from bond issues, compared to 9 percent in other industries.
Yet even among that relatively debt-free industry, Ford stood out, with only 0.02
percent—$145,000-—of its capital backed by bonds.15
Finance enabled GMAC to expand, which in turn allowed GM to expand. Raskob
imagined consumer credit as an alternative to socialism, since credit might make possible
"the dream haven of plenty for everybody and fair shake for all, which the socialists have
pointed out to mankind. But our route will be by the capitalist road of upbuilding rather
than by the socialistic road of tearing down."16 Financing also made money: by the late
1920s, auto sales faltered, but the number of cars financed by GMAC grew from 646,000
in 1926 to 824,190 in 1927. In 1927, GMAC financed slightly over one million GM cars.
Henry Ford, meanwhile, fought back against putting Americans in debt. As GM became
the leading American car company in 1927, Ford groused, "1 sometimes wonder if we
have not lost our buying sense and fallen entirely under the spell of salesmanship. The
American of a generation ago was a shrewd buyer. He knew values in the terms of utility
and dollars. But nowadays the American people seem to listen
1920s, GM had become the dominant auto manufacturer in America and Ford struggled
to keep up as it rapidly lost profits and market share. By that point the Model T was
nearly twenty years old, and its low-price design had never changed. It had no roof. It had
no shock absorbers, no electric starter, no battery-powered ignition. It came in. any color
you liked, as long as that color was black. Americans were now willing to pay more to
get a car with a color—and a roof. And they were willing to borrow to do so. Within, ten
years of World War I, installment sales of automobiles rose to 60 percent of total car
sales—from zero. Ford resisted consumer choice and consumer finance at every turn.
By the late 1920s, nearly all goods could be had on the installment plan. Cars and radios
could be bought on time, and so too could vacuum cleaners, phonographs, washing
machines, cabinets, clothes, and nearly anything else. Conservatives worried that all this
borrowing—implicitly a lack of saving—reflected a failure of the American character.
Republican senator James Couzens of Michigan, an early investor in Ford Motor
Company and lifelong friend of Henry Ford, was an outspoken critic of installment
credit. The "growing evil" of installment credit, he said, "results in weakening of
character and neglect of the more substantial things of life."25 Budgeting to spend
instead of budgeting to save, Couzens thought, undermined, the purpose of budgets.
Echoing today's denunciations, he could "say from [his] personal knowledge that the
education of children, their physical well-being generally, even the care of their teeth are
being neglected to enable families to purchase on installments many luxuries [sic]." "If
this is sound," he said, "then let the orgy proceed." It did. Retailers and manufacturers,
ignoring politics in favor of profits, learned to lend, creating finance companies not just
for automobiles but for everything, linking consumers' desire with banks' capital. One of
the main justifications for all this lending was, of course, the character of the people who
borrowed. Early-twentieth-century "Credit men" evaluated borrowers by what they called
the four Cs: "character, capacity, capital, [and] collateral," of which character, it was
claimed, was the basic rock foundation of the four big Cs.26 If borrowing required
character and. the act of borrowing itself eroded character, then all those credit men were
in quite a fix. Luckily it was not just character but the other Cs that mattered as well.
More important than character was the stability of income. Even the Saturday Evening
Post could explain, in 1928, that a car loan "cannot be sold with safety to a man with
even a large income if he has no stability and no character."27 While character,
depending on what one thinks, is within our control, stability often is not. Couzens's
"warning against the continuance of practices which everyone who has had any
experience at all knows to be unsound, unwise, and dangerous" went happily ignored as
long as the economy chugged stably along. Those who grumbled, like the economist C.
Reinhold Noyes writing in the Yale Review, about "financing prosperity on tomorrow's
income" and the inevitability of the business cycle were unheeded.28 Noyes held "the
motor industry to be the storm centre of the next period of depression, and it will be
entirely to blame" for infusing installment credit so thoroughly into the economy. The
Depression, which he correctly predicted in 1927 to be "two or three years" away, would
be "automatic and inevitable" as it was the result of "retribution for economic sin,"29 The
"various bubbles" of cars and houses would burst and. drag down the economy.
Noyes, like all bellyachers, was blissfully ignored. The celebrated economic pundits
pronounced the late 1920s as a New Era forever free of recession. Expansion, made
possible by the electrical age and enabled through credit, would continue forever.
Another Yale economist, Irving Fisher—much more famous1 than Noyes for his
optimism—pronounced in 1929 that stocks, in this new economy, would never fall again.
And then, three days later the world—including Yale-watched slack-jawed as the stock
market crashed.
CHAPTER 4 CREDIT CARDS
GOALS FOR THIS CHAPTER
To understand how the credit card developed in the US
To understand its explosive growth in the 1980 – 2000 period
To understand its development from 2000 – 2012
To predict the future
To understand where the credit card fits in with other payment vehicles and consumer
credit vehicles
In 2010 The BBC produced a series with the lofty title “The History of the World in 100
Objects.” The modern day credit card is and deserves to be one of those 100 objects.
When this course was first taught in the late 1990’s the story of consumer credit seemed
to be the story of American Love Affair with the Credit Card. This was true even though
total credit card debt is just a small fraction of mortgage debt and has even been eclipsed
by educational debt. It remains vitally important today, but its importance economically,
and anthropologically in the years from 1988 to 2000 cannot be overstated.
Before we begin with a quick look at the history of the credit card it is interesting to note
that in Canada and various other countries around the globe the debit card and the credit
card arrived simultaneously and a great many consumers preferred the debit card. No
borrowing (except for charges for overdraft protection) !!! Yet in the United States the
credit card was deeply ensconced in the wallet and the brain and the soul of the American
consumer before the debit card arrived.
Timing may not have been “everything” but it was at least almost everything.
There are some who believe the difference in profitability between the debit card and the
credit card provided the rationale for the timing that occurred.
QUESTION #1 ; In what ways is credit card debt different from other types of consumer
debt such as purchase money mortgage debt, auto debt and educational debt?
Part of the reason is that it is so directly tied to purchasing. It is so tempting and with no
delay a consumer can decide to purchase something they may or may not be able to
afford and buy it now with no scrutiny and perhaps without even much thought or
consideration.
It is so tempting
It is so important to the growth of American consumer spending.
To start with some numbers to give a quick sense of the growth. ( in Billions)
1980
1984
1990
1994
2004
$54 Billion
79
214
313
753
and then look at the ancient history of the credit card in the United States. Commentators
disagree on the beginning of credit card debt; the primary source of information is by
Professor Mandel but Borrow by Louis Hyman has a good section as well. The story is
fairly simple though it has its fits and starts.
STAGE ONE 1950 - 1980
It starts on at least two separate tracks, the growth of single source cards from department
stores and the oil companies and the growth of Diners Club, travel and entertainment
cards which could be used more broadly. There were two primary challenges for the
growth of the business. First and more simple was the technology; second was the
“chicken and egg” problem of needing customers to use the card before retailers became
interested and needing retailers before customers became interested
Diners Club, one of the first of these “universal” cards began to be issued in the early
1950’s and persevered past these problems. It was used mostly by salesmen who were
traveling into their territory. It is often called the pioneer of the use of a third party to act
as a go between for the salesman and the restaurant or hotel. Once it began to thrive,
American Express and Carte Blanch followed its lead. Most of these early cards were
“convenience” cards and not “credit” cards and they required full payment upon full
payment upon receipt of the bill.
. Bank of America dove in on the west coast in the 1950’s and invited great numbers of
largely undifferentiated consumers to sign up. The costs of the effort were considerable,
the results although disappointing were large enough to show the lack of credit standards
and various other problems when both billing errors and delinquencies mounted. . Bank
of America persevered in its own right as an issuer and extender of credit and expanded
to provide the infrastructure under which other banks might issue credit cards affiliated
with the BankAmericard system. Eventually those other banks resented paying a
competitor and the VISA system was created In order to compete with
BankAmericard/VISA other banks joined together to in various associations in what
became the InterBank Card, the Mastercharge and then the MasterCard system.
There was a popular negative reaction to the unsolicited mailings which had swelled the
ranks of the card holders and Congress passed a series of bills intended to regulate the
fast growing industry. American Express passed Diners Club and Carte Blanch by and
continued to grow. These travel and expense cards as they were called charged a
monthly fee, catered to high income card holders and were reasonably profitable. On the
other hand, the startup costs combined with higher delinquencies than the T and E cards
presented challenges to the profitability of the bank cards. This was exacerbated as the
large retailers refused to honor bank cards. Competitive factors kept the banks from
charging monthly or annual fees and state law usury rates kept them from charging
meaningful interest rates. As a partial antidote the banks tried innovative ways of
becoming more profitable.
This was the state of bank credit cards in 1980 as interest rates started to soar and bank
cards were about to enter stage two of their development and growth. JC Penneys, which
had led the resistance to the honoring of bank cards surprised everyone when they
changed course and began to accept the cards. This opened the floodgates and they were
followed by most of the other large department stores that had previously held out.
Lewis Mandell was one of the early scholars of the credit card. The following excerpt
from the Introduction to his work entitled: The Credit Card Industry: A History is helpful.
STAGE TWO 1980 – 1990.
This stage was marked by an extraordinary increase in the number of consumer
borrowers with excellent credit scores and the amount each borrowed. The competition
for market share was extreme and billions of preapproved applications were sent in the
mail. Just as with the current markets for cell phones or computers in Asia, the profit
potential in selling credit this way to Americans seemed unlimited and without parallel in
the financial services industry. The 1980’s witnessed a sea change in the profitability of
credit card operations. Technology and the beginnings of securitization helped but higher
interest rates charged to an increasing number of the same kinds of card holders were the
jet fuel on this sea change.
STAGE THREE 1990 – 2000
Beginning in about 1990 a number of additional factors combined to allow the financial
institutions to reach out far beyond its historical customer base to consumer borrowers
with lower credit scores and to impose fees and penalties of all kinds that would stretch
profitability beyond belief.
For a fascinating article in which the FDIC asked all the right questions but came up with
all the wrong answers please read carefully this article.
http://www.fdic.gov/bank/analytical/fyi/2003/091703fyi.html
STAGE FOUR 2000 – 2007
By 2000, the potential of new customers had become more limited and the companies
were working hard to take customers from one another. The concentration among the
issuer-lenders had intensified and the top six now had a majority of the market. This
allowed them to begin to charge greater fees for the use of the cards. The run up in real
estate values combined with very low interest rates and certain tax advantages combined
to empower a serous rival, the home equity line of credit. If a consumer was a
homeowner then she could likely borrow against the recent increase in the value of her
house at a lower interest rate and with an IRS subsidy on the payment of that interest.
We will study this development in greater detail in the chapter on home mortgages, but
suffice to say that consumer borrowing shifted away from credit cards to home equity
lines of credit. In many cases the consumer paid down her credit card balance with the
proceeds of the home equity loan or line of credit, but in some cases they built them right
back up. Growth rates for credit card debts were smaller, partly because of home equity
lending and partly because the base was so much higher than it had been twenty years
before.
The Mechanics of Payment Card Transactions
The distinctions between ATM cards, charge cards, credit cards, and debit cards are
largely invisible to the ordinary user. Still, those differences are critical to informed
policymakers. To set the stage, this chapter discusses the mechanics of credit and debit
card transactions, providing basic information on the economics of payment cards,
primarily from the perspective of the merchant.
The Credit Card Transaction
Most credit card transactions involve four participants: a purchaser that pays with a credit
card, an issuer that issues the credit card, a merchant that sells goods or services, and an
acquirer that collects payment for the merchant. The acquirer is so named because it
"acquires" the transaction from the merchant and then processes it to obtain payment
from the issuer. In American Express and Discover transactions, the same entity that
issues the card also acquires the transaction. That arrangement is called a three-party or
closed-loop system.
Although the purchaser, issuer, merchant, and acquirer are the nominal parties to the
transaction, the network under which the card has been issued (usually Visa or
MasterCard) is also involved. The networks (associations of member banks that issue
Visa or MasterCard branded cards) provide information and transaction-processing
services with respect to the transaction between the acquirer and the issuer. For example,
when an acquirer has transactions involving Visa-branded cards, it will use VisaNet to
communicate with the issuer of the card to obtain authorization and payment for the
transaction.
Perhaps more importantly, Visa and MasterCard (and the other network providers)
establish and enforce rules and standards surrounding the use of cards carrying their
brands that govern the contract between the acquirer and the issuer. Instead of negotiating
a separate agreement with each issuer, each acquirer simply joins the relevant network
and agrees to comply with the network rules for all transactions on that network. For
example the network rules specify for all entities in the network the fees that the issuer
will deduct from each transaction when it forwards payment to the acquirer. Although the
network rules are central to the operation of the system, they are proprietary documents,
owned by the networks, and thus not readily available.
The key to any credit card transaction is the relationship between the cardholder and the
card issuer. The typical relationship is familiar. The issuer commits to pay for purchases
made with the card, in return for the cardholder's promise to reimburse the issuer over
time. That relationship is the opposite of the common checking relationship, where the
customer normally must deposit funds before the bank will pay checks.
The buy-first, pay-later aspect of most credit-card relationships alters the underlying
economics of the system. Banks that provide checking accounts can earn profits by
investing the funds that customers have placed in their accounts. A credit card issuer does
not have that option, because most cardholders do not deposit funds before they make
purchases on their cards. Indeed, at least in the United States, the cardholder often does
not even have a depositary relation with the card issuer. Traditionally and predominantly,
the profit for the typical card issuer comes from the interest that the issuer earns on the
balances its cardholders carry on their cards from month to month.
The business models have become more diverse in recent years. Some major full-service
issuers like Bank of America, Wells Fargo and JP Morgan Chase, for example, use
relationships to create synergies among a broad portfolio of products. The centrality of
this strategy is epitomized by Wells Fargo's annual report, the theme of which is its
corporate commitment to have seven of its products in the hands of each of its customers.
For these issuers, the profit conies from creating switching costs so that the banks can
charge higher fee levels without losing customers to competitors.
A second group of issuers, banks such as MBNA, Providian and Capital One, focus on
cards as individual profit centers. Those issuers often are called monolines, because they
typically do not offer depositary accounts or other traditional consumer banking products.
Monolines rely for a large part of their income on interest and fees. Even among those
issuers, though, there is a considerable amount of specialization. MBNA, for example,
uses sophisticated data mining to profit in a market niche for loyalty cards, attractive to
upper middle class card users. Those cards and other premium-brand loyalty cards
typically carry a substantial annual fee. By contrast, Providian and Capital One
traditionally have emphasized cardholders of considerably lower credit quality. Still other
issuers focus entirely on highly risky subprime cardholders.
As a matter of industry structure, the monolines are important because they give each
potential cardholder multiple issuers from which to select credit cards. This is not true in
other countries. For example, in England and in France, the majority of cards are issued
by banks that hold deposit accounts for the cardholders. It is fair to say that the card
industry in those countries has not shown as rapid a pace of product innovation or as
aggressive a competition on price as the United States card industry.
That structure has been in considerable flux. In 2005, large mainstream financial
institutions acquired several of the prominent monolines. Although the ultimate
competitive implications of those mergers are difficult to assess, it seems clear that one of
the dominating motivations was the need of monoline issuers to lower the cost of their
funds. It is clear from the annual reports of the acquired entities that these acquisitions
would increase the profitability of the monolines even if the acquiring entities made no
changes in business operations and were unable to create any synergies with their
existing customer bases. To give a sense for the overall revenue structure of the industry,
as it currently exists, Figure 2.2 displays the sources of the $100 billion in 2004 revenues
for United States bank card issuers.
American Household Credit Card Debt Statistics: 2013
The average US household credit card debt stands at $15,325, the result of a small
number of deeply indebted households forcing up the numbers. Based on an analysis of
Federal Reserve statistics and other government data, the average household owes $7,149
on their cards; looking only at indebted households, the average outstanding balance rises
to $15,325. Here are statistics, trends, studies and methodology behind the average U.S.
household debt.
Current as of July 2013
U.S. household consumer debt profile:
•
Average credit card debt: $15,325
•
Average mortgage debt: $147,924
•
Average student loan debt: $32,041
In total, American consumers owe:
•
$11.16 trillion in debt
o
A decrease of 1.6% from last year
•
$856.5 billion in credit card debt
•
$7.86 trillion in mortgages
•
$999.3 billion in student loans
•
An increase of 6.1% from last year
Deep dive: credit card debt
Credit card debt is the third largest source of household indebtedness. Only the mortgage
and student loan debt markets are larger. Here are the latest credit card debt statistics
from the Federal Reserve:
Total Credit Card Debt
Average Household Credit Card Debt
Average Indebted Household Debt
.
Between 2006 and 2008, credit card debt rose steadily and reached its height in January
2009, six months into the financial crisis, as unemployment soared and defaults began in
earnest. From there, average debt loads took a sharply downward trajectory and dipped
below 2006 levels in mid-2010. 2011, however, saw the decline in average debt become a
plateau, and debt levels have since then hovered around $15,600. There is a broad
consensus on why indebtedness rose during the boom years: low interest rates and easy
access to credit brought Americans to take on record levels of debt. However, the data
still leaves two questions:
•
Why did indebtedness decline in 2009 and 2010?
•
Why has indebtedness plateaued since then?
Why did indebtedness fall in 2009 and 2012? Ideally, debt levels would have fallen
because newly frugal Americans paid off their credit card balances. However, a number
of not-so-pleasant factors contributed to the decline. In 2010, credit card companies wrote
off seriously delinquent debts in earnest, lowering the total amount of revolving credit
card debt. The charge-off rate – the percentage of dollars owed that issuers have written
off as uncollectable – rose to 10.9% in the second quarter of 2010. This represented an
increase of over 300% from the first quarter of 2006, when the charge-off rate was only
3.1%. Charge-offs account for a significant portion of the debt reduction.
The graph says it all: between the fourth quarter of 2009 and the fourth quarter of 2010,
average household debt fell by $2,722. The speed with which average debt fell indicates
that loans were written off, rather than paid off. As a result of those losses, spooked credit
card companies tightened their purse strings. Stricter lending standards also contributed
to a fall in total credit card debt. Those two factors – fewer loans, made to more
creditworthy consumers – are troubling, as they speak to a one-off correction rather than
an improvement in underlying factors such as increased income or fiscal prudence.
Why did indebtedness plateau in 2011? As the economy limps forward, credit card
companies increasingly loosen their lending standards. Confident that consumers will be
able to pay off their debts, the issuers allow more people to borrow more money.
NerdWallet expects household indebtedness to resume an upward trend in the coming
years as creditors become more lenient.
Methodology
Household indebtedness estimates can only be considered reliable when three sets of data
were released at approximately the same time:
•
The U.S. Census, taken by the federal government every 10 years, tells us how
many American households there are;
•
The Aggregate Revolving Consumer Debt Survey, taken monthly by the Federal
Reserve, tells us how much debt is outstanding, in total; and
•
The Survey of Consumer Finances, taken by the Federal Reserve every 3-5 years,
tells us the percentage of families with credit card debt.
The last date at which this occurred was March 31st, 2010. To estimate consumer debt in
June of 2012, we extrapolated from the following data sets:
•
The 2010 U.S. Census (2 years out of date)
•
The 2009 Survey of Consumer Finances (3 years out of date)
We also use the Aggregate Revolving Consumer Debt survey, which is current.
Mortgage, student loan and auto loan data come from the New York Federal Reserve’s
Household Credit Report.
Notes about 2012 data:
NerdWallet used a straight-line extrapolation to estimate the number of household units
each month, based on census estimates from 2005 as well as official census data from
2010.
The percentage of credit card approval rates is updated every few years by the Federal
Reserve, and was last published in March 2011 covering a survey period from 2007 to
2009. NerdWallet’s monthly estimates of this figure are based on internal data of credit
card approval rates.
Average U.S. household credit card debt by quarter, 2006-2012
Quarter
Average debt/household
Average debt/
indebted household
1Q2006
$7,826 $16,373
2Q2006
$7,926 $16,582
3Q2006
$8,008 $16,752
4Q2006
$8,123 $16,994
1Q2007
$8,237 $17,232
2Q2007
$8,367 $17,505
3Q2007
$8,543 $17,873
4Q2007
$8,740 $18,285
1Q2008
$8,329 $17,425
2Q2008
$8,416 $17,607
3Q2008
$8,440 $17,759
4Q2008
$8,341 $17,874
1Q2009
$8,186 $17,871
2Q2009
$7,963 $17,718
3Q2009
$7,750 $17,582
4Q2009
$7,516 $17,356
1Q2010
$7,281 $16,633
2Q2010
$7,101 $15,910
3Q2010
$6,939 $15,250
4Q2010
$6,816 $14,702
1Q2011
$6,746 $14,461
2Q2011
$6,730 $14,427
3Q2011
$6,708 $14,380
4Q2011
$6,753 $14,476
1Q2012
$6,754 $14,479
2Q2012
$7,224 $15,485
3Q2012
$7,160 $15,348
4Q2012
$7,168 $15,366
Average U.S. household credit card debt by year, 2006-2012
Year Average debt/household
Average debt/
indebted household
2006 $7,971 $16,675
2007 $8,472 $17,724
2008 $8,382 $17,666
2009 $7,854 $17,632
2010 $7,034 $15,624
2011 $6,734 $14,436
2012 $7,172 $15,374
Credit Performance
Loan Charge-Offs
The charge-off statistics released by the Federal Reserve Board are calculated from data
available in the Report of Condition and Income (Call Report), filed each quarter by all
commercial banks. Charge-off rates for any category of loan are defined as the flow of a
bank's net charge-offs (gross charge-offs minus recoveries) during a quarter divided by
the average level of its loans outstanding over that quarter. Data for each calendar quarter
become available approximately 60 days after the end of the quarter.
Access at: http://www.federalreserve.gov/releases/chargeoff/
Loan Charge-Offs
2006 2007 2008 2009 2010 2011 Q3.12 Q4.12
Charge-Off Rate1 (SAAR, %)
Consumer Loans
2.01 2.50 3.53 5.49 5.88 3.62 2.47 2.50
Credit Cards 3.54 4.00 5.52 9.40 9.34 5.68 3.86 4.06
Residential Real Estate Loans2
0.10 0.26 1.28 2.36 2.12 1.58 1.74
1.08
Net Charge-Offs3 (NSA, $ Mil)
Consumer Loans
$16,314
$21,987
$34,190
$52,961
$74,345
$43,010
$7,305 $7,558
Credit Cards $11,007
$13,339
$19,950
$34,883
$61,886
$35,017
$5,788 $5,906
Residential Real Estate Loans2
$1,835 $5,036 $25,513
$49,540
$44,273
$32,155
$9,058 $5,669
Source: Federal Financial Institutions Examination Council. FRB Call Report. Board of
Governors of the Federal Reserve System.
Notes: SAAR = seasonally adjusted annual rate, NSA = not seasonally adjusted
1 Charge-off rate is the flow of a bank's net charge-offs (gross charge-offs minus
recoveries) during a quarter divided by the average level of its loan outstanding over that
quarter multiplied by 400 to express the ratio as an annual percentage rate. Charged-off
loans are reported on schedule RI-B and the average levels of loans on schedule RC-K.
2 Residential real estate loans include loans secured by one- to four-family properties,
including home equity lines of credit.
3 Charge-offs are the value of loans and leases removed from the books and charged
against loss reserves.
Credit Card Charge-Offs: Managed Assets Basis*
This chart is derived from data available in the Report of Condition and Income (Call
Report), filed each quarter by all commercial banks. The charge-off rate is calculated by
dividing the sum of on- and off-balance-sheet credit card net charge-offs (gross chargeoffs minus recoveries) during a quarter by the on- and off-balance-sheet total amount
outstanding for the end of the previous quarter.
*The charge-off rate presented here may vary slightly from measures reported by the
Board because the Board’s charge-off rate is calculated on the basis of average quarterly
credit card assets. (http://www.federalreserve.gov/releases/chargeoff/)
Source: Federal Financial Institutions Examination Council. FRB Call Report.
Note: The on-balance-sheet net charge-offs calculation comes from the aggregation of
variables RIADB514 (gross charge-offs) and RIADB515 (recoveries) from the Call
Report. The total amount outstanding for on-balance-sheet assets comes from the
aggregation of variable RCFDB538 from the Call Report. For off-balance-sheet assets,
the calculation of net charge-offs comes from the aggregation of variables RIADB749
(gross charge-offs) and RIADB756 (recoveries) from the Call Report. The total amount
outstanding for off-balance-sheet assets comes from the aggregation of variable
RCFDB707 from the Call Report. The bars depict on- and off-balance-sheet charge-offs
in the quarter in which they occurred. The charge-off rate is the ratio of net charge-offs
realized in the quarter divided by the sum of on- and off-balance-sheet credit card assets
from the end of the previous quarter.
Loan Delinquencies
The delinquency statistics presented on the Federal Reserve Board's website are
calculated from data available in the Report of Condition and Income (Call Report), filed
each quarter by all commercial banks. The delinquency rate for any loan category is the
ratio of the dollar amount of a bank's delinquent loans in that category to the dollar
amount of total loans outstanding in that category. Data for each calendar quarter become
available approximately 60 days after the end of the quarter.
Access at: http://www.federalreserve.gov/releases/chargeoff/
Loan Delinquencies
2006 2007 2008 2009 2010 2011 Q3.12 Q4.12
Delinquency Rate1 (SAAR, %)
Consumer Loans
2.90 3.13 3.76 4.70 4.15 3.23 2.77 2.62
Credit Cards 4.01 4.25 5.03 6.53 4.90 3.54 2.82 2.73
Residential Real Estate Loans2
1.73 2.54 4.99 9.14 10.84 10.41 10.60
10.07
Delinquencies3 (NSA, EOP, $ Mil)
Consumer Loans
$26,104
$33,737
$44,007
$46,140
$46,064
$38,573
$33,554
$33,684
Credit Cards $13,738
$17,376
$22,935
$24,368
$27,489
$20,950
$17,295
$17,563
Residential Real Estate Loans2
$39,925
$65,942
$145,024
$232,739
$220,389
$217,754
$221,307
$215,039
Source: Federal Financial Institutions Examination Council. FRB Call Report. Board of
Governors of the Federal Reserve System.
Notes: NSA = not seasonally adjusted, EOP = end of period
1 "Delinquency Rate" is delinquent loan/lease as a percent of end-of-period loan/lease
balance
2 Residential real estate loans include loans secured by one- to four-family properties,
including home equity lines of credit.
3 Delinquent loans include those past due 30 days or more and still accruing interest, as
well as those on nonaccrual status.
Credit Standards and the Demand for Credit
The data used to describe banks’ credit standards and demand for consumer loans come
from two questions asked by the Senior Loan Officer Opinion Survey (SLOOS). This
survey covers approximately 60 large domestic banks and 24 U.S. branches and agencies
of foreign banks. The Federal Reserve generally conducts the survey quarterly, timing it
so that results are available for the January/February, April/May, August, and
October/November meetings of the Federal Open Market Committee. Questions cover
changes in the standards and terms of the banks' lending and the state of business and
household demand for loans, or occasionally specific topics of current interest.
Access at: http://www.federalreserve.gov/boarddocs/snloansurvey/
Note: The height of the line in the above graph is the net percentage of banks tightening
credit standards for new credit card applicants.
Note: The height of the line in the above graph is the net percentage of banks with
strengthening demand for consumer loans.
Debit Cards
The data used to describe debit cards come from the 2007 and 2010 Federal Reserve
Payments Studies and The Nilson Report, a twice-monthly newsletter based in
Carpinteria, California. The Federal Reserve Payments Study is a triennial survey of the
payments industry first conducted in 2001. These studies are part of a Federal Reserve
System effort to track noncash payments in the United States, and they reflect the efforts
of hundreds of organizations across the country. Nilson kindly permits some of its data to
be included in tabulations that appear in the U.S. Census Bureau’s Statistical Abstract of
the U.S. We include data from the 2009 edition here. More recent data should be obtained
directly from Nilson.
Access at:
•
The 2010 Federal Reserve Payments Study
Return on Assets at Large U.S. Credit Card Banks (%)
Year Return
2001 3.24
2002 3.28
2003 3.66
2004 3.55
2005 2.85
2006 3.34
2007 2.75
2008 1.43
2009 -3.01
2010 2.36
2011 5.25
Note: Credit card banks are commercial banks with average managed assets (loans to
individuals, including securitizations) greater than or equal to $200 million with a
minimum 50 percent of assets in consumer lending and 90 percent of consumer lending
in the form of revolving credit. Profitability of credit card banks is measured as net pretax
income as a percentage of average quarterly outstanding balances.
Source: Report of Condition and Income (Call Report)
Consumer Borrowing Falls as Less Is Put on Credit Cards
By THE ASSOCIATED PRESS
Published: September 10, 2012
WASHINGTON (AP) — Americans cut back on their credit card use in July for a second
consecutive month, suggesting that many remain cautious in the face of high
unemployment and slow growth.
The New York Times
Total consumer borrowing dipped $3.3 billion in July from June, to a seasonally adjusted
$2.705 trillion, the Federal Reserve reported Monday. The drop in credit card debt offset
a small rise in a measure of auto and student loans.
The Fed also said Americans had borrowed much more than previously estimated after it
revised consumer borrowing data back to December 2010. June’s figure was increased to
$2.708 trillion, or $130 billion more than initially thought. That is also well above
prerecession levels.
Consumer debt declined even though Americans increased their spending in July by the
most in five months, according to government data released last week.
Consumers have been using credit cards much less since the 2008 financial crisis. Four
years ago, Americans had $1.03 trillion in credit card debt, a record high. In July, it was
$850.7 billion, 17 percent lower.
During that same time, student loan debt has increased sharply. The category that
includes auto and student loans, along with other loans for items like boats, has jumped to
$1.85 trillion from $1.56 trillion in July 2008. The weak job market is putting more
pressure on the Federal Reserve to provide more help to the anemic economy. The Fed’s
policy makers will meet Wednesday and Thursday to consider whether to take further
action at this time.
The economy is growing too slowly to bolster business and consumer confidence and
spur sustained gains in spending and hiring. Overall economic growth slowed to an
annual rate of just 1.7 percent in the April-June quarter and analysts do not expect much
of a pickup for the rest of the year.
Over all, Americans have been steadily paring debt since the financial crisis. Household
debt, including mortgages and home equity lines of credit, has declined for 16 straight
quarters to $12.9 trillion in March, according to a separate Fed survey on consumer
finances. That is down from $13.8 trillion in March 2008.
is largely due to defaults rather than repayment
Debit card usage
•
THE AVERAGE DEBIT CARD HOLDER SPENT $8,326 ON THE DEBIT
CARD IN 2011, UP FROM $7,781 IN 2010.38
•
ACTIVE DEBIT CARD USERS PERFORMED AN AVERAGE OF 18.3
PURCHASES A MONTH WITH THEIR DEBIT CARDS IN 2011 COMPARED WITH
16.3 A MONTH IN 2010.38
•
THE AVERAGE PRICE ON A DEBIT TRANSACTION IN 2011 WAS $38.
THE MEDIAN PRICE ON A DEBIT TRANSACTION IN 2011 WAS $19. MORE
THAN 30 PERCENT OF DEBIT TRANSACTIONS IN 2011 WERE LESS THAN
$10.38
•
63 PERCENT OF DEBIT CARD HOLDERS SURVEYED IN 2011 SAID THEY
USED THEIR DEBIT CARDS MOST OFTEN TO PAY FOR GROCERIES,
COMPARED WITH 19 PERCENT WHO SAID CREDIT CARDS AND 13 PERCENT
WHO SAID CASH.37
•
50 PERCENT OF DEBIT CARD HOLDERS SURVEYED IN 2011 SAID THEY
USED THEIR DEBIT CARDS MOST OFTEN TO PAY FOR GASOLINE,
COMPARED TO 25 PERCENT WHO SAID CREDIT CARDS AND 13 PERCENT
WHO SAID CASH.37
•
50 PERCENT OF DEBIT CARD HOLDERS SURVEYED IN 2011 SAID THEY
USED THEIR DEBIT CARDS MOST OFTEN TO PAY AT DISCOUNT STORES,
COMPARED WITH 17 PERCENT WHO SAID CREDIT CARDS AND 23 PERCENT
WHO SAID CASH.37
•
47 PERCENT OF DEBIT CARD HOLDERS SURVEYED IN 2011 SAID THEY
USED THEIR DEBIT CARDS MOST OFTEN TO PAY AT DEPARTMENT STORES,
COMPARED WITH 25 PERCENT WHO SAID CREDIT CARDS AND 8 PERCENT
WHO SAID CASH.37
•
46 PERCENT OF DEBIT CARD HOLDERS SURVEYED IN 2011 SAID THEY
USED THEIR DEBIT CARDS MOST OFTEN WHEN ONLINE SHOPPING,
COMPARED WITH 40 PERCENT WHO SAID CREDIT CARDS AND 2 PERCENT
WHO SAID CASH.37
•
46 PERCENT OF DEBIT CARD HOLDERS FSURVEYED IN 2011SAID
THEY USED THEIR DEBIT CARDS MOST OFTEN WHEN DINING IN
RESTAURANTS, COMPARED WITH 26 PERCENT WHO SAID CREDIT CARDS
AND 21 PERCENT WHO SAID CASH.37
•
38 PERCENT OF DEBIT CARD HOLDERS SURVEYED IN 2011SAID THEY
USED THEIR DEBIT CARDS MOST OFTEN WHEN SHOPPING AT
CONVENIENCE STORES, COMPARED WITH 11 PERCENT WHO SAID CREDIT
CARDS AND 38 PERCENT WHO SAID CASH.37
•
36 PERCENT OF DEBIT CARD HOLDERS SURVEYED IN 2011 SAID THEY
USED THEIR DEBIT CARDS MOST OFTEN WHEN DINING AT FAST FOOD
RESTAURANTS, COMPARED WITH 11 PERCENT WHO SAID CREDIT CARDS
AND 46 PERCENT WHO SAID CASH.37
•
DEBIT CARD PAYMENTS ACCOUNTED FOR 43 PERCENT OF 110
BILLION TRANSACTIONS IN 2011, UP FROM 19.4 PERCENT IN 2003.40
•
HALF OF ALL NONCASH PAYMENTS FOR FUEL IN 2012 WERE MADE
WITH DEBIT CARDS.41
•
AMONG HOUSEHOLDS WITH INCOME OF LESS THAN $50,000, DEBIT
CARDS ACCOUNTED FOR TWICE AS MANY GAS STATION TRANSACTIONS
AS CREDIT CARDS IN 2012.41
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Follow us: @CreditCardsCom on Twitter | CreditCards.com on Facebook
Compare credit cards here - CreditCards.com
Credit card usage
•Nearly half of low- and middle-income households carried debt from out of pocket
medical expenses on their credit cards in 2012. The average amount of medical credit
card debt was $1,678.19
•Proportion of parents who used credit cards to pay for their kids’ college bills as of
2012: Approximately 4 percent, borrowing on average $4,911.11
•Proportion of college students borrowing from credit cards to pay for college as of 2012:
3 percent. Average amount in college costs financed on those credit cards as of 2012:
$2,169.11
•Low- and middle-income households that used credit cards to pay for basic living
expenses such as rent or mortgage, groceries or utilities, in the 12 months prior to March
2012 because they did not have enough money in their checking or savings accounts: 40
percent.19
•Credit card holders with two to three credit cards who actually use two to three each
month, as of 2012: 49 percent. Credit card holders with four or more credit cards who
only use two to three each month, as of 2012: 68 percent.33
•Credit card users surveyed in 2012 who used their cards to buy: Clothing: 67 percent
Gas: 64 percent
Food: 64 percent
Travel: 62 percent.33
•Among credit card holders surveyed in 2012, those age 50 and up were more likely than
those age 18 to 49 to use their credit card for travel (68 percent versus 55 percent ),
clothing (72 percent versus 62 percent), home maintenance (39 percent versus 28
percent) and car maintenance (54 percent versus 40 percent).33
•63 percent of debit card holders surveyed in 2011 said they used their debit cards most
often to pay for groceries, compared with 19 percent who said credit cards and 13 percent
who said cash.37
•50 percent of debit card holders surveyed in 2011 said they used their debit cards most
often to pay for gasoline, compared to 25 percent who said credit cards and 13 percent
who said cash.37
•50 percent of debit card holders surveyed in 2011 said they used their debit cards most
often to pay at discount stores, compared with 17 percent who said credit cards and 23
percent who said cash.37
•47 percent of debit card holders surveyed in 2011 said they used their debit cards most
often to pay at department stores, compared with 25 percent who said credit cards and 8
percent who said cash.37
•46 percent of debit card holders surveyed in 2011 said they used their debit cards most
often when online shopping, compared with 40 percent who said credit cards and 2
percent who said cash.37
•46 percent of debit card holders surveyed in 2011 said they used their debit cards most
often when dining in restaurants, compared with 26 percent who said credit cards and 21
percent who said cash.37
•38 percent of debit card holders surveyed in 2011 said they used their debit cards most
often when shopping at convenience stores, compared with 11 percent who said credit
cards and 38 percent who said cash.37
•36 percent of debit card holders surveyed in 2011 said they used their debit cards most
often when dining at fast food restaurants, compared with 11 percent who said credit
cards and 46 percent who said cash.37
Read more: http://www.creditcards.com/credit-card-news/credit-card-industry-factspersonal-debt-statistics-1276.php#ixzz2nICxeQWh
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Compare credit cards here - CreditCards.com
Debit Cards End 20-Year Trend Of Gaining Share Against Credit Cards According to
The Nilson Report
November 11, 2013 03:44 PM Eastern Standard Time
CARPINTERIA, Calif.--(BUSINESS WIRE)--The more than 20-year trend that had
debit card purchase volume and purchase transactions gaining share versus credit cards
ended in 2012, according to The Nilson Report, a leading payment industry newsletter. In
a feature projecting results for U.S. payment cards through 2017, it reported that spending
for goods and services on general purpose and private label consumer and commercial
credit, debit, and prepaid cards reached $4.633 trillion in 2012, and is projected to reach
$7.285 trillion by 2017.
“There is a finite amount of money in deposit accounts owned by consumers”
Credit cards accounted for 52.82% of spending in 2012 compared to 47.18% for debit
cards. In 2011 credit cards accounted for 52.63% and debit cards accounted for 47.37%
of $4.301 trillion in purchase volume. In 2017, 54.72% is projected to be generated from
credit cards and 45.28% from debit cards.
“There is a finite amount of money in deposit accounts owned by consumers,” said David
Robertson, Publisher of The Nilson Report. “Credit cards are different. Because they can
borrow money and pay it back over time, they can spend more on credit than they have in
their own accounts.”
Visa debit cards’ market share of 23.83% was highest when comparing purchase volume
for all product types in 2012. Visa credit cards ranked second with 21.18%, followed by
American Express credit cards (12.70%), MasterCard credit cards (11.53%), and
MasterCard debit cards (9.67%).
Visa credit card purchase volume is projected to have a greater share in 2017 at 23.65%
than Visa debit cards at 22.98%. American Express’s share is projected to grow to
13.36%. MasterCard’s credit card share is expected to fall to 10.82%, and its debit card
share is expected to fall to 9.40%.
About The Nilson Report
The Nilson Report is a highly respected source of global news and analysis of the card
and mobile payment industries. The subscription newsletter provides in-depth rankings
and statistics on the current status of the industry, as well as company, personnel, and
product updates. David Robertson, Publisher of The Nilson Report, and a recognized
expert in the field, is a frequent speaker at industry conferences, and is regularly quoted
in publications worldwide. Over 18,000 readers in 90 countries value The Nilson Report
to track industry trends and market information.
Contacts
The Nilson Report
Lori Fulmer, 805-684-8800
lfulmer@nilsonreport.com
CHAPTER 5 STUDENT LOANS
January 2, 2014
The growth of student loan debt from 2004 to 2014
Please read: http://mercatus.org/publication/student-loan-debt-increases-281-percentover-ten-years
A FEW SLECTED QUESTIONS AND QUIERIES
QUESTION
1.
How do you explain this explosive growth?
QUESTION
2.
What does this mean, micro and macro for people of color?
What does it mean for those people in the lower 40 % by income or new worth
What does it mean for our society
What are its implications for our economy
What to do about it?
3.
Compare and contrast student loan with credit card and auto debt
As the growth of credit card debt slowed and as the Crash hit the mortgage debt world,
student loan debt exploded to overtake credit card debt and to overtake auto debt.
4.
.
What are the effects of not having lending criteria applied to the
making of student loans
5.
What should the bankruptcy discharge rules be for student loans?
Should there be any special rules to govern student loans that are used at for profit
educational institutions
Here are two websites that may be useful.
www.studentloanborrowerassistance.org
www.studentaid.gov
Here are a few recent articles.
Digging Deeper Into Student Loan Debt
Posted: 04/09/2013 11:49 am
.
As student loan debt rises at an alarming rate in the United States, some analysts fear that
this trend could cause another economic crisis. From 2005 to 2012, student loan debt
grew from $364 billion to $904 billion -- an increase of 13.9 percent annually. In a recent
Federal Reserve Bank of Kansas City working paper, Kelly Edmiston, Lara Brooks, and
Steven Shepelwich concluded that:
High debt levels, coupled with high default rates, present a number of challenges for
individual student loan borrowers, but do not necessarily pose a substantial burden on
society at large.
High aggregate student loan debt may have only a minimal impact on the U.S. federal
government and its taxpayers, but individual debt can be a major problem for borrowers.
Too often, high school graduates do not know how financial aid works, how much aid
they really need, or even that they have to repay student loans. With more financial
education at this critical juncture, a young college student will maximize scholarships and
minimize loans. This knowledge can also be empowering -- motivating a student to finish
a degree program on time.
It is also important to dig deeper into "the student loan problem." There are two key
considerations that should mitigate some of our concerns about aggregate U.S. student
loan debt.
•Although the average student loan is approximately $26,000, the median loan is about
$13,000. There is a substantial difference between the mean and the median because
some borrowers amassed student loan bills, skewing the student loan mean to twice the
median. $13,000 is certainly nothing to sneeze at, but for individuals that pay their loans
back over ten years, the monthly loan payment is lower than the typical car payment.
•A deeper analysis of student loan debt suggests that most of the increase in aggregate
debt has resulted from an increase in the number of borrowers. When the economy is in
bad shape, more people make the decision to pursue a college degree. Over the past five
years in particular, many post-secondary institutions have seen a marked rise in
enrollments.
Don't get me wrong, high student loan debt is worrisome. A high individual debt burden
restricts one's discretionary purchasing power. If I need to budget $190/month for student
loan payments, I have less ability to consume more generally. This is a problem because
it limits economic growth. While student loan debt may not trigger an economic crisis, it
is a serious problem for many borrowers. If you are a recent graduate in a poor economy,
it is extremely difficult to pay back that loan if you cannot find a job that pays well.
Seventeen percent of individuals with student loan debt are delinquent on their payments.
This is a higher delinquency rate than most other forms of debt. Moreover, bankruptcy
does not free the borrower from student loan debt.
But student loans play an important role in the United States. College is expensive, and
most students cannot finance their education without loans. Student loan debt is used to
make an investment in human capital. Since this investment may seem intangible to
young people, they may start to wonder: is college worth it?
The answer is yes, for two reasons:
•As of January 2013, the unemployment rate was 8.1 percent for high school graduates
with no college, but only 3.7 percent for college graduates.
•College graduates earn $21,900 more per year than high school graduates who do not
have a post-secondary degree.
Teenagers need help understanding financial aid. High school counselors and parents
play critical roles in facilitating these important conversations. Once they start college, it
is really important that students complete a degree. On average, only 60 percent of
students enrolling in a post-secondary institution complete their degree program within
six years. Not surprisingly, the delinquency rate on student loans is much higher for the
40 percent that start -- but do not finish -- college.
Although student loan debt may not be a collective crisis, it can certainly be a crisis for
the individual borrower. It is crucial that teenagers think long and hard about the degree
they plan to pursue, the work prospects for people with that degree, and their future
ability to repay student loans.
Follow Mike English on Twitter: www.twitter.com/@moeconomics
How many Americans borrow/have borrowed for college?
• Nearly 20 million Americans attend college each year. (Source: Chronicle of Higher
Education)
• Of that 20 million, close to 12 million – or 60% - borrow annually to help cover costs.
(Source: Chronicle of Higher Education)
• There are approximately 37 million student loan borrowers with outstanding student
loans today. (Source: Federal Reserve Board of New York)
• As of the first Quarter of 2012, the under 30 age group has the most borrowers at 14
million, followed by 10.6 million for the 30-39 group, 5.7 million in the 40-49 category,
4.6 million in the 50-59 age group and the over 60 category with the least number of
borrowers at 2.2 million for an overall total of 37.1 million. (Source: FRBNY)
How much do Americans borrow/have borrowed for college?
•There is roughly somewhere between $902 billion and $1 trillion in total outstanding
student loan debt in the United States today. The Federal Reserve Bank of New York
reports $902B while the Consumer Finance Protection Bureau reports $1T.
•Roughly $864 billion is outstanding federal student loan debt while the remaining $150
billion is in private student loans(Source: Consumer Finance Protection Bureau). Private
student loans are not made or backed by the federal government.
•As of Quarter 1 in 2012, the average student loan balance for all age groups is $24,301.
About one-quarter of borrowers owe more than $28,000; 10% of borrowers owe more
than $54,000; 3% owe more than $100,000; and less than 1%, or 167,000 people, owe
more than $200,000. (Source: FRBNY)
•Among all bachelor's degree recipients, median debt was about $7,960 at public fouryear institutions, $17,040 at private not-for-profit four-year institutions, and $31,190 at
for-profit institutions. (Source: College Board)
•As of October 2012, the average amount of student loan debt for the Class of 2011 was
$26,600, a 5 percent increase from approximately $25,350 in 2010. (Source: The Project
on Student Debt)
Who borrows/has borrowed?
Among all 2007-08 bachelor's degree recipients:
• 66% graduated with some education debt, while 10% had borrowed $40,000 or more.
• 62% at public four-year institutions borrowed.
• 72% at private nonprofit four-year institutions borrowed.
• 96% at private for-profit institutions borrowed.
Associate’s degree and certificate recipients, 2007-08:
• 38% of associate’s degree recipients at public institutions borrowed.
• 98% of associate’s degree recipients at private for-profit institutions borrowed.
• 30% of certificate recipients at public institutions borrowed.
• 90% of certificate recipients at private for-profit institutions borrowed.
Among students who earned graduate degrees in 2007-08:
• 26% had no education debt at all.
• 14% had undergraduate debt but no graduate school debt.
• 7% had borrowed $80,000 or more for graduate school.
• 5% had borrowed between $60,000 and $79,999.
(Source: The College Board)
The majority of borrowers still paying back their loans are in their 30s or older. Of the 37
million Americans with outstanding student loan debt:
• Almost 40% of these borrowers are under the age of 30.
• Nearly 42% are between the ages of 30 and 50.
• 17% are older than 50.
• Borrowers age 30-39 carry $307 billion in student loans, followed by those under 30 at
$292 billion, $154 billion in the 40-49 age group, 50-59 at $106 billion and the over 60
category carrying $43 billion, for a total outstanding debt of $902 billion.
(Source: FRBNY)
How many student loan borrowers struggle with repayment?
• Of the 37 million borrowers who have outstanding student loan balances, 14%, or about
5.4 million borrowers, have at least one past due student loan account.
• Of the $870B-$1T in outstanding student loan debt, approximately $85 billion is past
due.
(Source: FRBNY)
• The official FY 2010 two-year national student loan cohort default rate rose to 9.1
percent, up from 8.8 percent in FY 2009, while the three-year rate declined slightly from
13.8 percent to 13.4 percent. (Source: U.S. Department of Education)
• Only about 37 percent of federal student loan borrowers between 2004 and 2009
managed to make timely payments without postponing payments or becoming
delinquent.
• For every student loan borrower who defaults, at least two more borrowers become
delinquent without default.
• Two out of five student loan borrowers – or 41%- are delinquent at some point in the
first five years after entering repayment.
(Source: Institute for Higher Education Policy)
• As of 2012, there are now more than $8 billion in defaulted private loans, or 850,000
distinct loans in default. (Source: CFPB)
Who struggles most?
• As of early 2012, borrowers in their 30s have a delinquency rate (more than 90 days
past due) of about 6%, while borrowers in their 40s have a delinquency rate double that,
at about 12 percent. Borrowers in their 50s have a delinquency rate of 9.4% and those
over 60 have a delinquency rate of 9.5%.(Source: Federal Reserve Bank of New York
Consumer Credit Panel)
Students who drop out of college before earning a degree often struggle most with
student loans:
• From 2004 to 2009, 33% of undergraduate federal student loan borrowers who left
without a credential became delinquent without defaulting and 26 percent defaulted, vs.
21% with a credential who became delinquent without defaulting and 16% who
defaulted.(Source: IHEP).
And the number of drop-outs is on the rise:
• Nearly 30 percent of college students who took out loans dropped out of school, up
from fewer than a quarter of students a decade ago. (Source: Education Sector)
• More than half of students who take out loans to enroll in two-year for-profit colleges
never finish. At traditional nonprofit and public schools, the percentage of students with
loans who started college in 2003 and dropped out within six years is about 20 percent.
(Source: Education Trust)
Type of institution attended can also make a difference:
• From 2004-09, a third or less of federal student loan borrowers at four-year, public or
private nonprofit institutions became delinquent or defaulted on their loans, while nearly
half or more (45 percent and 53 percent, respectively) of their borrowers were making
timely payments on their loans.
• One-quarter to one-third of borrowers at for-profit and public two-year institutions were
making timely payments on their loans, and more than half of all borrowers in these
sectors were delinquent or had already defaulted.
(Source: IHEP)
Why do they struggle?
• 48% of 25-34 year-olds say they’re unemployed or under-employed.
• 52% describe their financial situation as just fair.
• 70% say it has become harder to make ends meet over the past four years.
• 42% of those under 35 have more than $5000 in personal debt that does not include a
mortgage.
• Student loans account for the most common form of increasing debt among ages 18-24
(54% have seen increased school loan debt) while those in the older group attribute
increased debt equally to school loans (37%) and credit cards (37%).
(Source: Demos and Young Invincibles)
How well do students and alumni understand their options to minimize borrowing and
manage the debt once they have it?
• As of 2012, only 700,000 borrowers had enrolled in Income-Based Repayment (Source:
Project on Student Debt), but the Obama Administration estimates that IBR could reduce
monthly payments for more than 1.6 million student borrowers. (Source: White House
Fact Sheet)
• About 65 percent of high-debt student loan borrowers misunderstood or were surprised
by aspects of their student loans or the student loan process. (Source: Young Invincibles)
• Approximately one-third of recent grads, if they could do it all again, would have
pursued more scholarships or financial aid options, pursued a major that would have led
to a higher paying job, or gotten a job while in college and started saving earlier. (Source:
Accounting Principals)
How is student debt impacting borrowers - and the U.S. economy?
A college degree does increase an individual’s potential for earnings:
• In 2010, people ages 25 to 34 with bachelor's degrees earned 114 percent more than did
those without high-school diplomas.
• College graduates earned 50 percent more than did young adults who completed only
high school, and 22 percent more than did those with associate degrees.
• The median income for young adults with a bachelor's degree was $45,000, and with an
associate degree, $37,000
(Source: National Center for Education Statistics)
Why Do Students Borrow So Much? Recent National Trends in Student Loan Debt
By Kenneth Redd
Educational Resource Information Center (U.S. Department of Education)
College students are leaving their higher education institutions with more educational
loan debt than ever before. From academic year 1994- 1995 to 1999-2000, the amount
postsecondary education students borrowed through the federal student loan programs
jumped from $24 billion to $33.7 billion (U.S. Department of Education 1999 and
2000a). Cumulative federal student loan debt for bachelor's degree recipients rose 19
percent, while total debt for borrowers who received master's and other advanced degrees
more than doubled (Scherschel 2000). What has led to the increased use of student loans?
Is the rising indebtedness harming students' futures?
While concern about rising student debt levels remains high (Scherschel 1999a and
2000), recent data reveal that much of the increased borrowing occurred due to the
expansion of the loan programs rather than to growth in college costs. Further, many of
the new loan recipients came from middle- and upper-income families, and most
undergraduate borrowers do not appear to have been adversely affected by their added
indebtedness.
Reasons why Borrowing has Increased
Several recent studies (King 1999, Redd 1994, Scherschel 1999a and 1999b) provide
three possible reasons for the growth of student loans. First, increases in federal grant aid
have not kept pace with rising postsecondary education costs, and the widening gap
between college prices and grant aid compelled more students to borrow. Second,
students' financial need has increased as educational costs have grown, and more of this
need is met by loans. And third, increases in loan limits and ease of borrowing have
allowed more students to receive loans. Each of these reasons has merit and deserves
consideration.
There is no question that postsecondary education costs grew rapidly during the 1990s.
The College Board's most recent Trends in College Prices report (College Board 2000)
shows that, when adjusted for inflation, tuition and fee charges at four-year public
colleges and universities increased 49 percent during the decade; at four-year private
institutions, tuition prices rose 32 percent. Meanwhile, median income for families with a
head of household age 45 to 54 (families most likely to have college-aged children) grew
by just 4 percent, and appropriations for Federal Pell Grants (aid for low-income
undergraduates) increased only 15 percent.
At first glance, these factors would appear to have been the primary causes for the growth
in borrowing. However, data from the National Center for Education Statistics' National
Postsecondary Student Aid Study (U.S. Department of Education 2000b and 2000c) show
that, for middle- and upper- income undergraduate students, amounts of loans actually
grew faster than their total costs. For families with income of $40,000 to $59,999, the
average annual amount of federal student loans grew to $3,729 from $3,216 during the
1992-93 to 1995-96 period, but total cost of attendance (tuition, fees, room, board, books,
educational supplies, and other expenses) fell from $14,150 to $13,267. Costs declined
because a greater share of the students were enrolled at lower-cost four-year public
institutions in 1995-96 than in 1992-93. Despite the shift in enrollment to less expensive
colleges and universities, students from middle-income families borrowed more. Among
all undergraduate borrowers, average federal student loans grew 16 percent but
educational costs increased just 3 percent. Clearly, growth in educational costs does not
completely explain the increase in borrowing.
Similarly, amounts borrowed grew much faster than upper-income students'
demonstrated financial need. Financial need is defined as the difference between students'
and families' total postsecondary education costs and the estimated amounts they can
afford to pay from their income and other resources. For undergraduates from families
with income of $80,000 or more, financial need increased only 3 percent, but average
loan amounts jumped 13 percent. Low-income students faced the opposite extreme; for
undergraduates from families with income of under $20,000, financial need jumped 23
percent, while average amounts borrowed only grew 11 percent (U.S. Department of
Education 2000b and 2000c).
These results strongly suggest that much of the growth in borrowing also can be
attributed to the changes made in the Higher Education Act (HEA), the federal law that
governs the financial aid programs. In 1992, the law increased the annual and cumulative
maximum amounts students could borrow (Redd 1999). Annual loan limits under the
Stafford Subsidized Loan program (loans provided to students based on their financial
need) for second-year undergraduates were raised to $3,500 from $2,625. The maximum
loan to students in the third or higher year of undergraduate study was raised to $5,500
from $4,000, and graduate/professional student loan maximums grew to $8,500 from
$7,500. More importantly, the law also authorized a new loan program-the Stafford
Unsubsidized Loan program-which essentially allowed all students, regardless of their
families' financial need or income, to receive assistance. Students also were allowed to
receive both subsidized and unsubsidized loans in the same academic year. When the new
unsubsidized loan amounts were combined with the maximum subsidized amounts,
undergraduates in the junior or senior years could borrow up to $10,500 in federal student
loans annually.
Income Levels of Students Who Received Loans:
Much of the recent growth in federal student loan borrowing has been through the
Stafford Unsubsidized Loan program. From its inception in 1993-1994 to 1999-2000, the
amount of unsubsidized loans more than tripled-rising from $4.1 billion to $12.9 billion.
In the same period, amounts of subsidized loans grew 40 percent, from about $12.5
billion to $17.5 billion (U.S. Department of Education 1999 and 2000a).
Because students may receive unsubsidized loans regardless of their families' incomes, a
large share of the added loan dollars appear to have gone to students from middle- and
upper-income families. The percentage of undergraduate students from families with
income between $60,000 and $79,999 who received federal student loans grew from 56
percent in 1992-93 to 67 percent in 1995- 96. At the same time, the proportion of
borrowers from families with income of less than $20,000 who received federal loans
dropped from 52 percent to 49 percent (U.S. Department of Education 2000b and 2000c).
Middle- and upper-income families who might not have qualified for need-based Stafford
Subsidized Loans became eligible to receive Stafford Unsubsidized Loans. While the
unsubsidized program allowed more middle- and upper-income students to receive loans,
it is possible that a number of these students were borrowing more than they really
needed to attend postsecondary education (King 1999, Redd 1994 and 1999).
The Effects of Loans on Borrowers who Receive Degrees
However, the growth in indebtedness has to be put into a larger context. For some
students, borrowing could be a wise investment because it allows them to finish their
educational programs and increases the odds of achieving success in employment and
other areas of life. For others, borrowing might lead to financial burdens. It is commonly
suggested that loan repayment obligations may cause some loan recipients to delay home
and car purchases, marriage, child rearing, and other aspects of life (Baum and Saunders
1998).
Recent information (Baum and Saunders 1998, Choy 2000, Davis 2000) shows that
despite the recent increases in borrowing, loan repayment obligations represent just a
small portion of most borrowers' after-college salaries. For borrowers who received
bachelor's degrees in engineering from four-year public colleges and universities in 1999,
monthly loan repayments accounted for just 4.4 percent of average starting salaries. For
computer science majors, loan repayments represented only 4.5 percent of average
wages, and among education majors, loan repayments equaled only 7 percent of starting
salaries. These findings are not meant to suggest that all borrowers were able to repay
their loans without hardship. Students from medical, dental, and other professional degree
programs typically face debts of $100,000 or more (National Association of Student
Financial Aid Administrators 1999). Another study (Davis 2000) shows that borrowers
who do not finish their educational programs have a much more difficult time in repaying
their loans. Students who leave higher education without obtaining a bachelor's degree
often have lower incomes than degree recipients, which makes it much harder for noncompleters to repay their loans.
Summary
Federal student loan borrowing grew primarily because the maximum loan limits were
increased and middle- and upper-income students became eligible for Stafford
Unsubsidized Loans. However, despite the increases in cumulative debt that occurred,
most undergraduate loan recipients appear to be able to repay their loans with little
difficulty, as long as they complete their degree programs. However, repayment
obligations are much more difficult for professional school students, who often leave
their institutions with debt of $100,000 or more, and for undergraduate borrowers who do
not complete degree programs. More research would provide greater insights into how
indebtedness affects these students after they leave higher education.
References
Baum, S. and D. Saunders. (1998). " Life After Debt: Results of the National Student
Loan Survey." Journal of Student Financial Aid, 28(3) 7-23. EJ 584 134.
Choy, S.P. (2000). Debt Burden After College. Washington, DC: U.S. Department of
Education, National Center for Education Statistics Report Number 2000-188.
College Board. (2000). Trends in College Prices. Washington, DC: The College Board.
Davis, J.S. (2000). College Affordability: Overlooked Long-Term Trends and Recent 50State Patterns. Indianapolis, IN: USA Group Foundation.
King, J.E. (1999). "Crisis or Convenience: Why Are Students Borrowing More?" In
Financing a College Education: How It Works, How It's Changing. Edited by J.E. King.
Phoenix, AZ: American Council on Education/Oryx Press. ED 427 630
National Association of Student Financial Aid Administrators. (1999). Financial Aid
Policies and Practices at Graduate and Professional Schools: Results from the 1998
Survey of Graduate Aid Policies, Practices, and Procedures. Washington, DC: National
Association of Student Financial Aid Administrators.
Redd, K.E. (1994). The Effects of Higher Loan Limits and Need Analysis Changes on
FFELP Borrowing in Pennsylvania, July to December 1992 to 1993. Harrisburg, PA:
Pennsylvania Higher Education Assistance Agency. ED 369 368.
Redd, K.E. (1999). "The Changing Characteristics of Undergraduate Borrowers." In
Financing a College Education: How It Works, How It's Changing
The following report may be helpful.
http://www.nera.com/nera-files/PUB_Student_Loans_0312.pdf
Special Rules for Dischargeability of Student Loans in Bankruptcy
Student loans are, for the most part, not dischargeable in bankruptcy. That means that if
you have a student loan, in most cases you will not be able to eliminate the student loan
debt in bankruptcy. Student loans used to be dischargeable under certain circumstances
prior to October 2005. However, in October 2005, the bankruptcy law on student loans
was rewritten to make all educational loans nondischargeable.
Can I File Bankruptcy on Student Loans in San Diego?
If you are asking the question, can I file bankruptcy on student loans, in most cases the
answer is no. With the revisions to the Federal bankruptcy law in 2005, and the Brunner
Test, which is controlling law in San Diego County as well as throughout the State of
California, there is a very tough standard that you would need to meet in order to be able
to wipe out student loans in bankruptcy. Under this standard, set forth by the Brunner
Test, you need to show that you are so physically or mentally disabled that you cannot
engage in substantial gainful employment. For this reason, it is rare case in which a
borrower is able to eliminate a student loan in bankruptcy.
History
Prior to 1998, you could file a Chapter 7 or Chapter 13 bankruptcy on student loans if the
loan had been in repayment status (not including any deferment period) for at least 7
years at the time that your case is filed.
On October 7, 1998, the Bankruptcy Code was amended to make it more difficult to file
bankruptcy on student loans. The 1998 law made student loans nondischargeable if the
loan was made or guaranteed by the Federal Government unless you could show that
nondischargeability would pose an “undue hardship” upon you and your dependents.
Student loans still remained dischargeable if the loans were not made or guaranteed by
the Federal Government.
On October 17, 2005, the New Bankruptcy Law went into effect and drastically changed
your ability to discharge student loans for most people. The new law, in effect, treats
privately funded student loans in the same manner as government backed loans were
treated since 1998: you cannot eliminate them in most cases. The only exception is that
if you can meet the standard set forth by the Brunner Test.
Under the new law, in effect since 2005, all educational loans, whether governmentbacked student loans or privately funded loans, are nondischargeable in either a Chapter 7
case or Chapter 13 case unless you can show that nondischargeability would post an
“undue hardship” upon you and your dependents.
Undue Hardship – The Brunner Test
The Bankruptcy Code does not define what constitutes an “undue hardship.” To
determine whether or not an undue hardship exists, sufficient to allow you to obtain a
Hardship Discharge of an educational loan in bankruptcy, the Court will apply a specific
test, known as the “Brunner Test.”
The Brunner Test is a 3-Part test first established in 1985 by the Second Circuit Court of
Appeals. At the time the test was established, it was not controlling in the State of
California. Fifteen years after the decision was made by the Second Circuit Court of
Appeals, the Federal Circuit Court having jurisdiction over California, namely the Ninth
Circuit Court of Appeals, made the test applicable in California.
On September 11, 1998, the Ninth Circuit Court of Appeals, which is the Federal Circuit
Court that has controlling jurisdiction over California Bankruptcy Courts, formally
adopted the Brunner Test and made it the applicable test in our state. Since that time, the
Brunner Test has been the controlling test that is applied by California Courts and judges
in deciding whether to grant you Hardship Discharge of your educational loans when you
file for bankruptcy.
Under the Brunner Test, the Court will apply a 3-Part test to determine whether an undue
hardship exists sufficiently for the Court to grant you a Hardship Discharge when you file
for bankruptcy: (1) You must establish that you cannot maintain, based upon your
current income and expenses, a minimal standard of living for yourself and your
dependents if you are forced to repay your loans; (2) You must show that additional
circumstances exist indicating that your current state of affairs is likely to persist for a
significant part of the repayment period of your loans; and (3) You must have made good
faith efforts to repay your loans.
In practice, it is very difficult to obtain a Hardship Discharge under the Brunner Test.
Once you pass the first part of the test- you establish that you cannot maintain a minimal
standard of living if forced to repay your student loans- you must still show the Court that
your situation is not going to change for a significant part of your repayment period.
It will not be presumed by the Court that your current state of affairs is not going to
change for a significant part of your repayment period. Rather, you must make an
affirmative showing and prove to the Court that you have an insurmountable barrier to
financial recovery that is likely to remain with you for a substantial portion of your
repayment period.
Technically, under the Brunner Test, your barrier to financial recovery does not
necessarily need to be so extreme that it rises to the level of a physical disability, learning
disability, mental illness, or other similar extreme circumstance.
In reality, bankruptcy judges frequently reserve granting a Hardship Discharge to the
extreme case- a case where you are physically unable to work and there is virtually no
chance that you will recover and obtain gainful employment in the future. If there is
hope for you to engage in gainful employment, most judges would expect you to find a
job and pay off your loans.
Even if you have an extreme case, you must further show that you have made good faith
efforts to repay your educational loans. This means, for example, attempting to work out
a repayment plan, consolidating your loans under the Federal Direct Loans consolidation
program, and other similar good faith efforts to repay your educational loans prior to
filing bankruptcy and requesting a Hardship Discharge.
Partial Discharge
Discharging student loans in bankruptcy is not always an all-or-nothing proposition.
Bankruptcy Courts are Courts of Equity and judges have equitable powers and may
exercise their equitable powers to partially discharge a portion but not all of your student
loans based upon your individual circumstances.
To obtain a partial discharge of your student loans you will still need to meet all 3 parts
of the Brunner Test with respect to the portion of your educational loans that you are
seeking to discharge. If and only if you meet all 3 parts of the Brunner Test, then the
judge may exercise his or her discretion to grant you a partial discharge of your student
loan debt.
HEAL Loans
Health Education Assistance Loan (HEAL) Act loans are subject to an even stricter
standard (stricter than the Brunner Test) and are harder to discharge than any other type
of educational loan debt. In particular, discharging a HEAL Loan in bankruptcy requires
a finding by the Court that, among other findings, it would be “unconscionable” not to
discharge a HEAL Loan. Unconscionability is a very difficult standard to meet.
Adversary Proceeding Required
If you can establish that your case meets the standard for granting a hardship discharge or
partial discharge of your student loan debt, you will need to initiate an adversary
proceeding in your Chapter 7 or Chapter 13 case and request that the Court make a legal
determination that your loans are discharged by your Chapter 7 or Chapter 13 discharge.
KEY QUESTIONS
Student Loans in Bankruptcy by Chen
http://www.policyarchive.org/handle/10207/bitstreams/19283.pdf
NON BANKRUPTCY RULES FOR FORGIVENESS
From http://studentaid.ed.gov/repay-loans/understand/plans/income-based
December 24, 2013
If your student loan debt is high relative to your income, you may qualify for the IncomeBased Repayment Plan (IBR).
Most major types of federal student loans—except for PLUS loans for parents and
Consolidation Loans that repaid PLUS loans for parents—are eligible for IBR.
Income-Based Repayment (IBR) is designed to reduce monthly payments to assist with
making your student loan debt manageable. If you need to make lower monthly
payments, this plan may be for you.
To qualify for IBR, you must have a partial financial hardship. You have a partial
financial hardship if the monthly amount you would be required to pay on your IBReligible federal student loans under a 10-year Standard Repayment Plan is higher than the
monthly amount you would be required to repay under IBR. Your payment amount may
increase or decrease each year based on your income and family size. Once you've
initially qualified for IBR, you may continue to make payments under the plan even if
you later no longer have a partial financial hardship.
-------------------------------------------------------------------------------Eligible Federal Loans
The following loans from the William D. Ford Federal Direct Loan (Direct Loan)
Program and the Federal Family Education Loan (FFEL) Program are eligible for IBR:
Direct Subsidized Loans
Direct Unsubsidized Loans
Direct PLUS Loans made to graduate or professional students
Direct Consolidation Loans without underlying PLUS loans made to parents
Subsidized Federal Stafford Loans
Unsubsidized Federal Stafford Loans
FFEL PLUS Loans made to graduate or professional students
FFEL Consolidation Loans without underlying PLUS loans made to parents
-------------------------------------------------------------------------------Loans That Are Not Eligible
The following loans are not eligibile for repayment under IBR:
PLUS loans made to parents
Consolidation Loans that include underlying PLUS loans made to parents
Private education loans
-------------------------------------------------------------------------------Monthly Payments
Under this plan, your monthly payments are
based on your income and family size;
adjusted each year, based on changes to your annual income and family size;
usually lower than they are under other plans;
never more than the 10-year standard repayment amount; and
made over a period of 25 years.
-------------------------------------------------------------------------------Advantages of IBR
Pay based on what you earn—Under IBR, your monthly payment amount will be 15
percent of your discretionary income, will never be more than the amount you would be
required to pay under the 10-year Standard Repayment Plan, and may be less than under
other repayment plans.
Interest payment benefit—If your monthly IBR payment amount doesn’t cover the
interest that accrues (accumulates) on your loans each month, the government will pay
your unpaid accrued interest on your Direct Subsidized Loans or Subsidized Federal
Stafford Loans (and on the subsidized portion of your Direct or FFEL Consolidation
Loans) for up to three consecutive years from the date you began repaying your loan
under IBR.
Limitation on the capitalization of interest—While you have a partial financial hardship,
interest that accrues but is not covered by your loan payments will not be capitalized,
even if interest accrues during a deferment or forbearance.
25-year forgiveness—If you repay under IBR and meet certain other requirements, any
remaining balance will be forgiven after 25 years of qualifying repayment.
10-year public service loan forgiveness—If, while you are employed full-time for a
public service organization, you make 120 on-time, full monthly payments under IBR (or
certain other repayment plans) you may be eligible to receive forgiveness of the
remaining balance of your Direct Loans through the Public Service Loan Forgiveness
Program.
-------------------------------------------------------------------------------Disadvantages of IBR
You may pay more interest—A reduced monthly payment in IBR generally means you’ll
be repaying your loan for a longer period of time, so you may pay more total interest over
the life of the loan than you would under other repayment plans.
You must submit annual documentation—To set your payment amount each year, your
loan servicer, the organization that handles billing and other services for your loan, needs
updated information about your income and family size. You must provide the
documentation or your monthly payment amount will be changed to the amount you
would be required to pay under the 10-year Standard Repayment Plan, based on the
amount you owed when you began repaying under IBR, and will no longer be based on
your income. This amount will be higher than your prior IBR payment that was based on
your income. If you do not provide the required income documentation, unpaid interest
will also capitalize.
You may have to pay taxes on any loan amount that is forgiven after 25 years.
-------------------------------------------------------------------------------Using the Repayment Estimator to See How Much You’d Pay Under IBR
Your loan servicer, the company that handles the billing and other services on your
federal student loan, can help you choose a loan repayment plan that’s best for you.
Before you contact your loan servicer to discuss repayment plans, you can use our
Repayment Estimator to get an early look at which plans you may be eligible for and see
estimates for how much you would pay monthly and overall.
-------------------------------------------------------------------------------Tools and Resources for IBR
Want more detailed information about IBR?
1.Download the IBR fact sheet.
2.Browse the IBR Questions and Answers (Q&As). Q&As are grouped into six
categories:
General Information
Eligible Loans
Determination of IBR Monthly Payment Amount
Married Borrowers
Application Process
Other Information
-------------------------------------------------------------------------------Want to Apply for IBR?
Contact your loan servicer before you apply for IBR. Your loan servicer will answer
your questions about the IBR plan and help you to decide whether IBR is the right plan
for your situation.
If you are ready to apply for IBR, go to StudentLoans.gov, sign in, and complete the
electronic Income-Based (IBR)/Pay As You Earn/Income-Contingent (ICR) Repayment
Plan Request.
-------------------------------------------------------------------------------Need Help Repaying Your Student Loans?
If IBR is not right for you, contact your loan servicer to discuss other repayment options.
You may be able to change your repayment plan to one that will allow you to have a
longer repayment period. Also ask your loan servicer about your options for a deferment
or forbearance or loan consolidation.
CHAPTER 6 Loans In Which A Person’s Home Is The Collateral.
I.
Understanding Home Ownership in the United States The pressure to buy a home and then buy a bigger home. These cultural norms are a
driving force in the U.S. and are supported with various kinds of tax breaks and other
government subsidies.
Home construction, home improvements and mortgage finance are
very big pieces of the US economy. In order to regulate mortgage finance we need to
understand the cultural imperatives to own a home and the policies that aim to facilitate
those imperatives.
In order to understand the demand for home equity loans rather than purchase money
mortgages it is necessary to think “credit card spending” with home foreclosure remedies.
As a starter please read this article from 2001
http://www.nytimes.com/2001/11/25/business/a-boom-built-upon-sand-gone-bust.html
(The Green Tree Financing Story- precursor to the Housing Finance Crash)
II.
Tax and other government policies aimed at facilitating home ownership.
III.
Scope of Mortgage Debt.
Mortgage debt is several times the total of all other types of consumer debt rolled
together.
Ratio of mortgage debt to entire consumer debt
Growth of mortgage debt
1990 – 2007 2000 – 2007 OR 8
1975
1990
1998
2005
2009
2012
$1 Trillion
$2 Trillion
$2.8 Trillion
$5 Trillion
$10.5 Trillion
$9 Trillion
IV. History of Mortgage Debt in the United States.
1.
Homestead Acts
2.
Farm Mortgages
3.
1900 – depression
Build up of demand; rising prices; 5 year balloon notes to control interest rate risk for the
lender; problem of refinancing at the end of that five year period when prices stopped
rising or when the crash and depression reduced the availability of funds to lend. Most of
the funds came from deposits so when they dried up …
4.
Depression to the end of World War II. Government tries various methods to
restart home purchases and home construction and ameliorate the effects and damages of
the depression and enormous number of foreclosures.
5.
Post WW II; FHA, VA Fannie Mae, Ginnie Mae: role of government in
promoting and facilitating home ownership and home construction. Interest rate
concessions; making loans available; lower down payment requirement. Racial disparity
of post WWII home push to the suburbs and other places where minority families could
not move. Redlining
6.
1999 Low Interest rates: rising home values; rising percentage of homeowning
families. Explosion of refinancing; growth of home equity loans and combining
refinancing with home equity loans. Growth of securitization as source of the funds to
lend; separating risk of default from the party who makes the loan.
7.
The explosion of sub-prime mortgage products combined with the rising real
estate values and the death of credit standard underwriting.
8.
The Crash
9.
After the Crash – what next???
The expansion of home ownership. How to do it effectively??
1.
History of Mortgage financing from 1900 to 1970
Prior to 1900 a great deal of the home financing in the US was done through the various
homestead programs and with institutions that financed the purchase of farms.
Commencing in the early part of the twentieth century these were supplemented by
various other sources that provided funds to lend to families to purchase their homes, in
the city or in the country. The bulk of this lending was done by banks, or building and
loan associations or savings and loan associations which took in deposit and then lent
those funds out to prospective home purchasers. The spread between what the financial
institutions were paying for the deposits and what they were charging for the loans was
the “profit.” In order to insure themselves against a unexpected increase in the rate they
had to pay depositors, the institutions kept the home loans to a term of five years or less.
At a time when real estate values were rising and there were ample funds to loan, this was
not much of a problem. When the home loans came due the original lender gave a new
loan or the homeowner found a new lender and used those funds to pay off the loan. If
not funds were available the home owner could avoid foreclosure by selling the home
since the rising home values made it likely that the value of the home would exceed the
debt. These increase in values and opportunity for profits for the financial institutions
created the same kind of pre bubble, giddy atmosphere as was created in the early parts of
the twenty first century and there was an explosion of new home construction and home
loans.
All of this was stopped in its tracks by three developments.
The first of course was the stock market crash;
The second was the contraction of funds available to loan; and
The third was the concomitant leveling off of home values.
As a result when the five year term loans matured the home owner could not find any
source to repay the entire principal of the loan and an extraordinary number of homes
were foreclosed upon.
Almost immediately the home construction business drew to a halt which exacerbated the
employment problems.
Between the time of the crash and the end of World War 2 the government tried a number
of vehicles to end the foreclosure crisis and to restart the home construction industry.
.
Depression to the end of world war ii. Government trying to figure it out and
ameliorate the effects and damage of the depression and enormous number of
foreclosures
.
Post World War 2- FHA – VA - Fannie Mae, Ginnie Mae; role of government .
the importance to the economy and the society of home building and home ownership;
the push for home ownership; including the interest rate deduction; racial disparity of
post ww2 home push to the suburbs and other places where minority families could not
move.
.
1995 low interest rates; rising home values; refinancing growth; growth of
securitization and mortgage brokers; separating risk of default from the party who made
the loan
.
The explosion of sub prime mortgages combined with the rising values combined
with the death of credit standards
It is crucial to consider and understand the supply side and the sources of the funding of
the explosions from 1970 – 2005 including FHA and Fannie Mae. It is just as important
to understand the power of the search for an above market rate of return in the private
investment sector that stepped in when government sources were temporarily stuck in the
early part of the 21st century.
Demand side
Consider the following factors:
1. Traditional purchase money first mortgage
2.
3.
4.
5.
6.
First time home buyer/ higher prices
First time buyer outside historical parameters for buying a home
Effect of higher prices
Trading up; why do people trade up?
. 2000 – 2005 the various effects of:
low interest rates,
securitization,
and the rise in real estate values; also the efforts to increase the % of home
ownership
a.
the explosion of refinancing please read the following two articles
http://www.frbsf.org/publications/economics/letter/2003/el2003-29.pdf
http://www.federalreserve.gov/pubs/bulletin/2002/1202lead.pdf
QUESTIONS;
HOW DID IT WORK AND
WHY.
LOOK AT THE NUMBERS ;
LOOK AT THE PROCESS;
LOOK AT THE PLAYERS AND WHO MAKES MONEY
Use of the money
Fees and the like
Who provided it; competition
Explosive growth
Financial formulas
b.
THE DEVELOPMENT OF THE HOME EQUITY LINE OF CREDIT
A MIX OF THE CREDIT CARD WITH THE HOME MORTGAGE
Trillion dollars per year of home equity withdrawals 2001 -2005
1990 – 2006 6.2 trillion
Pay down credit card debt (and build it up again or not?)
Home improvements
Vacations
College
At the beginning of this period some states, such as Texas did not allow home equity
lines of credit. What might they have made that policy decision?
Consider the tax benefits of borrowing on a mortgage rather than any other kind of
borrowing;
Consider the cash flow impact of borrowing on a mortgage rather than a credit card loan.
and the
Run a cash flow analysis on a home owner who is ready to refinance and who is
encouraged to borrow extra dollars for a room addition.
What are the risks and benefits of taking that loan?
d.
Securitization and the search for higher rates of return. Growth of the mortgage
brokerage business and the split between sales and credit and the breakdown of credit
standards.
e.
THE GROWTH OF THE SUB PRIME MORTGAGE MARKET
Please read
http://research.stlouisfed.org/publications/review/06/01/ChomPennCross.pdf
Consider the following factors in trying to understand the bubble that led to the crash.
1.
NEW HOUSE PRICES ARE HIGHER AND HIGHER
2.
PRESSURE TO PUT MORE PEOPLE INTO HOUSES, ESPECIALLY PEOPLE
OF COLOR
3.
THE CREDIT CARD SUB PRIME WORLD SPILLS OVER TO MORTGAGE
DEBT
4.
FNMA GETS STUCK PRESSURE TO MAKE LOANS AVAILABEL BUT.;
THEY RELAX THEIR STANDARDS
5.
THE WORKD OF I BANKERS AND LAWYERS SEE THE PROFITS TO BE
MADE IN THE PRIVATE SECURITIZATION WORLD SO THEY MULTIPLY IT
AND ATTRACT ENORMOUS AMOUNTS OF CAPITAL
6.
THE MORTGAGE BORKERS THAT WERE DOING WELL ON REFI AND
REFI AND HECKLE AND NEW HOMEPRUCHASES ARE DELIGHTED; THEY
MAKE THE MONEY, THEY HAVE LITTLE OR NO RISK
7. THE ROLE OF THE RATING AGENCIES. The role of the rating agencies
8. FRENZY
Please read
Breaking New Ground in U.S Mortgage Lending as of 2006
http://www.fdic.gov/bank/analytical/regional/ro20062q/na/2006_summer04.html
Please predict the future growth of mortgage debt in the United States.
When Home Equity Loans or Lines of Credit Can Lead to Trouble
Use your home equity loan or line of credit wisely -- here's how.
Many homeowners have a home equity loan or line of credit but don't know the best way
to use it. Using home equity can be smart in certain circumstances, and not so smart in
others.
What is home equity? Your home equity is the difference between the value of your
home and your mortgage balance. With a home equity loan or line of credit, you use this
equity as collateral in order to get the loan. (To learn more about home equity loans and
lines of credit in general, including how to get one, read Nolo's article Home Equity Loan
Basics.)
With the current financial crisis, you may have heard experts advising getting a loan or
line of credit even if you don't need the money now. However, it's wise to use caution
when using a home equity loan or line of credit, given that:
•
Like any loan, you'll pay fees and interest.
•
Your home is collateral for the loan, so if you default on the loan, you could lose
your home.
•
By its very nature, a home equity loan depletes equity in your home.
Here are some of the best ways to use your home equity for a loan or line of credit.
Emergencies
Traditionally, financial experts have advised homeowners to open a home equity line of
credit for use in emergencies. This strategy is especially helpful for those concerned
about losing their jobs. Because the lender must document your income before giving you
a line of credit, if you wait until you are unemployed to apply, the lender will most likely
reject your application.
New advice for hard financial times. In these shaky times, some experts advise that
homeowners actually take money out of their line of credit, or get a home equity loan,
even before they need the cash. This is because in the past, as long as you had equity in
your home, you could draw on it in the form of a loan or line of credit. But with today's
flat and falling home prices, some risk-adverse lenders are turning off the tap on home
equity loans. That might mean you can't get a home equity loan or line, or that your
existing home equity line of credit will be reduced, or eliminated altogether.
If you take out money ahead of time, you can use the cash to consolidate other bills like
credit card bills -- provided you cut up all the credit cards and actually close the accounts.
This can also give you some financial breathing room in hard times.
The more conservative approach. Not all experts advocate the "use it or lose it" school of
thought. The most conservative advice suggests you should leave your home equity in
place. If in doubt about what's best for you, consider talking to a trusted financial advisor.
Capital Investment
Both conservative and more liberal financial experts agree, if you've got equity to use and
don't need to hold onto it as a safety net, the best way to use it is as a prudent capital
investment. Some examples include:
•
home improvements with high value returns
•
education for the kids
•
financing a sound business plan, and
•
other financial moves that have a good chance of providing an equal or better
return on your money than the cost of the loan.
Real Estate Investment
Today, lower home prices make buying another home or real estate investment property a
potentially sound capital investment, but only over the long haul (more than five or ten
years). If you use a home equity loan to buy real estate, be sure that rental income will
offset all or most of your carrying costs or that you have other means to carry the
investment risk until it pays off.
Unwise Use of Home Equity
Experts agree that you should not use home equity to buy luxury items like big gas
guzzling cars, boats, RVs, vacations, home theaters, and other items that don't give you a
return on your money.
Using equity money to make monthly payments on the equity loan itself, other debts,
utility payments, and small household bills, is often a sign of financial distress. The same
is true if you use equity money to buy consumables such as groceries, gasoline, clothing,
and similar essentials. If your income doesn't cover those items, your household budget
isn't balanced and it's time to seek financial counseling.
The Home Equity Crisis Ahead
By Mara Der Hovanesian on January 15, 2008
Even banks that dodged the subprime bullet face losses from loans based on homes now
at risk
Subprime mortgages have taken a lot of blame for banks' big losses. But there's another
problem lurking behind the mess: home-equity lending.
Buoyed by rising prices, borrowers increasingly tapped into the equity on their properties
to finance a new car, renovations, or even a down payment, making equity a key source
of consumers' strength. But with the housing market in disarray and prices plunging, the
business of home-equity lending is souring. At least $14.7 billion in loans and lines of
credit were already delinquent through the end of September—the highest level in a
decade. "After subprime, home-equity lending is the biggest problem the industry has
right now," says analyst Frederick Cannon of Keefe, Bruyette & Woods.
What's more, there's little that can be done to prevent the pain from the deterioration of
this $850 billion market. A lender on a mortgage has the first claim on the underlying
property. In the case of foreclosure, it can sell the property and recoup some money. The
bank with the home-equity piece has no such collateral and is usually out the money.
"The home-equity lender is going to get hosed," says Amy Crews Cutts, deputy chief
economist at mortgage giant Freddie Mac (FRE).
JPMorgan Chase (JPM), Washington Mutual (WM), IndyMac (IMB), Countrywide
Financial, and others are getting hit. On Jan. 16, JPMorgan announced it set aside an
additional $395 million for troubled home-equity products in the last quarter, compared
with just $125 million for subprime mortgages. Washington Mutual reported in the latest
period that its bad home-equity loans and lines of credit surged by 130% from the end of
2006, forcing the bank to up losses by $967 million. Even lenders of a conservative bent,
those that managed to sidestep much of the subprime mess, are getting hammered: Wells
Fargo (WFC) took a recent $1.4 billion writedown, largely from home-equity lending.
Piling Higher
Until recently, the preponderance of home-equity lending came in the form of lines of
credit. They allowed borrowers to convert their equity into cash to pay down credit-card
debt and the like. But as the boom raced on and housing prices soared to unimaginable
heights, banks started offering second-lien, or piggyback, loans that buyers could use to
finance their down payments. The practice allowed buyers, especially subprime ones, to
buy ever-bigger houses they could ill afford. Traditional underwriting standards were
thrown out the window, with buyers increasingly borrowing more than the value of their
homes. As a result, this segment soared to 14.4% of the home-equity market in 2006,
according to industry newsletter Inside Mortgage Finance.
The boom brought about some especially toxic home-equity loans. Homeowners gamed
the system, steadily cashing out every bit of equity from their houses—a situation that
arose in part because banks didn't track whether borrowers took out subsequent loans
from competitors. Another bad practice: a home-equity loan on top of a payment-option
adjustable-rate mortgage. Those ARMs allow borrowers to make monthly payments that
amount to less than the interest. The principal keeps growing, eroding the equity, which
makes it a risky home-equity loan on top of an already risky mortgage.
In a rapidly rising housing market, such practices didn't seem particularly reckless. After
all, homeowners could quickly refinance, using newly accumulated equity to pay off a
second loan, or even a third. So lenders were confident they would get their money back.
"The proposition was that borrowers would refinance and pay this sucker off in six
months or a year," says Guy Cecala, publisher of Inside Mortgage Finance. "But the
market died."
And a dramatic drop in prices started wiping out the value of many of these loans. Say a
buyer purchased a home for $300,000, taking out a mortgage for $240,000 and a
piggyback loan for $60,000 to cover the down payment. If the price of the house then
dropped by 20%, to $240,000, the equity evaporates.
That's what's now happening in some of the hardest-hit states such as Florida and
California. So banks are getting stuck with home-equity loans that are worthless. That's
because borrowers who don't have any equity in their homes are more likely to walk
away entirely. Standard & Poor's (which, like BusinessWeek, is owned by The McGrawHill Companies (MHP)) looked at investment pools, analyzing the performance of
640,000 first mortgages with a piggyback loan attached to them. They found that those
loans are 43% more likely to go into default than stand-alone mortgages.
As a result, banks are scrambling to change their ways. Some are implementing stricter
underwriting standards, ensuring that new borrowers have plenty of skin in the game by
putting up more cash. Chase, for example, which tightened standards several times in
2007, lowered how much it would lend to borrowers in California and Florida by 10%.
"Given our current underwriting standards, we wouldn't have done 30% of the homeequity loans we originated in 2006," says Thomas A. Kelly, a spokesman at Chase.
Banks also contend that most of the problem loans and lines of credit came from thirdparty brokers and wholesalers, which they say did a poor job assessing borrowers' ability
to repay. Wells calculates that independent brokers, which represented just 7% of its
home-equity lending, accounted for 25% of its third-quarter losses. So Wells and other
lenders are now refusing to buy home-equity products from that group.
Meanwhile, the list of casualties is expanding to those who own and insure investment
pools filled with home-equity loans. One of the worst-performing assets in E*Trade's
(ETFC) $17 billion investment portfolio: bonds backed by home-equity loans. After more
than a third of the bonds were downgraded to junk, the online broker in late November
sold the troubled bonds and other investments to hedge fund Citadel.
Radian Guaranty (RDN), which lost business to the banks when home-equity loans that
doubled as down payments reduced the need for their mortgage insurance, started
insuring securities backed by home-equity loans instead. In the latest quarter, it
announced losses of $1.1 billion related to those deals. "We essentially stopped writing
this business," Radian's Mark Casale said in a recent call with investors. "Unfortunately,
we're still feeling the effects."
The following article is one of the very very few pre 2005 articles on a key contributing
factor to the Crash. Home is Where the Equity Is.
Mortgage Refinancing and Household Consumption
Erik Hurst
Graduate School of Business University of Chicago, Illinois 60637
and
Frank Stafford Department of Economics Institute for Social Research University of
Michigan
Ann Arbor, Michigan 48109 - 1220
August 2002
Excerpts from: Home is Where the Equity Is:
Mortgage Refinancing and Household Consumption
Abstract: This paper documents the extent to which homeowners use housing equity to
smooth their consumption over time. Unlike drawing down other forms of saving,
accessing accumulated home equity can be quite costly. Theoretically and empirically, a
key distinction can be drawn between those refinancing their home mortgage to improve
their wealth position from those who had a consumption smoothing motivation to
refinance. Incorporating characteristics of a mortgage into a traditional permanent
income model with exogenous liquidity constraints, one can understand household
refinancing behavior in a world where mortgage interest rates are historically high and
rising - up to now, an empirical puzzle. This model predicts a large consumption
stimulus as mortgage rates are reduced allowing households with low pre-existing levels
of liquid assets to more easily access their accumulated home equity. Using data from
the Panel Study of Income Dynamics, households that experienced an unemployment
shock and who had limited initial liquid assets to draw upon are shown to have been 25%
more likely to refinance in the early 1990s. On average, liquidity constrained households
converted over two-thirds of every dollar of equity they removed while refinancing into
current consumption as mortgage rates plummeted between 1991 and 1994. In contrast,
no such behavior was found in non-liquidity constrained refinancers. We estimate a
corresponding stimulus of at least $28 billion from the refinancing activity of
liquidity constrained households during the 1991-1994 period when mortgage interest
rates were falling.
VI. Mortgage Refinancing, Liquidity Constraints and Consumption
It is quite conceivable that forward looking households would have equity trapped in
their home. A series of negative income shocks could easily have depleted a household’s
liquid saving. Given the large fixed costs associated with accessing their home equity,
some households may prefer to alter their consumption away from their optimal path
instead of refinancing. We saw such behavior predicted from the model in Section III.
In these instances, households will be essentially liquidity constrained; they wish to
increase their consumption, but are confronted by an unfavorable cost structure.
However, the liquidity constraint can be partially alleviated in periods of declining
interest rates as the net benefits to accessing the accumulated home equity are now larger.
In order to compare the consumption behavior of liquidity constrained refinancing
households, we
first have to isolate households who we plausibly believe would be liquidity constrained.
In this section,
15 Even if the present value wealth gain is not independent of the amount of equity that
a household would like to remove, we
VI. CONCLUSION AND POLICY IMPLICATIONS
There are two reasons why a household may choose to refinance. 1) In periods of
relatively low interest rates, the household would refinance to receive a lower stream of
mortgage payments and consequently receive an increase in lifetime wealth, referred to
as the “financial motivation” to refinance, and 2) households may refinance so as to
access accumulated home equity - referred to as the “consumption smoothing
motivation” to refinance. While the first motivation has been studied in detail in the
literature, we are the first to model and test for the consumption smoothing motivation to
refinance. If households receive a negative income shock they are more likely to choose
to refinance if their reserves of more-liquid assets are limited, all else equal.
Empirically, households are found to use their home as a financial buffer. Homeowners
who had low levels of beginning period liquid assets and who subsequently experienced
an unemployment shock were 25 percent more likely to refinance than other households
– although they had to pay a higher rate to do so. The probability of refinancing
diminished for households who experienced an unemployment shock and who had
greater amounts of liquid assets to buffer the shock. Additionally, households who
experienced a spell of unemployment and who had low levels of liquid assets were far
more likely to remove equity during their refinancing process. These findings reconcile
what have been termed as an
Home Mortgage Finance
Home ownership has been an important American value and the percentage of American
households who own their own home has grown significantly to nearly sixty six per cent.
Over the past half decade this growing percentage of home ownership has combined with
rising real estate values, and historically low interest rates to produce a record breaking
number of refinancings, and huge home equity withdrawals, Home equity is the largest
"savings account" for most Americans, and as the real estate value cycle has put money
in their savings accounts they have been withdrawing money through refinancing and
through home equity withdrawals. Those who were able to secure long term fixed rate
borrowings gained a good deal from the refinancings, even if they may have borrowed
additional funds. Those whose rates are adjustable, or who had only short term fixed rates
may encounter problems when interest rates rise.
The assigned articles discuss these developments. Think about both individual family
units that withdraw equity and compare and contrast their situations before and after the
withdrawals.
What are the primary reasons that people refinance?
What are the primary reasons that people take out home equity loans?
Why do you think is behind the deducibility of interest on a home mortgage?
Do you agree with this policy?
Problem Number 1
In 1998 Mr. and Mrs. Homeowner bought a home for $165,000; they put down @35,000
and took out a mortgage for the balance of $130,000.
In 2005 the value of the home is $265,000 and interest rates have dropped from 6% to
5%. They have credit card debt of $25,000 and decide to withdraw $25,000 to pay off
that debt and another $15,000 for home improvements and $4/000 for a once in a lifetime
vacation.
Compare and contrast their balance sheet before and after the transaction and their
housing expenses and finally, consider the other ramifications of having more debt
secured by the home and less credit card debt.
In 2006 one of the largest home equity lending companies entered into a settlement
agreement regarding allegations that its employees had encouraged prospective
borrowers to fill in inaccurate information on their credit application in order to make the
applications look better. Several years ago it came to light that Green Tree Acceptance
Corporation was providing the financing for manufactured homes to thousands of people
who clearly did not qualify for these loans.
What are the causes and effects of such actions?
What are the remedies when a consumer defaults on her home mortgage?
What are the remedies when a consumer defaults on a loan secured by her car or her
furniture?
FIRST TIME HOME BUYERS
Securitization and the Mortgage crisis
http://fcic-static.law.stanford.edu/cdn_media/fcic-reports/2010-0407Preliminary_Staff_Report_-_Securitization_and_the_Mortgage_Crisis.pdf
Chapter 7
SUBPRIME Credit
Is the goal of sub-prime credit
1. To open the opportunity to borrow to people who would not qualify under lending
criteria for prime products? or
2.
To create profit by lending to people who do not have access to prime lending
products?
II.
Differentiation Points
A.
B.
rules
Cost – interest rate, fees
Practices – enforcement of Car title loans vs. article 9; credit card cross default
.
Sub-prime only products
Payday , car title , tax refund anticipation loans, sued care dealer finance
Normal products at sub prime rates and with sub- prime practices
I.
Introduction
In this chapter we look at some peculiarly subprime products such as payday lending, car
title lending, tax refund anticipation loans and rent to town and also the subprime
products in mainstream lending such as mortgages, car loans and credit cards.
First a definition or description of the term subprime.
Here is what the FDIC says.
The term "subprime" refers to the credit characteristics of individual borrowers.
Subprime borrowers typically have weakened credit histories that include payment
delinquencies, and possibly more severe problems such as charge-offs, judgments, and
bankruptcies. They may also display reduced repayment capacity as measured by credit
scores, debt-to-income ratios, or other criteria that may encompass borrowers with
incomplete credit histories. Subprime loans are loans to borrowers displaying one or
more of these characteristics at the time of origination or purchase. Such loans have a
higher risk of default than loans to prime borrowers. Generally, subprime borrowers will
display a range of credit risk characteristics that may include one or more of the
following:
•Two or more 30-day delinquencies in the last 12 months, or one or more 60-day
delinquencies in the last 24 months;
•Judgment, foreclosure, repossession, or charge-off in the prior 24 months;
•Bankruptcy in the last 5 years;
•Relatively high default probability as evidenced by, for example, a credit bureau risk
score (FICO) of 660 or below (depending on the product/collateral), or other bureau or
proprietary scores with an equivalent default probability likelihood; and/or
•Debt service-to-income ratio of 50% or greater, or otherwise limited ability to cover
family living expenses after deducting total monthly debt-service requirements from
monthly income.
This list is illustrative rather than exhaustive and is not meant to define specific
parameters for all subprime borrowers. Additionally, this definition may not match all
market or institution specific subprime definitions, but should be viewed as a starting
point from which the Agencies will expand examination efforts.
And Investopedia
Definition of 'Subprime Loan'
A type of loan that is offered at a rate above prime to individuals who do not qualify for
prime rate loans. Quite often, subprime borrowers are often turned away from traditional
lenders because of their low credit ratings or other factors that suggest that they have a
reasonable chance of defaulting on the debt repayment.
And finally an article from the Wall Street Journal Blog bemoaning the difficulties in
defining sub prime.
Defining Subprime: Easier Said Than Done.
The Securities and Exchange Commission’s probe into Fannie Mae and Freddie Mac
appears to be hinging on a simple question: What’s the definition of a subprime
mortgage?
The SEC is investigating whether the mortgage titans’ disclosures to investors of
subprime and other risky mortgages may have misled investors about their decisions to
take on more risk. So far, four current or former officials of the companies have
acknowledged that they could face civil charges from the SEC, including Daniel Mudd
and Richard Syron, the former chief executives of Fannie Mae and Freddie Mac,
respectively.
The trick in this case is that there never was an agreed upon definition of a “subprime”
mortgage. Fannie and Freddie got into even more trouble by buying up lots of Alt-A
mortgages, which is even harder to define but generally consisted of loans between prime
and subprime where borrowers didn’t have to document their incomes.
So what are some of the potential definitions of subprime?
The FDIC in 2001 said that loans with credit scores below 660 generally had a “relatively
high default probability.” The mortgage industry, by contrast, generally said that loans
below 620 were subprime. (While there weren’t explicit definitions of subprime loans,
federal regulators did have detailed definitions of “high cost” mortgages. Those were
often confused with subprime loans because those mortgages were the most likely to go
to borrowers with weak credit.)
In other cases, subprime referred not to the borrower, but to the loan. Some in the
industry considered subprime mortgages to be those that weren’t eligible for sale to
Fannie and Freddie. Over the past decade, the mortgage titans gradually relaxed their
loan-purchase standards, which made that definition unusable.
While around 5% of loans guaranteed by Fannie in 2007 had credit scores below 620, the
company said that only 0.3% of its loans were considered “subprime.” That was because
Fannie defined subprime loans only as those that were flagged as “subprime” by the loan
seller or that were purchased from subprime originators.
“There’s a broad agreement on what the qualities of a subprime loan are, but there’s no
very technical definition. There’s a big gray area,” says Mark Calabria, director of
financial regulation studies at the libertarian Cato Institute who recently published a
paper exploring some of these issues.
Further muddying the waters, as lending standards deteriorated, more borrowers were
able to take out mortgages with no down payments, with minimal income verification,
and with special “interest only” features that allowed them to avoid making principal
payments for several years.
Some analysts have argued for a much broader definition of “subprime” to include these
loans. Here’s an example: nearly 15% of loans bought by Fannie in 2007 were “interest
only.” If those loans went to borrowers with great credit, it would be hard to argue that
they were subprime loans. But if they went to borrowers who made minimal down
payments, it would similarly be hard to argue that these were traditional “prime” loans.
These definitions were the subject of some intense debate by members of the Financial
Crisis Inquiry Commission.
What is the difference between subprime and predatory?
Please read the following articles:
Ronald Mann on sub- prime is a good thing.
After the Great Recession: Regulating Financial Services for Low and Middle Income
Communities by Ronald Mann
http://scholarlycommons.law.wlu.edu/cgi/viewcontent.cgi?article=4275&context=wlulr
Subprime Lending Is Back, And That's Not Such A Bad Thing
Don’t look now but banks are once again issuing lines of credit to customers with bad
credit histories.
Bank credit cards, retail credit cards and auto loans are all more readily available to
subprime borrowers over the last year according to a March report from Equifax.
Bank-issued credit card lending to sub-prime consumers jumped 41% between 2010 and
2011 hitting a four-year high in December 2011 with 1.1 million new bank credit cards
issued. Plus, at $12.5 billion, bankcard limits are at their highest level since 2008 when
the limit stood around $27.4 billion.
No Surprise Here, Bank Of America Looks To Charge More Fees Halah TouryalaiForbes
Staff
Here Are The Banks That Lost The Most Under The Durbin Amendment Halah
TouryalaiForbes Staff
21 images Photos: Ten Top Credit Card Choices From College To Retirement
Retail credit cards also saw an increase in lending to riskier borrowers. From 2010 to
2011 there was a 4.7 percentage point increase in retail card originations to sub-prime
borrowers, making up 31% of 2011 retail credit card originations, Equifax says.
Subprime borrowers are also seeing credit lines easing in the auto loan arena. Equifax
says new auto finance loan amounts increased $11.6 billion from 2010 ($164.6 billion) to
2011 ($176.2 billion), hitting the highest originations level since 2007 ($221.1 billion).
“The evidence of increased lending to sub-prime consumers demonstrates banks’ ongoing
efforts to grow lending by providing credit opportunities to more consumers,” said
Equifax Chief Economist Amy Crews Cutts. “Year-over-year results show borrowers are
taking advantage of the new opportunities and seeking to diversify their financial activity,
which is building momentum toward economic improvement.”
That might be especially true for banks whose revenue pipelines have been squeezed in
part because of new rules and regulations. The so-called Durbin amendment, for instance,
limits the fees banks can collect from merchants like Target and Walmart when their
customers swipe their debit cards there. The Card Act is another revenue killer for banks
which, among other things, keeps them from charging overdraft fees. And there may be
more limitations on the way as the Consumer Finance Protection Bureau recently
launched an inquiry asking banks for data about their overdraft practices.
The New York Times wrote about the subprime lending comeback saying “As financial
institutions recover from the losses on loans made to troubled borrowers, some of the
largest lenders to the less than creditworthy, including Capital One and GM Financial, are
trying to woo them back, while HSBC and JPMorgan Chase are among those tiptoeing
again into subprime lending.”
Indeed, Trefis finds that JPM’s credit and debit card business is the most valuable unit,
contributing to just under a quarter of its value. The bank reports first quarter earnings
Friday and Trefis expects an increase in JPMorgan’s outstanding card loan portfolio and
improvement in its provisions for credit card loans as fewer loans are expected to go bad.
For the likes of Bank of America, JPMorgan Chase, Citi and Wells Fargo increasing
revenue in this low growth and heavily regulated environment is a big challenge for the
industry. So it’s not such a huge surprise that lenders are looking to widen their scope in
their search for new borrowers. After all, their investors are banking sector’s growth
prospects very closely in the post-crisis world.
Plus, increased lending, even if it is to subprime consumers, shouldn’t be completely
frowned upon because it’s one way to help boost economic growth. Besides, lending to
subprime borrowers wasn’t the whole problem–it was lending to them without so much
as verifying employment, their income and assets. Remember NINJA loans?
With that in mind, the most important thing for lenders is to keep the lessons learned
from 2008 crisis fresh in their memory. The key will be managing the risk that comes
with territory of lending to less than stellar borrowers.
QUICK HISTORY OF SUB PRIME LENDING
McLEAN, Va. (12/12/07)--In an effort to improve their credit history, many consumers
are unknowingly signing up for subprime credit cards--often with disastrous
consequences (USA Today Dec. 9). Targeted to young adults with no or little credit
history, as well as to those with a tarnished credit history, issuers of subprime credit
cards--referred to as predatory by some critics--are taking advantage of vulnerable
consumers who can least afford the excessive fees. How excessive? In one example, with
a low credit limit of $250, some applicants were socked with an array of fees that totaled
$178, leaving the user just $72 to spend on that card during the year. Instead of
improving their credit history, victims are sinking deeper in debt. The National Consumer
Law Center, Boston, issued a warning to consumers on Nov. 1 that these high-fee, lowcredit predatory credit cards are merely a way for some issuers to extract as many junk
fees as possible from consumers desperate for credit. What should you watch for?
* Low limits. If the card carries an unusually low line of credit--say, only a few hundred
dollars--that’s the first clue it may be a predatory credit card. * Phrases that may not
sound like fees. In the fine print, look for phrases such as account maintenance, account
set-up, program, participation, and activation fees. * Fees that put you over the limit.
Excessive fees--which add up quickly--reduce your available balance right off the bat.
Cardholders who don’t deduct those fees from their available balance increasingly are
slapped with over-the-limit fees. * ”Good-guy” claims. The issuer may make the claim
that it’s going out of its way to help users get out of debt trouble and give credit to
subprime borrowers. One issuer justified its predatory credit card by stating that its
“mission” is to bring affordable banking services to minority communities. And with
millions of cash-strapped homeowners facing foreclosure, claims like these may sound
enticing.
Looking for an alternative? Get a secured credit card, says Susan Tiffany, director of
personal finance information for adults at the Credit Union National Association's Center
for Personal Finance. “You’ll have to deposit money with your credit union or other
reputable lender, and then use that line of credit to build a good credit history. Repay
purchases in full and on time each month. Then after a time, say six months to a year,
apply for a traditional unsecured card with a higher limit.”
Subprime loans are pricey, but can help credit history
By Bankrate.com
So maybe you've never filed for bankruptcy, foreclosed on a house or defaulted on a loan.
You have, however, paid a few bills late, which lowered your credit score. If your credit
score dropped below 620, you may have made yourself a subprime lending customer.
Subprime loans are a mixed bag for those with blemished credit histories. They can help
renters own homes and cash-strapped folks pay off debts. They also cost more and come
with significant risks. Make sure you belong in the subprime category and understand all
its pitfalls before you proceed with a subprime loan.
Think about it
Experts caution people to carefully weigh the benefits and drawbacks of taking out a
subprime loan. Having one and handling it well can help repair a damaged credit history,
but a subprime loan can cost thousands more in interest than standard mortgages.
Subprime lending, by its very nature, places lenders at risk. When all is said and done,
that means banks and other players charge higher rates for subprime loans to compensate
for potential losses from customers who may run into trouble or default. Subprime loans
also cost more because they are considered "nonconforming," or not up to the standards
of Fannie Mae and Freddie Mac. Those two quasi-governmental agencies buy traditional,
"conforming" mortgages from lenders, repackage them and sell them to Wall Street
investment firms as securities.
Track record counts
Borrowers can fall into the subprime category for any number of reasons, and assessing
how risky a customer is can be a difficult thing for lenders. The process relies less on the
computerized credit scoring methods widely favored by traditional lenders and more on a
borrower's debt payment track record, according to subprime experts. In the end,
customers get stamped with a school-like ranking: A for those with the best credit, B, C
or D for those with progressively worse histories. An E can show up as well, but is
extremely rare.
One question, two answers
Where someone falls on the scale depends on a number of things. And two lenders may
look at the same borrower and arrive at two different credit grades because the categories
aren't set in stone.
Someone with a generally good credit record, but who paid their mortgage 30 days late
within the past year, could earn an A-minus. The grade of D could be the result of
bankruptcy or foreclosure. Subprime lenders will look at a potential borrower's general
pattern of financial behavior. If you are usually on time with your payments, you'll most
likely be a B or a C consumer.
A borrower's credit grade determines a number of factors, including what rate the loan
will carry and how much of a home's value will be loaned. On a 30-year fixed mortgage,
for instance, a borrower just shy of an A rating would most likely be able to borrow 90
percent of a new home's value at a rate a couple of percentage points or so above the
going rate. Someone with D credit could borrow less at a higher interest rate.
Use of the term predatory
When is sub prime predatory and
When is it not predatory
Discussion Issues:
Please consider the effects of Securitization on sub prime debt;
Please consider the effects of selling debt
Research Division
Federal Reserve Bank of St. Louis
Working Paper Series
The Impact of Local Predatory Lending Laws on the
Flow of Subprime Credit
Giang Ho and
Anthony Pennington-Cross
Working Paper 2006-009A
http://research.stlouisfed.org/wp/2006/2006-009.pdf
February 2006
FEDERAL RESERVE BANK OF ST. LOUIS Research Division
P.O. Box 442
St. Louis, MO 63166
The views expressed are those of the individual authors and do not necessarily reflect
official positions of the Federal Reserve Bank of St. Louis, the Federal Reserve System,
or the Board of Governors.
Federal Reserve Bank of St. Louis Working Papers are preliminary materials circulated
to stimulate discussion and critical comment. References in publications to Federal
Reserve Bank of St. Louis Working Papers (other than an acknowledgment that the writer
has had access to unpublished material) should be cleared with the author or authors.
The Impact of Local Predatory Lending Laws on the
Flow of Subprime Credit
A shorter version is forthcoming in the Journal of Urban Economics
Giang Ho & Anthony Pennington-Cross* Federal Reserve Bank of St. Louis Research
Division
The Impact of Local Predatory Lending Laws on the
Flow of Subprime Credit: North Carolina and Beyond
Abstract: Local authorities in North Carolina, and subsequently in at least 23 other states,
have enacted laws intending to reduce predatory and abusive lending. While there is
substantial variation in the laws, they typically extend the coverage of the Federal Home
Ownership and Equity Protection Act (HOEPA) by including home purchase and openend mortgage credit, by lowering annual percentage rate (APR) and fees and points
triggers, and by prohibiting or restricting the use of balloon payments and prepayment
penalties. Empirical results show that the typical local predatory lending law tends to
reduce rejections, while having little impact on the flow (application and origination) of
credit. However, the strength of the law, measured by the extent of market coverage and
the extent of prohibitions, can have strong impacts on both the flow of credit and
rejections.
Introduction
The current mortgage market consists primarily of two segments – the prime market and
the subprime market. The prime market extends credit to the majority of households. The
subprime market provides more expensive credit to households who do not qualify for a
prime mortgage. These households tend to be less financially secure and located in lowincome areas and areas with a concentration of minorities. The combination of higher
borrower costs and higher rates of delinquency and foreclosure have led to public policy
concerns over fairness and accessibility of credit.
Subprime lending represents an opportunity for the mortgage market to extend the
possibility of home ownership beyond traditional barriers. These barriers have existed
because the prime segment of the mortgage market uses lending standards (credit scores
and documented employment history, income, and wealth, among other factors) to accept
or reject loan applicants. Applicants that are rejected or expect to be rejected can look to
the more
expensive subprime market. In this fashion the subprime market completes the mortgage
market and can be welfare enhancing (Chinloy and MacDonald [4]) because it provides
the opportunity of home ownership to a larger portion of the population.
Over the past ten years subprime lending has grown rapidly -- from $65 billion to $332
billion of originations from 1995 through 2003 (Inside Mortgage Finance [17]).1
According to the Mortgage Bankers Association of America, the rate that loans were in
foreclosure from the
1 These numbers are derived from type B&C loans. B&C loans are loans with less than
an A (or prime) rating. See the Mortgage Markets Statistics Annual published by Inside
Mortgage Finance for more details on loan classification schemes.
first quarter of 1998 to the third quarter of 2004 rose by more than 400 percent for
subprime loans while declining by approximately 25 percent for prime loans. In addition,
during the same time period anecdotal evidence of predatory lending in the subprime
market was gaining more public and regulatory attention.2 Therefore, the welfare
benefit associated with increased access to credit is believed to have been reduced by
some unscrupulous lending in
the subprime mortgage market.
In response to public concerns of predation in the subprime mortgage market, federal
regulations generated under the Home Ownership and Equity Protection Act (HOEPA)
restrict some types of high-cost lending. Many states, cities, and counties have used
HOEPA as a template and have extended the restrictions on credit to an even broader
class of mortgages. These restrictions include limits on allowable prepayment penalties
and balloon payments, prohibitions of joint financing of various insurance products
(credit, life, unemployment, etc), and requirements that borrowers participate in loan
counseling.
By introducing geographically defined predatory lending laws, policymakers have
conducted a natural experiment with well defined control and treatment groups. Since
state boundaries reflect political and not economic regions, we can compare mortgage
market conditions in states with a law in effect3 (the treatment group) to those in
neighboring states currently without a predatory lending law (the control group).
However, instead of examining whole states we focus on households that are
geographically close to each other (border counties) and as a result are in similar labor
and housing markets.
2 See HUD-Treasury report (HUD-Treasury [16]) and Federal Reserve HOEPA Final
Rule (Federal Reserve [8]).
3 Laws are first enacted by the local legislature and become effective typically at a later
date. It is not until the law becomes in effect that lenders are required to follow the new
rules and restrictions.
Data at the individual loan level are used to identify the impact of local predatory lending
laws on subprime applications, originations, and rejections. Specifically, we find that
there is substantial heterogeneity in the response of the mortgage market to local
predatory lending laws. In fact, in contrast to previous research on the impact of the
North Carolina law, the flow of subprime credit can increase, decrease, or be unaffected
by the laws. To help understand this heterogeneity we create an index that measures the
strength of the local predatory laws. This index measures the increase in market
coverage and the extent that certain lending practices and mortgage types are restricted.
This paper provides at least four contributions to the literature: (i) a wide variety of local
predatory lending laws are characterized, (ii) the question of whether the market response
in North Carolina (reduce flow of credit) was typical or atypical is examined, (iii) the
importance of the strength of the law on the flow of credit is examined and (iv) the
probability of a state introducing a predatory lending law is treated as jointly determined
with the flow of subprime credit.
Given the perception that predation has occurred in the subprime market and not in the
prime market, the volume of lending as measured by the number of originations and
applications
may be lower than expected, given the distribution of credit risk, r (Φ) . One of the
primary
purposes of predatory lending laws is to weed out the “lemons” in the subprime mortgage
market. If households feel that the predatory lending law has been successful, there may
be less need to spend time and energy to identify the dishonest loans and other
households may
feel more comfortable applying for a mortgage; in this scenario Λ(.) is reduced to zero or
much closer to zero. Therefore, if the subprime market is operating as a lemons market
the introduction of the predatory lending law should have two countervailing forces.
First, as illustrated in Figures 1 and 2, the law should reduce applications and originations
because of tighter lending standards. Second, as illustrated in Figure 3, the law should
induce potential applicants back into the market; If the law removes or heavily regulates
the dishonest loans there would be little or no fear of being taken advantage of and no
need to expend effort sorting honest loans from dishonest loans. Therefore, in markets
with a substantial lemons
problem, or big Λ(.) , the impact of a predatory lending law could be neutral or could
increase
the rate of subprime application and origination. In addition, if Λ(.) is not strictly
proportional, but has a larger impact on potential borrowers closer or farther away from
Φ S , then the introduction of a predatory lending law could also increase or decrease
rejection
rates.
National Lending Restrictions – Home Ownership and Equity Protection Act
Congress enacted HOEPA (Pub. L. 103-325, 108 Stat. 21600) by amending the Truth in
Lending Act (TILA, 15 U.S.C 1601). In 1994, the Board of Governors implemented
HOEPA
through 12 CFR part 226 (Regulation Z), which articulates specific rules governing
lending practices.
HOEPA and the regulations promulgated under it define a class of loans that are given
special consideration. HOEPA-covered loans (loans where HOEPA applies) include only
closed-end home equity loans that meet APR and finance fee triggers. Home purchase
loans and other types of lending backed by a home, such as lines of credit, are not
covered by HOEPA. The original version, in 1994, set out the framework and defined
the triggers and restrictions. The second version, in 2002, adjusted some of the triggers
and restricted some additional
practices. In the 2002 version, HOEPA protections were triggered in one of two ways: (i)
if the loan’s APR exceeded the rate for Treasury securities of comparable maturity by 8
percentage points or more on the first lien and 10 percentage points or higher on higher
liens or (ii) if finance charges, including points and fees paid at closing for optional
insurance programs and other debt protection programs, were greater than 8 percent of
the loan amount or a fixed $480 amount indexed annually to the consumer price index.
For HOEPA-covered loans, creditors were not allowed to provide short-term balloon
notes, impose prepayment penalties greater than five years, use non-amortizing
schedules, make no- documentation loans, refinance loans into another HOEPA loan in
the first 12 months, or impose higher interest rate upon default. In addition, creditors
were not allowed to habitually engage in lending that did not take into account the ability
of the consumer to repay the loan.
Regional Restrictions – State and Local Predatory Lending Laws
A number of states and local municipalities have sought to impose restrictions on
predatory lending that reach further than HOEPA and Regulation Z. Ho and PenningtonCross [15] provide a detailed description of each law in Appendix A.6
Beginning with North Carolina in 1999, at least 23 states have passed predatory lending
laws that are currently in effect: including Arkansas, California, Colorado, Connecticut,
Florida, Georgia, Illinois, Kentucky, Maine, Maryland, Massachusetts, Nevada, New
Jersey, New Mexico, New York, North Carolina, Ohio, Oklahoma, Pennsylvania, South
Carolina, Texas, Utah, and Wisconsin.
Both the original and the 2002 versions of HOEPA defined a class of high-cost refinance
mortgages that were subject to special restrictions. The state laws tend to follow this lead
and expand the definition of covered loans. For example, North Carolina – the first state
to enact predatory lending restrictions -- includes both closed-end and open-end
mortgages but not reverse mortgages and limits loan size to the conventional conforming
limit (loans small enough to be purchased by Fannie Mae and Freddie Mac and therefore
not considered part of the jumbo market). HOEPA covers only those closed-end loans
that are not for home
purchase (typically refinance and second mortgages). North Carolina did leave the APR
triggers the same as the HOEPA triggers, although the points and fees triggers were
reduced from the HOEPA 8 percent of total loan amount to 5 percent for loans under
$20,000. For
6 Every attempt was made to include all laws in effect by the end of 2004 that, similar to
HOEPA, use triggers to define a class of loans eligible for restrictions and disclosures.
Because other laws are likely to exist, those discussed here should be viewed as a sample
of all the state and local predatory lending laws. Other states have laws that do not focus
on high-cost or subprime lending and do not have any triggers (Idaho, Michigan,
Minnesota, Mississippi, Nebraska, New Hampshire, Oregon, Tennessee, Washington,
and West Virginia).
loans $20,000 or larger, the same 8 percent trigger is used or $1,000, whichever is
smaller. The North Carolina law also prohibits prepayment penalties and balloon
payments for most covered loans. But the law also prohibits the financing of credit life,
disability, unemployment, or other life and insurance premiums, while HOEPA included
them only as part of the trigger calculation.
While most states followed the North Carolina example by expanding the coverage and
restrictions associated with HOEPA, there is substantial variation in the laws. In an
attempt to quantify the differences in the local laws, we created an index. The higher the
index, the stronger the law is. In addition, the index can be broken down into two
components. The first component reflects the extent that the law extends market coverage
beyond HOEPA. The second component reflects the extent that the law restricts or
requires specific practices on covered loans. Table 1 summarizes the construction of the
law index. The full index is the sum of all the assigned points as defined in Table 1 and
the coverage and restrictions indexes are the sum of points assigned in each subcategory.
The coverage category includes measures of loan purpose, APR first lien, APR higher
liens, and points and fees. In general, if the law does not increase coverage beyond
HOEPA it is assigned zero points. Higher points are assigned if the coverage is broader.
In each category the highest points are assigned when all loans are covered. For example,
points assigned for loan purpose range from zero to four and the highest point total (four)
indicates that the law covers all loan purposes. The points assigned for extending first
lien APR trigger ranges from zero to three depending on how low the trigger is. For
example, 7 percent triggers are
assigned one point while 6 percent triggers are assigned two points. In addition, laws that
do not have a first lien trigger are assigned three points. A similar scheme is used to
assigned points for higher lien triggers and the points and fees triggers. In general, if the
law includes multiple triggers within a category the most stringent trigger is used to
assign the points. 7
The restrictions index includes measures of prepayment penalty restrictions, balloon
restrictions, counseling requirements, and restrictions on mandatory arbitration. If the law
does not require any restrictions then zero points are assigned. Higher points indicate
more restrictions. For example, laws that do not restrict prepayment penalties are
assigned zero points, while laws that prohibit all prepayment penalties are assigned four
points. Laws that prohibit or restrict the practice more quickly are assigned higher points.
For balloon restriction, the points vary from zero for no restrictions to four when the law
prohibits all balloons.8 The last two restrictions measure whether the law requires
counseling before the loan is originated or restricts fully or partially mandatory
arbitration clauses.
Table 2 reports the calculated full (law) index, the coverage index, and the restrictions
index for each law identified as being in effect by the end of 2004. The average law
index is 10.16, varying from 4 in Florida, Maine, and Nevada to 17 in New Mexico and
Cleveland. The coverage index and the restrictions index have a mean just over 5. The
coverage and restrictions indexes are only modestly correlated at 0.19. This indicates
that, while laws that increase coverage more also tend to increase the restrictions more,
the relationship is very noisy. Therefore, there are laws that increase coverage without
increasing restrictions
Literature on Local Predatory Lending Laws
Research on the impact of predatory lending laws has been primarily focused on the
impact of the North Carolina law. Various data sets, both publicly available and privately
held, have been used for analysis. However, regardless of the method and author
affiliations, the North Carolina law was found to have a significant impact on the flow of
credit.
Papers by Ernst, Farris, and Stein [7] and Quercia, Stegman, and Davis [22, 23] use tables
of mortgage conditions before and after the North Carolina law became effective, or in
effect, and compares these metrics with growth rates in nearby states and the nation as a
whole. Using the Home Mortgage Disclosure Act (HMDA) data set and a list of
subprime lenders created by HUD, Ernst, Farris, and Stein [7] find that the volume of
loans originated did decline relative to the rest of the U.S. However, using data leased
from a private data vendor called LoanPerformance (LP), Quercia, Stegman, and Davis
[22] find no volume impact on purchases or low credit score loans. However, they do
find some evidence that interest rates are higher on average, refinance activity declines,
and the prevalence of prepayment penalties is lower; but the impact on balloons and high
loan-to-value loans is mixed. Using the same data, Quercia, Stegman, and Davis [23] find
that the decline in volume in North Carolina was largely associated with refinancing
loans. The LP data set differs greatly from the HMDA data because it provides much
more detail about loan characteristics and is very expensive to lease for one year (over
$100,000). In addition, the LP data likely does not provide a complete picture of the
subprime mortgage market because it includes only loans that are securitized. If loans of
better quality (A- rated) or pricing tend to have higher rates of securitization, then the LP
data represent only one segment of the subprime market. Chomsisengphet and
Pennington-Cross [5] show that the rate of foreclosures, as reported by the Mortgage
Bankers Association of America (MBAA), shows different time series properties than the
LP data and was on average almost three times the LP foreclosure rate. Therefore, for the
purpose of volume comparisons, HMDA is the preferred source because of its better
market coverage.
Harvey and Nigro [13, 14] and Elliehausen and Staten [6] go beyond univariate tables
and estimate multivariate equations to identify the impact of the laws in North Carolina,
Chicago, and Philadelphia. Since publication the Philadelphia law is no longer in effect.
On both Harvey and Nigro papers a proprietary version of HMDA along with the HUD
subprime lender list is used while Elliehausen and Staten use proprietary loan information
provided by nine members of the American Financial Services Association (AFSA).
AFSA has been an active participant in legal challenges of local predatory lending laws
and represents some of the largest subprime lenders (Ameriquest Mortgage Company,
Conseco Finance Corporation, Countrywide Home Loans, Equity One, CitiFinancial,
Household Finance Corporation, Key Consumer Real Estate, Washington Mutual
Finance and Wells Fargo Financial, Inc.). All three papers include explanatory variables
that control for location and borrower characteristics, as available. Harvey and Nigro
estimate at the loan level the probability of applying for a subprime loan, originating a
subprime loan, and being rejected on a subprime application in a logit estimation.
Elliehausen and Staten count the number of originations up
to the county level and create a panel data set from 1995 through 2000 and estimate a
negative binomial regression on all observed originations covering the whole U.S.
Despite these many methodological and data source differences, all three multivariate
papers find evidence that the introduction of the North Carolina law substantially reduced
the flow of credit in the subprime mortgage market. Consistent with the simple theory of
a market without considering any lemons issues, the reduction in flow was attributed
more to a reduction in applications than an increase in rejections. In addition, low-income
areas and households tended to have larger declines.
Data Design, Identification, and Probit Estimation
To examine whether the experience in North Carolina is typical we use the publicly
available version of HMDA in conjunction with the HUD subprime lenders list.9 Any
loan application or origination associated with a lender on the list is identified as a
subprime loan. All other loans are treated as not-subprime, that is, as a conventional loan.
Because it is impossible to fully characterize borrower and location characteristics, the
sample is reduced to include only locations where a new predatory lending law has been
introduced and other locations that are physically nearby. The locations where the law
comes into effect can be viewed as the treatment group and locations where no new law
comes into effect can be viewed as the control group.10 Therefore, only counties that
border other states without a local predatory lending law are used for the treatment group.
The control group includes only counties in neighboring states that border the treatment
state and do not have a predatory lending law in effect during the examined time period
(the year before and after the introduction of the law). This contrasts with other studies
(Harvey and Nigro [14], Elliehausen and Staten [6]) that have used the whole of the U.S.
or regions to define both control and treatment groups. To help remove the impact of any
temporary reaction to each law and any market reaction prior to the law coming into
effect, only the year before and the year after the law is in effect are
included in the sample. This approach should help to increase the comparability of the
9 http://www.huduser.org/datasets/manu.html, accessed on 2/1/05. HUD generates a list
of subprime lenders from industry trade publications, HMDA data analysis, and phone
calls to the lender confirm the extent of subprime lending. Since this list is defined at the
lender level, loans made by the subprime lenders may include both prime and subprime
loans. In addition, subprime loans made by predominately prime lenders will also be
incorrectly identified as prime lending. Therefore, an alternative interpretation of the
loans identified using the HUD subprime lender list is that it identifies the extent of
specialized subprime lending -- not full-service lending.
10 This geographically based sampling does not create a “matched” sample, where one
similar loan in the treatment location is matched with another loan in the control location.
In short, all observed loans in the
specified location and time periods are included.
treatment group and the control group because they are geographically closer and, as a
result, likely to be more economically similar than full state and region comparisons.
This approach and HMDA availability reduce the sample to ten local predatory lending
laws: California, Connecticut, Florida, Georgia, Maryland, Massachusetts, North
Carolina, Ohio, Pennsylvania, and Texas.
Identification Strategy
To identify the impact of a local predatory lending law, the location and timing of the law
becoming effective, along with borrower and location characteristics, are included. Table
4 describes the variables and data sources. Similar to Harvey and Nigro [13, 14], three
separate dependent variables will be tested for impacts of local predatory lending laws -the probability of applying for a subprime loan, the probability of originating a subprime
loan,
and the probability of being rejected on a subprime application.
The key variable of interest is Ineffect. This variable indicates that a loan is in a location
when and where a predatory lending law is effective. It is defined as zero before the law
is effective, even in the treatment location, and is always zero in the control location.
Ineffect is constructed by interacting the variable Law, which indicates locations where
the law will eventually be in effect, and Postlaw, which indicates the time period after a
law has become effective. Therefore, Law identifies the treatment location and Postlaw
identifies the time period the treatment is in effect. The reference group is defined as
locations where the law will never be in effect in the time period before the law is in
effect. There are no priors regarding the coefficients on Law or Postlaw, because they
will capture prevailing
probabilities associated with location and time that are not controlled for by other
variables. Given the results from prior research we would expect Ineffect to be negative
for the application and origination outcome and potentially insignificant for the rejection
outcome.
Conclusion
Starting with North Carolina in 1999, states and other localities across the U.S. have
introduced legislation intended to curb predatory and abusive lending in the subprime
mortgage market. These laws usually extend the reach of the Home Ownership and
Equity Protection Act (HOEPA) by including home purchase and open-end mortgage
credit, lowering annual percentage rate (APR) and fees and points triggers and
prohibiting and/or restricting the use of balloon payments and prepayment penalties on
covered loans.
While prior literature found evidence that the North Carolina law did reduce the flow of
credit, the results in this paper indicate that the typical law has little impact on the flow of
subprime credit as measured by loan origination and application. However, rejections do
decline by over 10 percent for the typical law. The reduction in rejections may reflect
less aggressive marketing, additional pre-screening by lenders, increased self-selection by
borrowers, or other factors. While a reduction in rejection rates may not have been the
intent of the predatory lending law, it does indicate that borrowers are benefiting by
saving non- refundable application costs when rejected for a subprime loan.
However, not all local predatory lending laws are created equal. The results indicate that
the heterogeneity in law strength can help further explain the mechanisms that make one
law decrease the flow of credit and another actually increase the flow of credit. The
strength of the law is measured along two dimensions – coverage and restrictions. Some
laws provide broad coverage of the subprime market (Colorado) and others very little
coverage (Texas).
Some have substantial restrictions (Georgia) on allowable lending, while others have very
few restrictions (Maine). The results indicate that coverage and restrictions tend to have
opposite impacts. In general, laws with more extensive restrictions are associated with
larger decreases in the flow of credit. In fact, laws with the strongest restrictions can
decrease applications by over 50 percent. In contrast, laws with broad coverage can
increase applications by even
more than 50 percent. Therefore, although on the surface local predatory lending laws
seem to have little impact, the design of the law can stimulate the subprime market,
depress the subprime market, or leave volumes relatively steady but with lower rejection
rates. As a
result, the design of the law can have economically important impacts on the flow and
make- up of the mortgage market.
In future research it would be helpful to determine how product mix adjusts to the
introduction of these laws. For example, the laws make no distinction between initial
interest rates on fixed rate and adjustable interest rate loans. But adjustable rate loans
tend to have lower initial rates, resulting in substitution rather than fewer loans, and can
include teaser terms that temporarily reduce the rate below the benchmark. Therefore,
adjustable rate loans may be one way to avoid the trigger APR levels in predatory lending
laws and shift a borrower out from under the protective coverage of the regulations.
There also may be a regulatory burden associated with these laws that needs to be passed
on to consumers through higher interest rates and upfront fees. Lastly, these laws may
reduce the availability of the secondary market leading to liquidity issues in the subprime
market, which may also increase the cost of credit.
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October 1, 2008
Sam Magavern
An edited version of this essay appeared in the Buffalo News, October 3, 2008 and is
available at http://www.buffalonews.com/149/story/453788.html.
Subprime lending has triggered a global financial crisis, but it remains misunderstood.
Here are some basic facts, culled from an upcoming report on abandoned housing by the
Partnership for the Public Good.
Subprime loans are high cost loans, ostensibly designed for people with less than “prime”
credit. In reality, mortgage brokers and lenders often succeed in selling subprime loans to
people with good credit. According to the Wall Street Journal, by 2006, fully 61% of
subprime loans were going to people who qualified for conventional loans.
Subprime lending grew very fast: from 7% of home loans (2000) to 21% (2006), creating
a $600 billion industry. This explosion was fueled by many factors, including the
deregulation of financial services, which allowed non-banks, such as mortgage
companies, to lend with very little oversight. Traditional, fully-regulated banks make
only 30% of subprime loans.
Subprime loans include many negative features beyond high rates and fees. Most
subprime loans in recent years have come with low teaser rates that reset into expensive
adjustable rates after two years. About 70% include prepayment penalties that trap
borrowers in the loans and prevent them from refinancing affordably if they discover
they’ve been duped. They have been marketed with intensive advertising and highpressure, often fraudulent, sales techniques designed to prey on elderly and other
vulnerable homeowners. Many lenders have broken even today’s lax lending laws.
Ameriquest paid $325 million, and Household International paid $484 million, to settle
predatory lending lawsuits.
Most importantly, subprime lending was never about expanding access to
homeownership. Only 38% of subprime loans are for home purchase, and only 9% go to
first time homebuyers. The rest are home equity loans and refinancings. What are home
equity loans used for? In 2004, 58% went for home improvements and personal
spending, and 27% went to pay off credit card debt.
Essentially, Americans are pawning their houses: using them as collateral for expensive,
high-risk loans. Thus, subprime lending has decreased homeownership by leading to
foreclosures. Homeownership rates for the bottom two fifths of the income scale dropped
from 45.4% (1980) to 42.4% (2005). The Center for Responsible Lending (CRL)
estimates that one out of five subprime loans made in 2006 will end in foreclosure. CRL
calculates that subprime lending has created a net loss of one million homeowners.
Buffalo has not escaped the subprime debacle. A 2008 federal study found 9,080
subprime loans in western New York, of which 22% were overdue, 5.5% were in
foreclosure, and 1.9% had been foreclosed. CRL predicts that 15.6% of the subprime
loans made in the Buffalo area in 2006 will end in foreclosure.
As the government attempts to repair the credit system, it must begin to regulate
subprime lenders just as it regulates banks, and it must strictly limit the ability of lenders
to sell credit on unaffordable and exploitative terms.
Sam Magavern teaches in the Affordable Housing Clinic at the University at the Buffalo
Law School and is one of the founders of the Partnership for the Public Good.
I.
Standalone sub prime
http://www.fdic.gov/bank/analytical/fyi/2003/012903fyi.html
http://www.fdic.gov/news/news/financial/2005/fil1405a.html
a.
Payday
What is Payday Lending?
Who uses it? and
what are the concerns?
Estimates are 30 to forty billions dollars per year. Hard to verify.
A few states have several limits a few are wide open and there is everything in the middle
Missouri efforts and payday lending in Missouri
Federal efforts/ military bases
Rise of the online payday lending
Who owns the payday lenders?
Who provides the money?
Rise of the mainline bank payday lending
What ingredients create the opposition?
Why continue it?
Sub Prime Products
The Payday Loan Industry in Missouri
A Study of the Laws, the Lenders, the Borrowers and the Legislation
Executive Summary
Sponsored by
BBB Serving Eastern Missouri and Southern Illinois ●15 Sunnen Drive ● Suite 107 ●
St. Louis, MO 63143 ● Phone: (314) 645-3300 ● www.stlouis.bbb.org
BBB of Southwest Missouri ● 430 S. Glenstone Avenue ● Springfield, MO 65802 ●
Phone: (417)
862-4BBB ● www.southwestmissouri.bbb.org
A Study of the Payday Loan Industry In Missouri
Executive Summary
Purpose Of This Study
One of the Better Business Bureau’s responsibilities is to inform the public of
questionable or unfair practices in the marketplace. In the past few years the payday loan
industry, termed by many as “predatory lending,” has grown significantly, both nationally
and in Missouri. In 1996 there were an estimated 2,000 payday loan outlets nationally,
and by 2008, that number grew to an estimated 22,000. During 2008, 2.8 million payday
loans were made by 1,275 lenders licensed in Missouri, according to the Missouri
Division of Finance. This study examines current Missouri laws regulating payday loans
and how these laws compare with those of other states. The study also looks at the status
of pending legislation and the effects of past legislation on the industry.
Sources used in this study include Missouri Division of Finance; 2001 Performance Audit
by State Auditor Claire McCaskill; current state laws; Form 10-Ks filed by some
companies with the U.S. Securities & Exchange Commission; interviews with officials;
National Consumer Law Center; bills introduced in the Missouri Legislature and
Congress; Web sites of lawmakers; FDIC Center for Financial Research; AARP; court
suits; Consumers Union; Missouri Secretary of State; PACER and Case.net (the court
case tracking systems of federal and Missouri courts respectively); Arkansas Supreme
Court; Consumer Federation of America; Center for Responsible Lending; the
Community Financial Services Association of America (CFSA); and BBB staff visits to
nursing homes.
Current Missouri Laws
In 2001, then-Missouri Auditor Claire McCaskill issued a Performance Audit regarding
the payday loan industry. She noted that statutes at that time did not limit the interest
rates lenders charge and that an annual percentage rate (APR) of 391% was common.
While not recommending a specific interest rate that the Legislature should impose, the
audit did recommend that the number of renewals of loans be reduced.
The next year, the Legislature passed laws that would allow a lender to charge fees and
interest up to 75% of the amount of the loan. On a two-week loan, that translates into a
1,950% APR, the highest allowed among the 43 states that have either banned or set APR
caps on payday loans. There are no APR caps in the seven other states. The new laws
also allow up to six renewals of loans. Since enactment of the laws, payday loans made
to consumers average more than 400% APR, according to the Division of Finance.
Missouri’s usury law is ineffective in policing exorbitant interest rates as the Division
notes on its Web site: “It applies to very little anymore because there are so many
exceptions.” Also on the site, the Division characterizes the current state laws as
consumer friendly in that they “subject this type of lender to a host of consumer
safeguards, i.e., places a 75% cap on interest and fees on the initial loan and renewals,
limits renewals to no more than six . . . .”
Obtaining a payday loan license in Missouri is a simple process. All that’s required is an
application and payment of a fee. There is no background check or determination of
financial capability, a Division spokesman said.
Missouri’s Laws Compared With Those Of Other States
The laws enacted by the Legislature in 2002 require the Division of Finance to report
biennially to the Legislature several facets of the payday loan industry. Responses by
lenders to the biennial request are not sworn statements. Among the requirements of the
report is that a comparison be made with states adjoining Missouri. The Jan. 14, 2009,
report to the Legislature shows that of the nine contiguous states, only Missouri allows
renewals of payday loans, allowing up to six renewals.
The lax payday loan laws in Missouri have made the state attractive to lenders. Among
the nine contiguous states, only Tennessee has more payday loan locations (1,481) than
Missouri (1,275) with the next highest being Kentucky with 785, according to the
Division of Finance’s report. The report also shows that the APR allowed by Missouri’s
statutes of 1,950% based on a two-week loan of $100 is by far the highest of the nine
contiguous states. The next highest was the Arkansas law which allowed an APR of
520%, but that law was declared unconstitutional by the Arkansas Supreme Court on
Nov. 6, 2008, because it allowed “usurious” rates of interest in violation of the state’s
constitution. The rest of the states’ laws based on a two-week payday loan of $100 allow
APRs of 390% except for Illinois which allows 403%.
The Lenders
While the number of payday loan licenses in Missouri may seem large, there are only 24
companies with 10 or more licenses. They operate at 719 locations, or 56% of the total
number of locations in the state. Seventeen of these larger lenders are based out of state.
Their headquarters are in Arkansas, Texas, North Carolina, Georgia, Tennessee, Ohio,
Colorado, Pennsylvania, Kansas, Alabama and Illinois. There are also 34 out-of-state
online companies that are licensed payday lenders in Missouri.
The three largest companies licensed to provide payday loans in Missouri are:
•
QC Holdings, Inc., a publicly traded company which does business under the
name Quik Cash, headquartered in Kansas City, Kan.;
•
Advance America, Cash Advance Centers, Inc., headquartered in Spartanburg,
S.C., also a publicly traded company; and
•
Bn’T Loan, LLC, of Springfield, Mo., which has licenses at various retail
locations.
The three companies operate 292 payday loan locations in Missouri or about 23% of the
total number of locations. Missouri accounted for 30% of QC Holdings’ total branch
gross profits last year, while Illinois accounted for 7%. The Form 10-Ks filed with the
U.S. Securities & Exchange Commission reveal that Cash Advance and Quik Cash made
a combined $5.5 billion in payday loans nationally in 2008. The primary business of
both companies is payday lending, and both companies began operations as the payday
lending industry began its great expansion, QC Holdings in 1992 and Advance America
in 1997. Bn’T Loan, LLC was created in 2002.
As the phenomenon of payday loans soared, the reputation of companies making them
declined. Said one large lender, “Certain banks have notified us and other companies in
the payday loan and check-cashing industries that they will no longer maintain bank
accounts for these companies due to reputation risks. . . .”
Nursing Homes Have Payday Loan Licenses
Two allied groups headquartered in Sikeston, Mo., operate 62 nursing homes in Missouri
with payday loan licenses. Principals in the two allied groups are James and Judy
Lincoln, Sikeston; Mathias P. Dasal, Eldon, Mo.; Gary Crane, Rogers, Ark.; and Timothy
Drake, Pascagoula, Miss. The sole director of a third group of 30 nursing homes is Don
Bedell, Sikeston, who also is sole director of a payday loan company that has licenses at
the homes. Nursing homes have regularly made loans to their employees at high interest
rates, deducting the payback of the loans from the employees’ next paycheck.
In September 2006, then-Gov. Matt Blunt announced that nursing homes would no longer
be allowed to make payday loans to their employees, saying, “Employers should not be
making money off the wages they pay their hardworking long-term care facility
employees.”
A spokesman for the Department of Health and Senior Services said that since then, the
department has been in negotiations with the nursing home owners, and that the
negotiations “became serious” this year. In April, he said the department and nursing
home owners reached an oral agreement, which will allow a parent company of nursing
home subsidiaries to hold a payday loan license and to conduct payday loan operations at
nursing homes that it owns, with payback of the loans being deducted from the
employees’ paychecks. Employees will take out a loan through computer terminals at the
nursing homes, the spokesman said. The transition to the system, which in essence
changes the present system very little, will be completed by late September, the
spokesman said. Department officials said loans were made only to employees and not to
residents of the homes.
The Borrowers
As might be expected, the definition of the typical customer taking out a payday loan
differs widely between companies that make them and consumer advocates. Two large
payday loan companies or their trade association say that borrowers are under 45 years
old, a large percentage have incomes of at least $40,000, nearly half are homeowners, at
least 87% have high school diplomas and more than half have attended college.
That picture of the typical borrower is in sharp contrast to that painted by officials and
consumer advocates. The Consumer Federation of America says that “payday loan
borrowers are typically female, make around $25,000 a year, are renters, and more likely
to be minorities than the general population.” Former Missouri State Auditor Claire
McCaskill said in an audit that “title and payday consumers are generally lower income
individuals. Title and payday lenders estimated 70 percent of their consumers earned less
than $25,000 annually.”
In a press release from the office of U.S. Rep. Luis Gutierrez (D-Ill.), who introduced a
bill that some say is friendly to the payday loan industry, it was noted: “Concentrated in
low-income and minority neighborhoods, payday lenders typically offer short-duration
loans, waiving the credit history requirement imposed by traditional banks.
Unfortunately, those who most need these loans are often the least able to repay them.”
The Missouri Division of Finance conducted a study in 2007. The survey of about 3,700
borrowers showed that the average age of consumers taking out payday loans was 43 and
income was $24,607. Borrowers were classified by vocation with 21% being “labor,”
and 12% classified as “secretarial/clerical.” The survey showed that 439 loans or 12%
were made to consumers on Supplemental Security Income (SSI) or disability. On its
Web site, AARP has this to say about the elderly and payday loans: “As studies show
that older people are incurring greater debt than ever before, and are filing for bankruptcy
in record numbers, they may find that their usual sources of credit are no longer
available. They may join the ranks of other low- and moderate- income consumers (who)
turn to non-traditional credit sources for very expensive loans.”
In a press release announcing his filing of a bill, U.S. Sen. Richard J. Durbin (D-Ill.) said,
“These excessive rates are often hidden and can have crippling effects on those
individuals who can afford it least.”
Last year, customers of payday loan companies filed 473 complaints with BBBs alleging
wrongdoing on the part of their lenders.
Bane Or Boon?
As with the identity of the typical borrower, the question of whether payday loans are
beneficial or not receives widely disparate answers from the industry and consumer
advocates. The Community of Financial Services Association of America (CFSA), the
trade association for the industry, says on its Web site, “Typically, a customer uses a
payday advance to cover small, unexpected expenses between paydays to avoid
expensive bounced- check fees, late bill payment penalties, and other less desirable shortterm credit options.” A major lender notes, “We believe that our customers choose the
payday loan product because it is quick, convenient and in many instances a lower-cost
or more suitable alternative for the customer than the other available alternatives.”
Another major lender says, “We believe customers use cash advances as a simple, quick
and confidential way to meet short-term cash needs between paydays while avoiding the
potentially higher costs and negative credit consequences of other alternatives.”
Consumer advocacy groups think differently. A study by the Center for Responsible
Lending noted: “Despite attempts to reform payday lending . . . lenders still collect 90
percent of their revenue from borrowers who cannot pay off their loans when due, rather
than one-time users dealing with short-term emergencies.” In comments to the Federal
Trade Commission, the Consumer Federation of America stated: “The essential features
of a payday loan make them a debt trap for borrowers” because the loans are made
without considering the borrower’s ability to repay and interest rates are exorbitant. The
Center for Responsible Lending said in another survey that “the entire payday lending
industry relies on a business model that encourages chronic borrowing.”
The consequences of the “debt trap” may be severe. A study made under the auspices of
the Federal Deposit Insurance Corp. (FDIC) was titled “Do Payday Loans Cause
Bankruptcy?” The researcher concluded: “We find that payday loan applicants approved
for their first loans file for Chapter 13 bankruptcy significantly more often than rejected
first-time borrowers.” And several consumer groups, in a letter to the sponsor of an
industry- friendly bill in Congress, said, “Using payday loans doubles the risk a borrower
will end up in bankruptcy within two years.”
Borrowers who cannot pay off a payday loan also may find themselves as defendants in
court actions. One of the largest lenders in Missouri has filed more than 100 small claims
suits in Missouri to force borrowers to pay.
A Center for Financial Responsibility study listed the cost of payday lending to
borrowers who have five or more loans per year in the 50 states and the District of
Columbia. California topped the list at $365 million, while Missouri ranked second with
$317 million.
Legislation
A bill introduced in the U.S. Senate by Sen. Durbin began by saying that governments
have been trying “to prohibit usurious interest rates in America since colonial times.”
Currently, there are four pending bills in Congress and two were introduced in the
recently concluded Missouri Legislature. But if the past--when several bills both at the
state and federal level died in committee or were not assigned to a committee--is any
indication of the future, the prospects of meaningful regulation of payday lenders is
questionable. Bills were introduced in the U.S. House or Senate in 2005, 2006, 2007 and
2008. And in Missouri bills were introduced in the House or Senate in 2006, 2007 and
2008. Only one of the bills was enacted into law--a bill passed by Congress in 2006 for
military service members and their families that placed an APR cap of 36% on several
consumer credit products including payday loans. Only two of the bills introduced this
year provide protection against extremely high interest rates.
These bills have been introduced:
•
U.S. Senate Bill 500 – Introduced on March 19, 2009, by Sen. Durbin. The bill
would cap interest rates on several consumer credit products including payday loans at a
36% APR and would provide a penalty for violation of the law of a year in prison or a
fine of $50,000.
•
U.S. House of Representatives Bill 1608 – Introduced on March 19, 2009, by
Rep. Jackie Speier (D-Calif.). This bill is identical to Senate Bill 500.
•
U.S. House of Representatives Bill 1214 – Introduced Feb. 26, 2009, by Rep.
Gutierrez. The bill would cap fees and interest at 15 cents per dollar, an APR of 390%
on a two-week loan. Twelve consumer advocacy groups sent a letter to Rep. Gutierrez
opposing the bill, saying it would “stall or stop the significant progress that has been
made at the state level to curb usurious lending” and that “legalizing payday lending at
triple- digit rates runs counter to President Obama’s promise to cap payday lending and
other loans at 36 percent annual rates.”
•
U.S. House of Representatives Bill 1846 – Introduced April 1, 2009, by Rep. Joe
Baca (D-Calif.). One of the main provisions of the bill is that it would preempt state
laws on payday lending, including those in states that have banned payday lending
entirely. The bill also calls for a 390% APR.
•
Missouri Senate Bill 20 – Pre-filed Dec. 1, 2008, by Sen. Rita Heard Days (D-St.
Louis). The bill allows a 390% APR (based on a two-week loan) for the first 30 days of a
loan and an APR of 36% thereafter. The bill also prohibits renewal of payday loans. The
legislative session ended with no action taken on the bill or its companion bill, Missouri
House Bill 150, pre-filed by Rep. Mary Still (D-Columbia).
Effects Of Past Legislation
More and more states are clamping down on the payday loan industry with legislation
that either bans payday lending entirely or provides stiff regulation of the industry. More
than 200 bills have been introduced in state legislatures in recent years. And as laws are
enacted, payday lending companies have ceased operations in those states. “In states
where a 36% cap is mandated, without additional fees, we are unable to operate at a
profit,” said QC Holdings in its 10-K report filed with the Securities & Exchange
Commission. And Cash Advance said in its 10-K, “Any federal law that would impose a
national 36% APR limit on our services, like that proposed in the Durbin bill, if enacted,
would likely eliminate our ability to continue our current operations.” The company also
noted that since 2007 it has closed or will close payday loan outlets in Arkansas, New
Mexico, New Hampshire, Oregon and Pennsylvania. Not only is the industry facing the
possibility of prohibitive legislation at the federal and state levels, local governments
have entered the picture by restricting payday lending through zoning and permit laws.
In addition to the prospect of increased regulation by federal, state and local
governments, payday loan companies also find themselves as defendants in court actions.
Class action suits are pending against two of Missouri’s largest payday lenders in
Arkansas, California, Florida, Georgia, North Carolina, Pennsylvania, South Carolina and
Missouri. Class action suits have been filed in St. Louis County Circuit Court and the
U.S. District Court in Jefferson City, Mo. Both suits are pending appeal regarding
procedural matters. The suit in St. Louis County alleges that QC Holdings (Quik Cash)
violated Missouri law by renewing loans more than six times, by failing to determine the
customer’s ability to repay the loans, and by charging interest and fees which were more
than 75% of the face amount of the original loan.
Conclusions
Missouri’s weak payday loan laws have attracted major out-of-state lenders to engage in
predatory lending, costing Missourians who can least afford it millions of dollars a year.
Because the continually increasing debt owed to payday loan companies is so onerous,
some consumers are caught in the “debt trap,” unable to pay the loan off or meet other
needs such as utilities, rent and food. Bankruptcy is the only answer for some of these
consumers. The bill introduced in Congress by Sen. Durbin and its companion bill in the
House, if enacted, would appear to halt the usurious practices, not only in Missouri but
nationally as well. The Missouri Legislature has not joined the parade of states which
have taken action recently to either prohibit or severely restrict payday lending. Payday
loans are banned in 12 states while three others have adopted restrictive laws. The two
bills introduced in this session of the Missouri Legislature, while forbidding renewals,
would still allow an APR of 390% on a two- week loan. Payday loan companies have
ceased operations in states that have enacted strict regulations on payday lending,
including placing a 36% or less APR cap on interest and fees.
BBB Researcher: Robert H. Teuscher, July 2009
Subprime Auto Lending Revs Up
Posted: 05/24/2012 3:11 pm Updated: 05/24/2012 3:20 pm
Car dealer David Kelleher of Glen Mills, Pa., says lately he's growing accustomed to a
new kind of customer: lawyers, doctors and other high-salaried professionals who are
now considered subprime credit risks.
As the current chairman of the Chrysler National Dealer Council, Kelleher said this
includes individuals who lost their financial footing when their investments soured in the
recession or a real estate deal went bad.
"We're seeing a new face of the subprime customer; that's for sure," said Kelleher, who
owns David Chrysler Jeep Dodge.
Subprime lending is on the rise in the auto industry, and even though the term "subprime"
makes people nervous, some players in the auto industry welcome it. They see it as a way
to reach customers who have been cut off from buying cars these past few years. When
the credit crisis hit in the fall of 2008, it was hard even for those with the best credit
scores to receive a car loan.
But while this kind lending could boost auto sales by opening up a larger market, it also
can pose a risk to subprime customers, who are susceptible to scams that could result in
higher interest rates.
As the car market and the credit markets recover from the recession, loans have slowly
started to be granted for individuals with lower and lower credit scores. These people end
up paying higher interest rates, though. Since this January, about 8 percent of car buyers
have secured loans with an interest rate of 10 percent or more, which indicates that the
bank sees them as a high risk, said Jessica Caldwell, a senior analyst at Edmunds.
Currently the average interest rate for a car loan is about 4 percent.
The increase in subprime lending is helping boost car sales to people who have been
holding off.
"There was a significant population who had no access to credit," Caldwell said. "People
get nervous when you hear we're letting subprime people back into the market, but these
people were really cut off … It's not a hog-wild lending frenzy, giving loans to anyone
who walks in."
Data from credit tracking firm Experian backs up what Edmunds has found: Subprime
lending for the first quarter of 2012 climbed 11.4 percent over the same period last year,
accounting for 23.16 percent of auto sales for the first quarter. After the credit crisis hit in
the fall of 2008, subprime lending plunged to 17.99 percent of auto sales during the first
quarter of 2009.
But consumers shouldn't confuse subprime auto lending with subprime mortgages, said
Melinda Zabritski, director of automotive credit for Experian. Delinquency rates are
lower for these types of car loans as people tend to pay their car loans before they pay
credit card loans and sometimes even before they pay their mortgage.
"Everyone says that's because you need a car to go to work," Zabritski said.
"Delinquencies right now are historically low."
Still, consumers with subprime credit scores need to be careful, warned Chris Kulka,
senior counsel for government affairs for the Center for Responsible Lending. Because
these customers often have a harder time securing a loan, dealers may take advantage of
them.
If a dealer sets up financing for a customer, that dealer is allowed to add in a percentage
markup that gets paid directly to the dealer. So, for example, if the subprime customer
qualified for a 10 percent loan, the dealer could add in another 5 percent and tell the
customer he or she qualified for a 15 percent loan. The Center for Responsible Lending is
lobbying to make this practice illegal.
"We think subprime customers are much more affected by this than other consumers,"
Kulka said. "We remain concerned that if the market takes off, but we haven't addressed
these issues, that's a problem."
Chrysler is selling more cars to subprime customers than almost any other auto
manufacturer, especially when it comes to its Dodge brand, Edmunds said. Year to date,
about 12 percent of all Chrysler purchases have been made with subprime loans, with
about 20 percent of Dodge buyers assuming subprime loans. In comparison, 11.5 percent
of Fiat buyers have a subprime loan. And 8.5 percent of Jeep buyers take on a subprime
loan.
Kia, Mitsubishi and Suzuki also are finding that more than 20 percent of their customer
base take on subprime loans, Edmunds said.
Ralph Kisel, a spokesman for Chrysler, said subprime customers are the biggest growth
area for the entire industry. "Credit availability is bringing these customers back to [the]
market at a disproportionate level versus prime customers," he said.
For Kelleher, the increase in subprime lending means he's hearing more stories from
people hard hit by the recession who now feel like they are on the rebound. He recently
had a customer who lost both his $200,000 job and a substantial fortune in real estate. He
filed for bankruptcy but now is back working and needed a car.
"In a lot of these cases, the people aren't going to be subprime forever," Kelleher said.
"We were able to get this gentleman a loan. And if things go right, maybe he'll buy from
us again."
Special Report: How the Fed fueled an explosion in subprime auto loans
Wed, Apr 3 2013
By Carrick Mollenkamp
JASPER, Alabama (Reuters) - Thanks largely to the U.S. Federal Reserve, Jeffrey Nelson
was able to put up a shotgun as down payment on a car.
Money was tight last year for the school-bus driver and neighborhood constable in Jasper,
Alabama, a beaten-down town of 14,000 people. One car had already been repossessed.
Medical bills were piling up.
And still, though Nelson's credit history was an unhappy one, local car dealer Maloy
Chrysler Dodge Jeep had no problem arranging a $10,294 loan from Wall Street-backed
subprime lender Exeter Finance Corp so Nelson and his wife could buy a charcoal gray
2007 Suzuki Grand Vitara.
All the Nelsons had to do was cover the $1,000 down payment. For most of that amount,
Maloy accepted Jeffrey's 12-gauge Mossberg & Sons shotgun, valued at about $700
online.
In the ensuing months, Nelson and his wife divorced, he moved into a mobile home, and,
unable to cover mounting debts, he filed for personal bankruptcy. His ex-wife, who
assumed responsibility for the $324-a-month car payment, said she will probably file for
bankruptcy in a couple of months.
When they got the Exeter loan, Jeffrey, 44 years old, was happy "someone took a chance
on us." Now, he sees it as a contributor to his financial downfall. "Was it feasible? No,"
he said.
The Maloy dealership wouldn't discuss the loan. "I got nothing to say to you," an
employee said.
At car dealers across the United States, loans to subprime borrowers like Nelson are
surging - up 18 percent in 2012 from a year earlier, to 6.6 million borrowers, according to
credit-reporting agency Equifax Inc. And as a Reuters review of court records shows,
subprime auto lenders are showing up in a lot of personal bankruptcy filings, too.
It's the Federal Reserve that's made it all possible.
MONEY, MONEY EVERYWHERE
In its efforts to jumpstart the economy, the U.S. central bank has undertaken since
November 2008 three rounds of bond-buying and cut short-term interest rates effectively
to zero. The purchases of mostly Treasury and mortgage securities - known as
quantitative easing and nicknamed QE1, QE2 and QE3 - have injected trillions of dollars
into the financial system.
The Fed isn't alone. Central banks from Tokyo to Frankfurt to London are running their
printing presses overtime. The heavily indebted advanced economies are trying to reflate
their way out of the prolonged bout of crisis and recession that crystallized with the
collapse of Lehman Brothers Holdings Inc in 2008. That crisis, of course, followed a
nearly decade-long cycle of easy money and exotic financial products that itself began
with the collapse of the tech-mania bubble of the late 1990s.
The Fed's program, while aimed at bolstering the U.S. housing and labor markets, has
also steered billions of dollars into riskier, more speculative corners of the economy.
That's because, with low interest rates pinching yields on their traditional investments,
insurance companies, hedge funds and other institutional investors hunger for riskier,
higher-yielding securities - bonds backed by subprime auto loans, for instance.
Lenders like Exeter have rushed to meet that demand. Backed by Wall Street banks and
big private-equity firms, they have been selling ever-greater amounts of subprime auto
loans in the form of relatively high-yield securities and using the proceeds to fund even
more lending to more subprime borrowers.
Expansion of the subprime auto business was chronicled in a 2011 Los Angeles Times
series. Since then, growth has continued apace. Consider that in 2012, lenders sold $18.5
billion in securities backed by subprime auto loans, compared with $11.75 billion in
2011, according to ratings firm Standard & Poor's. The pace has continued so far this
year, with $5.7 billion of the securities issued, compared with $4.4 billion for the same
period last year, according to Deutsche Bank AG. On Monday alone, three deals totaling
$1.6 billion of subprime auto securities were announced by Wall Street banks.
To make up for the risk of taking on increasing numbers of high-risk borrowers,
subprime auto lenders charge annual interest rates that can top 20 percent.
The Exeter loan Nelson and his wife got, for example, carried a 21.95-percent rate.
Exeter, which is majority-owned by private-equity giant Blackstone Group, assumes that
one in four borrowers will default on their loan, according to an Exeter investor pitch
book reviewed by Reuters.
"Exeter works with auto dealers throughout the country to help consumers who do not
qualify for prime financing," a company spokeswoman said. "Exeter offers conventional
financing with affordable payments tailored to each customer's individual
circumstances."
A Blackstone spokesman declined to comment.
BUBBLE TROUBLE
Critics of the Fed say the growth in subprime auto lending is just one of several minibubbles the bond-buying program has created across a range of assets - junk bonds,
subprime mortgage securities, and others. The yield chase delivered big windfalls to
some Wall Street firms and hedge funds holding securities that soared in value. But so
much money has flowed into these assets, the critics say, that the markets for some are
beginning to resemble the housing boom in the run up to the financial crisis.
"It's the same sort of thing we saw in 2007," said William White, a former economist at
the Bank for International Settlements. "People get driven to do riskier and riskier
things."
White is among the growing number of economists coming round to the view of Federal
Reserve Bank of Dallas President Richard Fisher, a non-voting member of the central
bank's policy-making panel and a longtime critic of quantitative easing. "We are sailing
deeper into uncharted waters," Fisher said in a speech six days after the Fed's September
13 announcement of QE3. "Why would the Fed provision to shovel billions in additional
liquidity into the economy's boiler when so much is presently lying fallow?"
A bust in the subprime auto market wouldn't have consequences nearly as devastating for
lenders, investors or the broader economy as the housing bust did. Securities underpinned
by subprime auto loans, estimated at about $80 billion between 2006 and 2012, are a
fraction of the $1.6 trillion in mortgage-backed products Wall Street created between
2006 and 2009, according to S&P data and the Financial Crisis Inquiry Commission,
created by the U.S. government to analyze the financial crisis.
And whatever its faults, the Fed's program, consistently supported by most members of
the central bank's policy-making body, has helped pull the U.S. economy out of recession
and boosted the stock market to record levels.
In congressional testimony last month, Fed Chairman Ben Bernanke, the main proponent
of the bond-buying program, said low interest rates have "helped spark recovery in the
housing market and led to increased sales and production of automobiles and other
durable goods."
Indeed, auto sales have recovered to nearly pre-crisis levels. New car, pickup truck and
sport-utility vehicle registrations are projected to increase 6.6 percent this year to 15.3
million, according to automotive market-analysis firm Polk. Registrations could exceed
16 million in 2015, a number last seen in 2007.
A Fed spokesman declined to comment.
Subprime auto loans may seem like an obscure corner of finance, but the names behind
the expansion are familiar.
Santander Consumer USA Inc, a unit of giant Spanish bank Banco Santander SA, is one
of the biggest sellers of securities backed by subprime auto loans, according to S&P. In
2011, KKR & Co, Warburg Pincus and Centerbridge Partners bought a 25 percent stake
in the Santander unit for $1 billion.
Capital One Financial Corp, General Motors Co and Ally Financial Inc are also steadily
increasing loans to subprime borrowers.
PERFORMANCE ANXIETY
Less well-known upstart Exeter, founded in 2006 and based in Irving, Texas, is run by
executives from AmeriCredit Corp, an auto-finance company acquired by General
Motors in 2010. It reported $100 million in originations in May 2010. It expected to hit
$1 billion in 2012 and $2.2 billion by 2015, according to the pitch book. The company
has grown to 46 branches with 532 employees serving more than 6,600 dealers, from one
branch and six employees serving 120 dealers in 2006.
In 2008, a Goldman Sachs Group Inc fund, through an investment in a private-equity
fund, helped infuse money into Exeter. Then, in 2011, Blackstone bought its controlling
stake, turbo-charging Exeter's expansion as the Fed decided to keep pumping money into
the economy. In October, Wells Fargo & Co, Citigroup Inc, Deutsche Bank AG and
Goldman agreed to provide it loan commitments totaling $1 billion.
After the Blackstone deal, in particular, the push was on for Exeter to expand its loan
book, according to a former employee. "Everybody was under extreme pressure to hit
goals," this person said. "Your job is in jeopardy. It was not sugar-coated."
To win more business from dealerships, Exeter lowered its "holdback fee" - the small
fraction of the loan amount that the lender keeps as a cushion against losses - to between
$395 and $495 from about $795.
The August 2012 Exeter investor pitch book touts the firm's "highly sophisticated risk
management process," which employs a "decision science" system underpinned by
"predictive models." The marketing book adds: "The end result is to deploy tools to
management allowing for precision control over credit performance."
This process results in customers with an average credit score of 556 and average annual
income of $38,393, according to the pitch book. These borrowers pay an average interest
rate of 21.4 percent a year. (Median U.S. household income was an inflation-adjusted
$50,054 in 2011, according to the Census Bureau. On the widely used FICO creditscoring scale, produced by Fair Isaac Corp, 640 or less is considered subprime.)
As for those Exeter clients who fall behind on payments, another former Exeter employee
said, "they're check to check."
TITLE LOANS, PAYDAY LENDERS
That's the case for Wayne Loveless.
Loveless and his wife in January 2012 got an Exeter loan to buy a 2006 Buick
Rendezvous from Victory Nissan in Dickson, Tennessee.
But Loveless, working as a cook at the local O'Charley's restaurant, had trouble keeping
up with the $329 monthly payment. In February last year, the family got a title loan
secured by a 2001 Ford Windstar van. In May, subprime lender World Finance gave them
a $1,500 loan, secured by a television, a PlayStation and a DVD player.
Court records show that Loveless took out payday loans totaling about $5,500 from
AmeriCash, ACE Cash Express and Cash In A Wink. (Payday loans, which are shortterm loans secured only by the borrower's future work pay, and title loans, also shortterm but secured by an auto title, are a popular but expensive route to ready cash for
many strapped Americans.)
Loveless said some of that money helped cover car-loan payments and some went toward
the cost of caring for his wife's mentally disabled brother. "It's stressful because... you're
always begging for more money," he said.
In July, Loveless and his wife filed for Chapter 7 bankruptcy, which erases unsecured
debt and calls for liquidation of assets to pay down remaining debt. At the time, Loveless
owed Exeter $9,900, excluding the value of the car.
Loveless recently lost his job as a cook and now works for a company that services fire
extinguishers. He and his wife kept the Buick.
As the Lovelesses were struggling last year, Exeter issued $500 million in securities
backed by subprime auto loans in two sales, in February and September. (Whether the
Loveless loan was part of those sales couldn't be determined.)
Like subprime mortgage securities issued in the past decade, each Exeter security was
divided into tranches, or layers, based on the risk and return of each. Investors couldn't
get enough of them, bidding up prices and thus lowering yields. In February, the yield on
the top-rated tranche was 2.029 percent. By September, demand had increased so much
that the yield was just 1.312 percent.
Ratings agency DBRS gave the least-risky tranche its top rating - triple-A - in part
because Exeter used a cushion to protect investors against losses and because it had a
management team experienced in subprime, the agency said in its ratings reports. Exeter's
proprietary model "declines approximately 50 percent of submitted applications," the
agency said.
MOODY'S WEIGHS IN
Moody's Investors Service, in a move rare among ratings agencies, issued a report in
March 2012 saying it would not have assigned a high investment-grade rating to the
notes. "Exeter is small and unrated, with limited experience and little asset performance
history," it said.
Chuck Weilamann, a senior DBRS official, declined to comment on the Moody's report.
He said DBRS was comfortable with the rating, noting that of the $142 million top-tier
notes backed by subprime auto loans in the first sale, half had been paid off. "It is
performing in line with expectations," he said.
Regardless of the relative safety of such securities, a rapidly growing lending business
that bakes into its assumptions a 25 percent failure rate is almost certain to result in more
people defaulting on more loans. In 2011, Exeter Finance was listed as a creditor or
participant in 252 bankruptcy proceedings, according to an online database of federal
court filings. In 2012, the number increased to 1,144.
Brett Wadsworth, the lawyer in Jasper who handled Jeffrey Nelson's bankruptcy, said the
bulk of the filings he works on involve subprime debt - loans his clients shouldn't have
gotten in the first place. "Most of them that's getting those types of loans are the same
ones who's getting the cash loans or payday loans or title loans," Wadsworth said.
Charles Thomas, an electrician in Park Forest, Illinois, filed for Chapter 7 bankruptcy
only four months before he took out loans from Exeter and Santander in November 2011.
Efforts to buy a car failed at six different dealers, but an online car-loan application he
had filled out prompted an employee from Family Hyundai to call: Thomas had been
preapproved.
Thomas settled on a 2012 Hyundai Sonata financed by Exeter. His wife got a 2008
Hyundai Sonata financed by Santander. "They presented both deals to me at the same
time," Thomas said. "You begin to try to rationalize, well maybe it was our time for the
sun to shine on us."
A Family Hyundai employee said the dealership doesn't comment on individual
customers. Santander Consumer, citing privacy concerns, declined to comment.
After his wife lost her job at a logistics company, the $900 in monthly car payments
proved to be too much. Thomas in February filed for Chapter 13 bankruptcy protection,
which would allow him to reorganize his debts.
Thomas's bankruptcy court filing lists personal property of $25 in a checking account,
$1,000 in household goods and $300 in clothing and a retirement account valued at
$24,000. It also shows he owes $22,060 to Exeter, and $11,538 to Santander.
AN APPETITE FOR RISK
Despite the risk that borrowers like Thomas present, investors have proved increasingly
willing to put their money into subprime auto debt for lower relative returns. According
to Barclays Plc, the average spread - a measure of investors' risk tolerance - between top-
rated securities underpinned by prime and subprime auto loans and a benchmark interest
rate hit 0.32 percentage point in February. That represents a remarkable increase in risk
appetite from the 8.85-percentage-point spread at the peak of the financial crisis in
autumn 2008.
With so much investor money backing subprime auto loans, and the resulting expansion
of lending to questionable borrowers, some market watchers are beginning to sound
alarms - albeit muted ones. Fitch Ratings in March said it was "concerned that the
competitive landscape is creating an environment that encourages lenders to compete by
easing credit terms."
Concerns are arising inside the business, too. At the annual American Securitization
Forum conference in Las Vegas in January, Goldman Sachs banker Robert McDonald
said persistent bullishness in pooled auto debt "worries me a bit." Noting the narrowing
of spreads, he said investors in subprime auto debt might ultimately balk if not paid
enough to take on the risk.
In Alabama, Jeffrey Nelson continues to drive a bus for the Walker County school system
and to work as a constable for his neighborhood. His financial struggles continue, too.
"It's one hit after another," he said recently at a local mall restaurant over a dinner of
bourbon-glazed chicken - some of it packed up for later. "Three days ago, I lost my
iPhone. Had to buy another."
Court records show Nelson has monthly income of $1,592.97, while monthly expenses
total $1,563.00, leaving about $29 in his wallet. His ex-wife got the Suzuki SUV.
He still owns a 1996 Dodge Ram pickup truck. If he can scrape together the money, he
said, he'll buy blue lights and a siren to put on the truck for his work as a constable.
(Edited by Paritosh Bansal and John Blanton)
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http://www.consumerfed.org/pdfs/driving_borrowers_rpt.pdf
Public Pensions Finance Payday Lenders
Some of the nation’s largest banks, including Wells Fargo and U.S. Bank, continue to
offer payday loans despite growing regulatory scrutiny and mounting criticism, according
to a report issued earlier this year by the Center for Responsible Lending. Evidently
gouging low-income borrowers into long-term debt charging outrageous interest rates of
500%, or more, is too good for big banks to resist.
Regulators have issued numerous warnings about abusive payday loan practices. Last
May, the Federal Deposit Insurance Corporation said the agency was “deeply concerned”
about payday lending. The Office of the Comptroller of the Currency, which oversees the
nation’s largest banks, said in June 2011 that the loans raised “operational and credit risks
and supervisory concerns.” The Consumer Finacial Protection Bureau has been
examining whether banks violate consumer protection laws in the marketing of these
products.
Fifteen states have banned usurious payday lending to protect workers and just last week
state authorities took action against certain predatory payday lenders.
Obviously, included in the portfolios of most of the nation’s massive state and local
public pensions (whether through actively managed accounts or index funds), are stocks
of large banks which derive a portion of their earnings from fleecing payday borrowers. It
may be unreasonable to expect public pensions to forego investing in major banks, or
scrutinize every activity of the major banks in which they invest and object to banking
practices they find reprehensible.
However, according to industry sources, in addition to large banks, some of the largest
payday loan companies are publicly traded, such as Cash America (CSH), and Dollar
Financial (DFC). Some other large lenders include Community Choice Financial and
SpeedyCash. Other lenders, according to the industry, are backed by investors large and
small, such as hedge funds, private equity companies and family offices. For example,
Payday One, was formerly offered by Think Finance, a company which claims to be
“privately held and backed by some of Silicon Valley’s most respected venture capital
firms, including Sequoia Capital and Technology Crossover Ventures.”
It’s more than likely that public pensions loading-up on hedge funds and private equity
are, due to the lack of transparency related to alternative investments, inadvertently
financing payday marauders.
Virtually all public funds that invest with alternative managers agree to reduced
transparency regarding the investments held in alternative portfolios, including denying
public access to such information. I’ve witnessed alternative managers and investment
consultants advise public pensions that ignorance regarding strategies and investments is
beneficial, permitting plausible deniability and avoidance of headline risk. You’ll never
have to admit to things which you purposely do not know.
Among publicly-traded payday lender Cash America’s top institutional holders is Earnest
Partners LLC, which owned $75 million of the stock at June 30, 2013. (Other major
holders of Cash America and Dollar Financial stock with significant public pension
clients include Vanguard and BlackRock.) According to its website, Earnest Partners
manages approximately $20 billion in assets for clients around the world, including
corporate pension plans, state and municipal pension plans.
According to published reports, the firm was recently terminated as a domestic midcap
equity manager handling $514 million for the Ohio Police and Fire Pension. (Ironically,
earlier this year Ohio’s Supreme Court announced it would hear a payday lending case
that could close the licensing loophole payday stores use to charge borrowers triple-digit
interest. It seems Buckeyes can’t decide whether to prohibit, or profit from, payday
lending.)
I don’t know whether Cash America stock was included in the $514 million portfolio
Earnest Partners managed for the Ohio Police and Fire Pension but, given the outrageous
returns related to payday lending, as public pensions migrate further into alternative
investments, they should, in my opinion, determine whether they are, directly or
indirectly, financing the business of screwing the poor.
-------------------------------------------------------------------------------This article is available online at:
http://www.forbes.com/sites/edwardsiedle/2013/09/04/public-pensions-finance-paydaylenders/
a.
Tax refund anticipation loans
What is tax refund anticipation loans?
Who uses them?
What are the concerns?
http://www.nclc.org/images/pdf/high_cost_small_loans/ral/report-ral-2011.pdf
Rent to Own
What are the common features that are problematic and may tip the balance to restrict or
prohibit?
Federalism / state law or federal law?
Big question in this field.
II.
Subprime product for conventional credit
a.
b.
Auto Lending Car purchase financing
buy here pay here dealer financing
What is car title lending?
Who uses it?
What are the concerns?
What makes it objectionable
Cost – fees – method of enforcement
Buy here pay here auto dealer financing
Added problem- quality of the car
c.
Subprime credit cards
What is the difference between a prime credit card and a subprime credit card?
What turns a subprime credit card financing to a predatory subprime credit card
financing?
As defaults exploded in the late 1990’s and early 2000’s what were the impact of shifting
to a higher percentage of subprime credit card customers?
Please read the following article
http://www.bos.frb.org/commdev/c&b/2008/fall/Anderson_subprime_credit_cards.pdf
d.
Subprime Mortgage Products
What are the differences between a prime mortgage loan and a sub prime?
As the crash started, think about the huge shift to sub prime, why it happened and what
its effects were?
What turns a sub prime home mortgage to a predatory sub prime mortgage loan
Price
Default Penalties
Enforcement terms and rights
IS THERE A LIMIT TO THE PRICE OR CONDITIONS OR PRACTICES THAT
SOCIETY SHOULD TOLERATE OR SHOULD WE JUST MAKE THE
COMPARISONS AS ACCURATELY AS WE CAN AND LET THE PARTIES
MAKE THEIR OWN BARGAIN??
Please read carefully the following article:
http://research.stlouisfed.org/publications/review/06/01/ChomPennCross.pdf
http://research.stlouisfed.org/wp/2006/2006-009.pdf
The subprime auto lending industry isn’t anything new; for years investors have taken the
risk on borrowers who have less than perfect credit, and lending companies that
specialize in high interest auto loans have offered loans to people who do not qualify for
regular auto loans. But while many advertised rates for auto loans are at percentages in
the low single digits, subprime auto loans can carry interest rates that are 20% or even
higher. These loans are granted under the assumption that a quarter of those borrowing
will ultimately default. But there is a lot more than the borrower’s vehicle that is at stake.
The high car payments often sends an already strapped budget into a downward spiral
and borrowers can wind up bankrupt.
The impact of securitization on the expansion of subprime credit ☆
•
Taylor D. Nadaulda, <img alt="Corresponding author contact information"
src="http://origin-cdn.els-cdn.com/sd/entities/REcor.gif">, <img src="http://origincdn.els-cdn.com/sd/entities/REemail.gif" alt="E-mail the corresponding author">,
•
Shane M. Sherlundb, <img src="http://origin-cdn.elscdn.com/sd/entities/REemail.gif" alt="E-mail the corresponding author">
Abstract
This paper investigates the relationship between securitization activity and the extension
of subprime credit. The analysis is motivated by two sets of compelling empirical facts.
First, the origination of subprime mortgages exploded between the years 2003 and 2005.
Second, the securitization of subprime loans increased substantially over the same time
period, driven primarily by the five largest independent broker/dealer investment banks.
We argue that the relative shift in the securitization activity of investment banks was
driven by forces exogenous to factors impacting lending decisions in the primary
mortgage market and resulted in lower ZIP code denial rates, higher subprime origination
rates, and higher subsequent default rates. Consistent with recent findings in the
literature, we provide evidence that the increased securitization activity of investment
banks reduced lenders' incentives to carefully screen borrowers.
Chapter 8 Surveys:
Surveys of Consumer Finances, Sentiment and the like
To be knowledgeable about consumer credit in the United States it is necessary to be
familiar with several consumer “surveys.” In the financial area the Fed Three year
survey is the key document. Take a careful look at it; pick out several areas of interest
and see what you can learn from the most recent results of the survey. For example, the
extent of student loan debt in the United States has become a very important topic. Look
at the various information available about that development.
I.
Survey of Consumer Finances In the economic area the Fed three year study is a
font of knowledge and information and is all the more useful because of its historical
comparisons. The Federal Reserve Board in April will begin a statistical study of
household finances, the Survey of Consumer Finances, that will provide policymakers
with important insight into the economic condition of all types of American families. The
survey has been undertaken every three years since 1983. It is being conducted for the
Board by NORC, a social science research organization at the University of Chicago,
through December of this year. The data collected will provide a representative picture of
what Americans own--from houses and cars to stocks and bonds--how and how much
they borrow and how they bank. Past study results have been important in policy
discussions regarding recovery of households from the Great Recession, changes in the
use of credit, use of tax-preferred retirement savings accounts, and a broad range of other
issues. "This survey is one of the nation's primary sources of information on the financial
condition of different types of households," Federal Reserve Board Chairman Ben S.
Bernanke said in a letter to prospective survey participants. "Our previous surveys…have
helped the Federal Reserve and other parts of the government make policy decisions and
have also supported a wide variety of basic research, public discussion, and education."
Participants in the study are chosen at random from 127 areas, including metropolitan
areas and rural counties across the United States, using a scientific sampling procedure. A
representative of NORC contacts each potential participant personally to explain the
study and request time for an interview.
Summary results for the 2013 study will be published in early 2015 after all data from the
survey have been assessed and analyzed.
Provide a few pages of the most recent survey.
Provide some questions that require use of those pages and that demonstrate the value of
the survey http://www.federalreserve.gov/pubs/bulletin/2012/pdf/scf12.pdf
Consider the light that the Survey casts on the following two issues.
1.
How and when did student loan debt become such a major issue?
Where was it in relation to car debt and credit card debt in each of the last five surveys?
What do we know about the income levels of people with the highest levels of student
debt?
2.
Who is suffering the most from the Crash and who is recovering the most
quickly?
More recently the New York Fed and Equifax have developed an instrument that is more
current and has other advantages.
II.
Survey of Consumer Sentiment
Provide a few pages of the most recent survey
Provide some questions that require use of those pages and that demonstrate the value of
the survey
.
Bureau of Labor Statistics (BLS)
The Consumer Expenditure Survey (CE) program consists of two surveys, the Quarterly
Interview Survey and the Diary Survey, that provide information on the buying habits of
American consumers, including data on their expenditures, income, and consumer unit
(families and single consumers) characteristics. The survey data are collected for the
Bureau of Labor Statistics by the U.S. Census Bureau.
The CE is important because it is the only Federal survey to provide information on the
complete range of consumers' expenditures and incomes, as well as the characteristics of
those consumers. It is used by economic policymakers examining the impact of policy
changes on economic groups, by businesses and academic researchers studying
consumers' spending habits and trends, by other Federal agencies, and, perhaps most
importantly, to regularly revise the Consumer Price Index market basket of goods and
services and their relative importance.
The most recent data tables are for July 2011 through June 2012, and were made
available on March 27, 2013. See Featured CE Tables and Economic News Releases
sections on the CE home page for current data tables and the news release.
The 2011 public-use microdata is the most recent and was released on September 25,
2012. It’s the last Tuesday of the month, which means it’s the day we hear about how
consumers are feeling about the economy from the Conference Board.
Today the Consumer Confidence Index says that consumers are downright gloomy.
But come Friday, you may hear something different about how consumers are feeling
from the University of Michigan, which releases its Consumer Sentiment Index.
You may be asking yourselves what’s the difference between these two monthly metrics?
Sr. Producer Paddy Hirsch explains the difference in today's Money Matters segment.
"Both measure consumers' ability or willingness to buy stuff," says Hirsch. "So say you're
thinking about buying a refrigerator. So the consumer confidence questions -- the
questions that they ask when they're polling people -- essentially ask you are you going to
be happy buying a refrigerator in six months time. The consumer sentiment people,
they're asking you how you feel about buying a refrigerator right now. "
6. Concluding Questions
The Index of Consumer Sentiment is now constructed from responses to five questions,
three of which concern economic expectations, with each question given equal weight.
The original “index of consumer attitudes” included responses to a price expectations
question as well. Except for eliminating the question on price expectations, the definition
of the index appears to have been very stable for fifty years. Yet one of the principal
investigators long ago called for careful reconsideration of the index in the concluding
paragraph of her paper:“The index of consumer attitudes which was related here to
individual purchases is still in an experimental stage. Ahead is the challenging problem of
seeing whether closer correlations with purchases can be established by improving the
index—by adding new series, revising the weighting of components, and refining the
attitudinal measures themselves” (Mueller, 1957, p. 965). Almost a half-century later, we
take up the challenge to improve the measurement of consumer confidence.
The findings reported in this paper suggest that improvement is feasible. Drawing on
these findings, we close with three major questions regarding the effective measurement
of consumer confidence:
1. Should the Survey of Consumers and similar surveys ask consumers about national
business conditions?
2. Should the qualitative questions of the Survey of Consumers be continued as is,
complemented by probabilistic questions, or replaced by probabilistic questions?
3. Should the responses to the various questions be aggregated into an index or presented
separately?
If an index is thought desirable, how should it be constructed?
Although it is premature to assert definitive answers to these questions, we feel ready to
offer tentative responses, drawing in part on the findings of this paper. Regarding the first
question, we do not see an obvious rationale for asking consumers about such distant,
ambiguous phenomena as “national business conditions.” The respondents are not
experts, as in the Livingston panel and the Survey of Professional Forecasters.4 If the
objective is to use expectations data to predict personal consumption, expectations for the
nation should be relevant only to the extent that they are an input into formation of
personal expectations. Hence, why not ask more questions that probe personal
expectations directly, and eliminate the questions on national business conditions? The
case for this change is especially strong if the month-to-month changes in the ICS are
being driven largely by spurious volatility in the responses to question BUS12.5
We do think that consumers may usefully be queried about well-defined macroeconomic
events that are directly relevant to their personal lives. The question eliciting expectations
for growth in the value of a mutual-fund investment exemplifies what we have in mind.
One might similarly elicit expectations for aspects of government policy that directly
affect consumer finances; for example, tax policy and social security policy.
Regarding the second question, we think that the traditional qualitative questions of
consumer-confidence surveys should at least complemented by, and perhaps replaced by,
probabilistic questions inquiring about well-defined events. Although probabilistic
questioning has obvious conceptual advantages, economists had little experience with it
before the early 1990s, and skepticism about its feasibility was rampant. However,
substantial experience has accumulated in the past ten years through the administration of
probabilistic questions in SEE and in such major national surveys as the Health and
Retirement Study (Hurd and McGarry, 1995, 2002) and the 4 These surveys of experts
are described in Caskey (1985) and Keane and Runkle (1990), respectively.
A possible scientific reason to retain questions on national business conditions is to study
expectations formation; one may want to understand how individuals use their
perspectives on national conditions to form their personal expectations. This objective is
distinct from the longstanding purpose of the Michigan survey. Moreover, expectations
formation may be much better studied through intensive interviewing than through short
telephone surveys.
National Longitudinal Study of Youth-1997 Cohort (Fischhoff et al., 2000; Dominitz,
Manski, and Fischhoff, 2001). This experience, plus the new findings on the Survey of
Consumers reported in this paper, make plain that probabilistic questioning is feasible
and yields richer information on consumer beliefs than is obtainable with traditional
qualitative questions. Finally, we suggest that the producers of consumer confidence
statistics prominently report their findings for separate questions. The responses to
separate questions are much more readily interpretable than are monthly reports of an
index constructed from disparate, non-commensurate elements. We do not go so far as to
suggest a halt to reports of indices; simple summaries of masses of data often are a
practical necessity. However, we do think it long overdue to reconsider the
particular structure of the ICS and similar indices.
Consumer Confidence to Be Measured at State Level Rather Than Just National
Forget national consumer confidence figures for a moment. The Conference Board has
just announced that when it releases its monthly Consumer Confidence Index you are no
longer just going to see the national figure. The Conference Board is now going to be
breaking out eight states individually as well.
The Conference Board will begin its new effort for eight U.S. states beginning with the
March 21 release. Alongside the national and regional figures will be state-specific
findings from the monthly Consumer Confidence Survey.
The new report may seem too narrow to matter, but this will highlight even closer the
difference between where sentiment and confidence are rising or dropping. The eight
lucky states are California, Texas, New York, Florida, Illinois, Pennsylvania, Ohio and
Michigan.
With this report having so many more households, it is going to be one more noticed over
the monthly Reuters/University of Michigan Consumer Sentiment readings released each
month. The University of Michigan report is released on a preliminary basis and then
given one revision at the end of each month. It is based on questions from only 500
households each month.
Krugman Doesn’t Understand IS-LM, Part 1 →
Preliminary March 2013 Michigan Consumer Sentiment Falls to 14 Month Low
Posted on 15 March 2013 by Doug Short
The University of Michigan Consumer Sentiment preliminary number for March came in
at 71.8, a substantial decline from the February final reading of 77.6. The Briefing.com
consensus was for no change. Briefing.com’s on estimate was for 79.0. The latest number
takes us back to the range normally associated with recessions.
See the chart below for a long-term perspective on this widely watched index. I’ve
highlighted recessions and included real GDP to help evaluate the correlation between the
Michigan Consumer Sentiment Index and the broader economy.
To put today’s report into the larger historical context since its beginning in 1978,
consumer sentiment is 16% below the average reading (arithmetic mean) and 15% below
the geometric mean. The current index level is at the 19th percentile of the 423 monthly
data points in this series.
The Michigan average since its inception is 85.2. During non-recessionary years the
average is 87.7. The average during the five recessions is 69.3. So the latest sentiment
number puts us only 2.5 above the average recession mindset and 15.9 below the nonrecession average.
It’s important to understand that this indicator can be somewhat volatile. For a visual
sense of the volatility here is a chart with the monthly data and a three-month moving
average.
For the sake of comparison here is a chart of the Conference Board’s Consumer
Confidence Index (monthly update here). The Conference Board Index is the more
volatile of the two, but the broad pattern and general trends are remarkably similar to the
Michigan Index.
And finally, the prevailing mood of the Michigan survey is also similar to the mood of
small business owners, as captured by the NFIB Business Optimism Index (monthly
update here).
The trend in sentiment since the Financial Crisis lows has been one of slow improvement.
We saw a major drop in sentiment in 2011 followed by a rapid return to the general trend
of higher highs. The March preliminary reading is much lower than analysts expected.
Apparently the impact of smaller paychecks for John and Jane Doe following the
expiration of the 2% FICA tax cut and the upward trend in gasoline prices have taken
their toll on the consumer’s state of mind.
Caveats on the Use of University of Michigan Consumer Sentiment
This survey is quantitatively derived from a fairly complex questionnaire (sample here)
via a monthly telephone survey. According to Bloomberg:
This release is frequently released early. It can come out as early as 9:55am EST. The
official release time is 10:00. Base year 1966=100. A survey of consumer attitudes
concerning both the present situation as well as expectations regarding economic
conditions conducted by the University of Michigan. For the preliminary release
approximately three hundred consumers are surveyed while five hundred are interviewed
for the final figure. The level of consumer sentiment is related to the strength of
consumer spending. Please note that this report is released twice per month. The first is a
preliminary figure while the second is the final (revised) figure.
This is a survey, a quantification of opinion rather than facts and data. The question –
does sentiment lead or truly correlate to any economic activity? Since 1990, there seems
to be a loose general correlation to real household income growth.
← February 2013 Industrial Production Growth Strong
Global consumer confidence increased in the first quarter of 2013, rising two index points
to 93 from 91 in Q4 2012, according to findings from the Nielsen Global Survey of
Consumer Confidence and Spending Intentions. Improved consumer attitudes about job
prospects, personal finances and the ability to spend in the U.S., across key Asian export
markets and throughout northern and central Europe helped drive the quarterly uptick. On
a year-over-year basis, however, the Q1 2013 index score of 93 is a point lower than it
was in Q1 2012.
In the latest survey, conducted Feb. 18–March 8, 2013, consumer confidence rose in 55
percent of markets measured by Nielsen, compared with a 33-percent increase in the
previous quarter. North America (94) reported the biggest quarterly increase of four
points, followed by Asia-Pacific (103), which increased two index points. Declines were
reported in the Middle East/Africa region (85), which decreased 11 index points, and in
Latin America (94), which declined two index points. Europe’s regional consumer
confidence index of 71 held steady from Q4 2012.
Confidence increased four points in the U.S. (93), three points in Germany (90), 14 points
in Japan (73), and held steady in China (108) from their levels in Q4 2012.
Purchase Historical Data
The Conference Board Consumer Confidence Index® Improves in April
30 Apr. 2013
NEW YORK, April 30, 2013…The Conference Board Consumer Confidence Index®,
which had declined in March, increased in April. The Index now stands at 68.1
(1985=100), up from 61.9 in March. The Present Situation Index increased to 60.4 from
59.2. The Expectations Index improved to 73.3 from 63.7 last month.
The monthly Consumer Confidence Survey®, based on a probability-design random
sample, is conducted for The Conference Board by Nielsen, a leading global provider of
information and analytics around what consumers buy and watch. The cutoff date for the
preliminary results was April 18.
Says Lynn Franco, Director of Economic Indicators at The Conference Board:
“Consumer Confidence improved in April, as consumers’ expectations about the shortterm economic outlook and their income prospects improved. However, consumers’
confidence has been challenged several times over the past few months by such events as
the fiscal cliff, the payroll tax hike and the sequester. Thus, while expectations appear to
have bounced back, it is too soon to tell if confidence is actually on the mend.”
Consumers’ assessment of current conditions improved moderately in April. Those
saying business conditions are “good” increased to 17.2 percent from 16.4 percent, while
those stating business conditions are “bad” decreased to 28.1 percent from 29.1 percent.
Consumers’ assessment of the labor market was mixed. Those claiming jobs are
“plentiful” edged up to 9.8 percent from 9.5 percent, however those claiming jobs are
“hard to get” increased to 37.1 percent from 35.4 percent.
Consumers were considerably more upbeat about the short-term outlook. The percentage
of consumers expecting business conditions to improve over the next six months
increased to 16.9 percent from 15.0 percent, while those anticipating business conditions
to worsen decreased to 15.1 percent from 17.7 percent.
Consumers’ outlook for the labor market was also more positive. Those expecting more
jobs in the months ahead improved to 14.2 percent from 13.0 percent, while those
expecting fewer jobs decreased to 22.4 percent from 26.0 percent. The proportion of
consumers expecting their incomes to increase rose to 16.8 percent from 14.6 percent,
while those expecting a decrease declined to 16.0 percent from 17.7 percent.
Source:
April 2013 Consumer Confidence Survey®
The Conference Board
About The Conference Board
The Conference Board is a global, independent business membership and research
association working in the public interest. Our mission is unique: To provide the world’s
leading organizations with the practical knowledge they need to improve their
performance and better serve society. The Conference Board is a non-advocacy, not-forprofit entity holding 501 (c) (3) tax-exempt status in the United States. www.conferenceboard.org
About Nielsen
Nielsen Holdings N.V. (NYSE: NLSN) is a global information and measurement
company with leading market positions in marketing and consumer information,
television and other media measurement, online intelligence, mobile measurement, trade
shows and related properties. Nielsen has a presence in approximately 100 countries, with
headquarters in New York, USA and Diemen, the Netherlands. For more information,
The next release is scheduled for Tuesday, May 28 at 10 A.M.
For further information contact:
Carol Courter at +1 212 339 0232 carol.courter@conference-board.org
Chapter 9
Sources of the Dollars that are Lent.
Most of our inquiry concerns the borrowers and the decisions of the borrowers to borrow and the
impact of those decisions. We now turn to the supply of the dollars. It is crucial to the sellers of
consumer lending that consumers borrow. In addition there is a third party at the table, but
provider of the dollars that are lent. One can make the case that the Crash of 2007 was caused by
the cumulative effect of actions by all three parties. Consumers in a frenzy to borrow; lenders
and mortgage brokers in a frenzy to make profits by making loans and then selling those loans;
and finally investors in a frenzy to make over market returns by investing dollars for the lenders
to lend and the borrowers to borrow. Add in the rating agencies in a frenzy to keep their
business and perhaps become sloppy in their rating of mixed securitization pools; and lawyers
and investment banks and perhaps accountants in a frenzy to make profits by putting together
transactions that accommodate all of these other frenzies. For this as well as for other reasons it
is essential to understand the source of the dollars that are lent.
Lenders have historically obtained the money they lend either;
(1)
by borrowing themselves at rates lower than the rates at which they intend to lend;
(2)
from capital or equity infusions; or
(3)
in the case of the Bailey Building and Loan of Bedford Falls by receiving deposits from
customers and paying those depositors a rate of interest lower than the rate of interest they intend
to charge to their borrowers.
Securitization originated in the 1920s when mortgage insurance companies sold guaranteed
mortgage participation certificates for pools of mortgage loans. Investors actively traded these
certificates until the real estate market crashed during the Great Depression.
In order to strengthen the housing market during the first great depression the U S government
tried several remedies. One of them was to inject more dollars into the lending supply by
creating a market and a fund for purchasing loans approved by the Federal Housing
Administration (FHA). This government participation encouraged private investors to put their
dollars into a fund that would purchase these mortgages. The hope was that this would increase
the volume of home loans that could be made and it had some success.
Following the Second World War the target was expanded to include VA as well as FHA
approved loans.
In the late 1970s and early 1980s securitization rose like a phoenix from the ashes. The twin
energy crises of the 1970s wreaked havoc on the economy and banks experienced severe
disintermediation. Freddie Mac – a federal purchaser of mortgages from members of the Federal
Reserve System – responded to this by taking legislative initiatives to improve liquidity in the
secondary market for mortgage loans so as to increase the availability of investment capital for
housing finance.”[2]
Sources:
From Bailey Building and Loan to Securitization
Bailey building and loan – using deposits
Raising capital
Borrowing from lenders to lend
Small loan
Payday- small to larger
Securitization: US mortgage finance history
Secondary market
Then private securitizations
Credit cards, car loans and huge market for mortgages.
Benefits and worries??
In the 2000
During the crash
Post crash
Future.
Discussion Questions:
Why is housing finance so crucial?
Why is owning a home an key value in the United States?
What role, if any should government have in the housing finance market and why or why
not?
What about the role of the Federal government in student loans?
What about credit cards or car loans?
Reuters) - The leaders of the U.S. Senate Banking Committee on Tuesday outlined plans
for legislation to wind down government-owned mortgage financiers Fannie Mae and
Freddie Mac that they said would continue to provide access to long-term, fixed-rate
mortgages.
Committee Chairman Tim Johnson, a Democrat, and Senator Mike Crapo, the panel's top
Republican, announced the agreement after working for months to bridge a partisan
divide with the hope of moving legislation this year. They said they were putting
finishing touches on a draft bill they planned to release "in the coming days."
Fannie Mae and Freddie Mac, which own or guarantee 60 percent of all U.S. home loans,
provide a steady source of mortgage funds by buying loans from lenders and packaging
them into securities they sell to investors.
Their central role in housing finance led the government to bail them out to the tune of
$187.5 billion when they ran into trouble in the midst of the financial crisis of 2007-2009.
Lawmakers from both parties want to revamp the $10 trillion mortgage market to make it
less likely taxpayers will ever be put on the hook again.
Under the outline from Johnson and Crapo, private interests would take the first 10
percent of any mortgage losses, before an emergency government backstop would kick
in.
"This agreement moves us closer to ending the five-year status quo and beginning the
wind down of Fannie and Freddie, while protecting taxpayers with strong private
capital," Crapo said in a statement.
The work by Johnson and Crapo builds off a bipartisan measure previously proposed by
Senators Bob Corker of Tennessee and Mark Warner of Virginia. While the
announcement from Johnson and Crapo marks the latest step forward, threading the
needle between centrist lawmakers, liberal Democrats and conservative Republicans is
still likely to prove a difficult task.
"This is another step towards reform, but we are still years away from having either the
legislative capacity or market willingness to embrace a new mortgage finance system,"
said Isaac Boltansky, a policy analyst with Compass Point Research and Trading.
Under the proposal, Fannie Mae and Freddie Mac would be wound down and replaced
with a new government reinsurer called the Federal Mortgage Insurance Corp., which
would only provide assistance after private creditors had taken a hit. The entity would be
financed by fees on lenders who want the government backstop.
Included in the outline is a mandate that strong underwriting standards be built into the
new system. It would also require a 5 percent downpayment for all but first-time buyers,
although that requirement would be phased-in over time. Some consumer and housing
advocates worry that a system with rigid down payments will prevent less affluent
Americans from accessing credit even if a limited government role is retained.
"There is near unanimous agreement that our current housing finance system is not
sustainable in the long term and reform is necessary to help strengthen and stabilize the
economy," said Johnson. "This bipartisan effort will provide the market the certainty it
needs, while preserving fair and affordable housing throughout the country."
The outline from the two senators said they plan to "eliminate affordable housing goals"
and instead establish housing-related funds to ensure housing is available for all types of
borrowers and renters. These funds would be financed through a user fee on lenders that
seek FMIC backing.
To ensure community banks are not squeezed out of the system, the senators said they
would seek to establish a "mutual cooperative jointly owned by small lenders" to offer a
cash window for eligible loans while allowing the institutions to retain mortgage
servicing rights.
Any housing reform plan passed by the Democrat-controlled Senate must also make its
way through the Republican-controlled House before it can be signed into law.
Fannie Mae and Freddie Mac were seized by regulators in 2008 as loan defaults drove
them toward insolvency. But they have since returned to profitability and have returned
$202.9 billion in dividends to taxpayers for their federal bailout.
(Reporting By Margaret Chadbourn; Editing by Tim Ahmann and Andrea Ricci)
Reuters) - The leaders of the U.S. Senate Banking Committee on Tuesday outlined plans
for legislation to wind down government-owned mortgage financiers Fannie Mae and
Freddie Mac that they said would continue to provide access to long-term, fixed-rate
mortgages.
Committee Chairman Tim Johnson, a Democrat, and Senator Mike Crapo, the panel's top
Republican, announced the agreement after working for months to bridge a partisan
divide with the hope of moving legislation this year. They said they were putting
finishing touches on a draft bill they planned to release "in the coming days."
Fannie Mae and Freddie Mac, which own or guarantee 60 percent of all U.S. home loans,
provide a steady source of mortgage funds by buying loans from lenders and packaging
them into securities they sell to investors.
Their central role in housing finance led the government to bail them out to the tune of
$187.5 billion when they ran into trouble in the midst of the financial crisis of 2007-2009.
Lawmakers from both parties want to revamp the $10 trillion mortgage market to make it
less likely taxpayers will ever be put on the hook again.
Under the outline from Johnson and Crapo, private interests would take the first 10
percent of any mortgage losses, before an emergency government backstop would kick
in.
"This agreement moves us closer to ending the five-year status quo and beginning the
wind down of Fannie and Freddie, while protecting taxpayers with strong private
capital," Crapo said in a statement.
The work by Johnson and Crapo builds off a bipartisan measure previously proposed by
Senators Bob Corker of Tennessee and Mark Warner of Virginia. While the
announcement from Johnson and Crapo marks the latest step forward, threading the
needle between centrist lawmakers, liberal Democrats and conservative Republicans is
still likely to prove a difficult task.
"This is another step towards reform, but we are still years away from having either the
legislative capacity or market willingness to embrace a new mortgage finance system,"
said Isaac Boltansky, a policy analyst with Compass Point Research and Trading.
Under the proposal, Fannie Mae and Freddie Mac would be wound down and replaced
with a new government reinsurer called the Federal Mortgage Insurance Corp., which
would only provide assistance after private creditors had taken a hit. The entity would be
financed by fees on lenders who want the government backstop.
Included in the outline is a mandate that strong underwriting standards be built into the
new system. It would also require a 5 percent downpayment for all but first-time buyers,
although that requirement would be phased-in over time. Some consumer and housing
advocates worry that a system with rigid down payments will prevent less affluent
Americans from accessing credit even if a limited government role is retained.
"There is near unanimous agreement that our current housing finance system is not
sustainable in the long term and reform is necessary to help strengthen and stabilize the
economy," said Johnson. "This bipartisan effort will provide the market the certainty it
needs, while preserving fair and affordable housing throughout the country."
The outline from the two senators said they plan to "eliminate affordable housing goals"
and instead establish housing-related funds to ensure housing is available for all types of
borrowers and renters. These funds would be financed through a user fee on lenders that
seek FMIC backing.
To ensure community banks are not squeezed out of the system, the senators said they
would seek to establish a "mutual cooperative jointly owned by small lenders" to offer a
cash window for eligible loans while allowing the institutions to retain mortgage
servicing rights.
Any housing reform plan passed by the Democrat-controlled Senate must also make its
way through the Republican-controlled House before it can be signed into law.
Fannie Mae and Freddie Mac were seized by regulators in 2008 as loan defaults drove
them toward insolvency. But they have since returned to profitability and have returned
$202.9 billion in dividends to taxpayers for their federal bailout.
(Reporting By Margaret Chadbourn; Editing by Tim Ahmann and Andrea Ricci)
Securitization is a complex series of financial transactions designed to maximize cash
flow and reduce risk for debt originators. This is achieved when assets, receivables or
financial instruments are acquired, classified into pools, and offered as collateral for
third-party investment. Then, financial instruments are sold which are backed by the cash
flow or value of the underlying assets. Securitization typically applies to assets that are
illiquid (i.e. cannot easily be sold). It is common in the real estate industry, where it is
applied to pools of leased property, and in thelending industry, where it is applied to
lenders' claims on mortgages, home equity loans, student
loans, vehicle loans and other debts. A list of the types of financial debt instruments that
have been securitized is included in these materials.
Any assets can be securitized so long as they are associated with a steady amount of cash
flow. Investors "buy" these assets by making loans which are secured against the
underlying pool of assets and its associated income stream. Securitization thus "converts
illiquid assets into liquid assets" by pooling, underwriting and selling their ownership in
the form of asset-backed securities (ABS). Securitization utilizes a special purpose
vehicle (SPV) (alternatively known as a special purpose entity [SPE] or special purpose
company [SPC]) in order to reduce the risk of bankruptcy and thereby obtain lower
interest rates from potential lenders. A credit derivative is also generally used to change
the credit quality of the underlying portfolio so that it will be acceptable to the final
investors.
II. History
Asset securitization began with the structured financing of mortgage pools in the 1970s.
For decades before that, banks were essentially portfolio lenders; they held loans until
they matured or were paid off. These loans were funded principally by deposits, and
sometimes by debt, which was a direct obligation of the bank (rather than a claim on
specific assets). After World War II, depository institutions simply could not keep pace
with the rising demand for housing credit. Banks, as well as other financial intermediaries
sensing a market opportunity, sought ways of increasing the sources of mortgage funding.
To attract investors, bankers eventually developed an investment vehicle that isolated
defined mortgage pools, segmented the credit risk, and structured the cash flows from the
underlying loans. Although it took several years to develop efficient mortgage
securitization structures, loan originators quickly realized the
process was readily transferable to other types of loans as well."
In February 1970, the U.S. Department of Housing and Urban Development created the
transaction using a mortgage-backed security. The Government National Mortgage
Association (GNMA or Ginnie Mae) sold securities backed by a portfolio of mortgage
loans.
In February 1970, the U.S. Department of Housing and Urban Development created the
transaction using a mortgage-backed security. The Government National Mortgage
Association (GNMA or Ginnie Mae) sold securities backed by a portfolio of mortgage
loans.
To facilitate the securitization of non-mortgage assets, businesses substituted private
credit enhancements. First, they over-collateralized pools of assets; shortly thereafter,
they improved third-party and structural enhancements. In 1985, securitization techniques
that had American Bankruptcy Institute been developed in the mortgage market were
applied for the first time to a class of non-mortgage assets — automobile loans. A pool of
assets second only to mortgages in volume, auto loans were a good match for structured
finance; their maturities, considerably shorter than those of mortgages, made the timing
of cash flows more predictable, and their long statistical histories of performance gave
investors confidence. The first significant bank credit card sale came to market in 1986
with a private placement of $50 million of outstanding bank card loans. This transaction
demonstrated to investors that, if the yields were high enough, loan pools could support
asset sales with higher expected losses and administrative costs than was true within the
mortgage market. Sales of this type — with no contractual obligation by the seller to
provide recourse — allowed banks to receive sales treatment for accounting and
regulatory purposes (easing balance sheet and capital constraints), while at the same time
allowing them to retain origination and servicing fees. After the success of this initial
transaction, investors grew to accept credit card receivables as collateral, and banks
developed structures to normalize the cash flows.
III.Benefits of Securitization
There are good reasons why securitization has taken off. The existence of a liquid
secondary market for home mortgages and other financial debt instruments increases the
availability of capital to make new loans. This increases the availability of credit.
Securitization also helps to decrease the cost of credit by lowering originator’s financing
costs by offering lenders a way to raise funds in the capital market with lower interest
rates. Finally, securitization reallocates risk by shifting the credit risk associated with
securitized assets to investors, rather than leaving all the risk with the financial
institutions.
IV.Who are the Players in the Securitization Process?
The primary players in the securitization of any particular pool of assets can vary.
Included in these materials is a flow chart for the MBS (mortgage backed securities)
issue identified as “Meritage Mortgage Loan Trust 2005-2, Asset-Backed Certificates,
Series 2005-2.” The flow chart illustrates the roles of and the relationships between the
various primary parties in a typical issue. Each party is addressed below:
A. Originators – the parties, such as mortgage lenders and banks, that initially create the
assets to be securitized.
B. Aggregator – purchases assets of a similar type from one or more Originators to form
the pool of assets to be securitized.
C. Depositor – creates the SPV/SPE for the securitized transaction. The Depositor
acquires the pooled assets from the Aggregator and in turn deposits them into the
SPV/SPE .
D. Issuer – acquires the pooled assets and issues the certificates to eventually be sold to
the investors. However, the Issuer does not directly offer the certificates for sale to the
investors. Instead, the Issuer conveys the certificate to the Depositor in exchange for the
pooled assets. In simplified forms of securitization, the Issuer is the SPV which finally
holds the pooled assets and acts as a conduit for the cash flows of the pooled assets.
E. Underwriter – usually an investment bank, purchases all of the SPV’s certificates from
the Depositor with the responsibility of offering to them for sale to the ultimate investors.
The money paid by the Underwriter to the Depositor is then transferred from the
Depositor to the Aggregator to the Originator as the purchase price for the pooled assets.
F. Investors – purchase the SPV’s issued certificates. Each Investor is entitled to receive
monthly payments of principal and interest from the SPV. The order of priority of
payment to each investor, the interest rate to be paid to each investor and other payment
rights accorded to each investor, including the speed of principal repayment, depending
on which class or tranche of certificates were purchased. The SPV makes distributions to
the Investors from the cash flows of the pooled assets.
G. Trustee – the party appointed to oversee the issuing SPV and protect the Investors’
interests by calculating the cash flows from the pooled assets and by remitting the SPV’s
net revenues to the Investors as returns.
H. Servicer – the party that collects the money due from the borrowers under each
individual loan in the asset pool. The Servicer remits the collected funds to the Trustee
for distribution to the Investors. Servicers are entitled to collect fees for servicing the
pooled loans. Consequently, some Originators desire to retain the pool’s servicing rights
to both realize the full payment on their securitized assets when sold and to have a
residual income on those same loans through the entitlement to ongoing servicing fees.
Some Originators will contract with other organizations to perform the servicing
function, or sell the valuable servicing rights.
Often, there are multiple servicers for a single SPV. There may be a Master Servicer, a
Primary Servicer, a Sub-Servicer, and a Default or Special Servicer. Each will have
672 responsibilities related to the pooled assets, depending on the circumstances and
conditions.
V. The Why’s and How’s of Securitization
A. True Sale and HIDC Status
The securitization process is designed, in most cases, to make the pooled assets
“bankruptcy remote.” To accomplish this, the transfer of the pooled assets from the
Originator to the SPV must be accomplished by way of a “true sale.” If the asset transfer
is not a true sale, investors are vulnerable to claims against the Originator, including the
claims of a bankruptcy trustee that might be appointed if the Originator were to file
bankruptcy. Without “bankruptcy remoteness,” Investors would bear the risk of default in
the underlying pooled assets, as well as any claim by the Originator’s bankruptcy trustee
that the pooled assets or cash flows from those assets are part of the bankruptcy estate
which could be used to satisfy claims of the Originator’s creditors. A true sale also
protects the Originator from claims by investors. If the pooled assets
are sold into an SPV, the Investor can only seek payment from that entity, not from the
general revenues of the Originator. In order to create the desired “bankruptcy
remoteness,” the pool assets must be transferred by “true sale.” Such a sale also provides
the SPV with Holder in Due Course (HIDC) status and protection. In order to gain HIDC
status, the SPV must satisfy the requirements of UCC section 3-302. The SPV must: take
the instrument for value, in good faith, without notice that the instrument is overdue,
dishonored or has an uncured default, without notice that the instrument contains
unauthorized signatures or has been altered, and without notice that any
party has a claim or defense in recoupment. Additionally, the instrument, when issued or
negotiated to the holder, cannot bear any evidence of forgery or alteration or have
irregularities that would give rise to questions of authenticity. The main benefit of HIDC
status is that the holder may enforce the payment rights under the negotiable instrument
free from all by a limited number of defenses as outlined in UCC 3-305. The HIDC takes
the note or instrument free from competing claims of ownership by third parties.
B. Pooling and Servicing Agreement
One of the most important documents in the securitization process is the Pooling and
Servicing Agreement (PSA). This is the contract that governs the relationship between
the various parties in the securitization process. The PSAs in many securitization deals
can run 300- 500 pages in length, spelling out the duties and obligations of each party and
the mechanics by which the actual securitization is accomplished. Included in these
materials is an excerpt of the PSA for the Meritage Mortgage Loan Trust 2005-2 AssetBacked Certificates, Series 2005-2.
Securitization provides a vehicle that allows lenders to lend well beyond the dollars they
could otherwise raise; it provides the investors with a way of investing in the profits that
will be made off of consumer borrowing; and it provides lenders with a way to “lay off”
the risk of the loans that it makes.
“
It's A Wonderful Mortgage Crisis
Dec 22, 2008 7:00 PM EST
What the classic holiday movie "It's a Wonderful Life" can teach us about the mortgage
industry meltdown.
It's traditional during the holiday season to watch the great Frank Capra movie "It's a
Wonderful Life," and this year, the film is particularly relevant—it can help us to better
understand our current economic malaise and the mortgage credit problem that is at the
center of the crisis.
In one of the most famous scenes, there's a run on the Bailey Building and Loan, a small
bank owned by George Bailey, the tortured character played by Jimmy Stewart. As
depositors clamor to get their money back, Stewart tells them, "You're thinking of this
place all wrong, as if I had the money back in the safe. The money's not here. Your
money's in Joe's house, that's right next to yours. And in the Kennedy house and Mrs.
Macklin's house and a hundred others. Why, you're lending them the money to build. …
Give us 60 days."
In the language of finance, Bailey is explaining that the Bailey Building and Loan made
and held "whole loans," mortgages that have not been securitized. Its liabilities are the
deposits the bank's depositors have come to withdraw, and its assets are the highly
illiquid mortgages that it holds as a result of lending money to the town's residents to
build their homes in Bedford Falls.
If the movie were remade today (and let's hope it's not), here's what would happen in
Bedford Falls. A different George Bailey—played, say, by Brad Pitt—would have
"originated" home loans in Bedford Falls. Pitt would have then sold those loans to
Freddie Mac or to Fannie Mae or to another loan aggregator. Each of those loans would
then ultimately have been "securitized" into one of many "tranches": cut up into many
slices based on the risk of repayment of each chunk of the loan. The various slices from
thousands of loans all over the United States would then be pooled, again by potential
risk of default, and that pool would issue a mortgage-backed security that was "rated" by
one or more of the federally sanctioned ratings agencies: Moody's, Standard & Poor's and
Fitch. (In the current crisis, those investments had cryptic names like "GSAMP 2006-S5
A2" and "WAMU 2007-HY6 2B1.") The idea behind the pooling of loan slices is a
powerful one—by sorting the payments to those supplying capital into specific risk
categories, it is possible to lower the cost of capital to borrowers.
Now, what would the Bailey Building and Loan do with the proceeds it receives from
selling the loans that it originated? It would buy securities that would be held as assets on
its balance sheet and, depending on the risk and value of those securities, it would
continue to originate more loans. So far, this all seems well and good. The securitization
has lowered the cost to borrowers and made the assets held by the Bailey Building and
Loan appear to be more liquid—instead of lumpy whole loans, its new assets are
securities that, at least in theory, can be sold and that are priced in the market.
The problem is that while the Building and Loan would buy securities such as treasury
bonds, it would also likely buy small amounts of a lot of mortgage-backed securities,
such as the above-mentioned GSAMP 2006-S5 A2 and hundreds of other such securities.
These securities aren't heavily traded in markets, but the top category of these offerings
typically was treated by bank regulators as extremely safe—likely to return the full value
of the investment made in them with interest—because of their very high investment
grade ratings. When housing declined in value throughout the United States, many
mortgage-backed securities became imperiled, and as a result, many of the nation's banks
became insolvent.
So in the presence of a run, in our remake, Brad Pitt might say this: "Why, don't ask for
your money back right now when the housing market is in decline. You know that money
isn't in the safe; it's invested in GSAMP 2006-S5 A2 and WAMU 2007-HY6 2B1 and the
like. I can't give you your money back unless and until those multiyear-duration
securities get repaid (if they ever do) or if they somehow revert back toward par value
and I can sell them. Since they're trading at cents on the dollar, they have a long way to
go. Just give me 60 days, and maybe the Treasury will bail me out."
Jimmy Stewart told his depositors that he knew that their investment in the Bailey
Building and Loan was "good," even though its assets were not liquid. This is because he
knew the location of each home held as collateral, the occupant-borrower, the prospects
for repayment and more. All that Brad Pitt's George Bailey could ever know is that he
bought securities rated highly by each and every one of the three government-endorsed
rating agencies, and that the investment banks that underwrote them thought those
securities were sound investments. Nothing more. He'd have no idea who the borrowers
are, where the homes are located, what their condition is or whether they are even
occupied, much less the likelihood that a particular borrower could weather the storm.
The contrast is what makes a new viewing of "It's a Wonderful Life" compelling this
holiday season—it's a reminder of a simpler time, and simultaneously a stark reflection of
what went wrong in the current crisis.
Benefits to the Originators, especially FIs
For FIs, securitisation is an opportunity offered in the form of capital relief, capital
allocation efficiency, and improvements in financial ratios.
•Lower cost of borrowing: Securitisation reduces the total cost of financing as assets are
transferred to a separate bankruptcy-resistant entity. To that extent FIs need not maintain
capital to maintain their capital adequacy norms. Also, entities with a riskier credit profile
can benefit from lowered borrowing costs.
•A source of liquidity: FIs could face a liquidity crunch either due to their risky credit
profile or delayed receivables. The liquidity provided by securitisation acts as a very
powerful tool, that FIs could use to adjust the asset mix quickly and efficiently. Further,
the risks in an asset portfolio can be identified and apportioned to arrive at an effective
asset mix.
•Improved financial indicators: Securitisation leads to capital relief that improves the
company’s leverage and in turn the Return on Equity. The repercussions of securitisation
on the balance sheet of a company can vary depending on the strategy for its capital
structure and its appetite for increasing or decreasing leverage.
•Asset-Liability Management: Securitisation offers the flexibility in structuring and
timing cash flows to each security tranche. It provides a means whereby customised
securities can be created which helps in matching the tenure of the liabilities and assets.
•Diversified fund sources: By securitising its receivables, the instrument of which could
be sold to global investors, the originator has an opportunity to diversify its funding
source.
•Positive signals to the Capital Markets: Lenders are at times trapped in a situation where
they cannot rollover their debt due to downgrading of their ratings, possibly due to
economic changes. Under these circumstances, securitisation enables lenders like FIs to
increase the rating of debt much higher than that of the issuer through the intrinsic credit
value of the asset. This enables the FIs to obtain funding.
•An avenue for divestiture: Securitisation offers an optimal exit route for entities that
wish to exit a business comprising of financial assets without going through the mergers
and acquisition route.
Benefits to the Investors
Investors purchase risk-adjusted securities based on its level of maturity and seniority.
For instance, an auto loan or credit card receivables backed paper carries regular monthly
cash flows, which can match the requirements of investors like mutual funds.
•New Asset Class: Securitised products provide new investment avenues for investors to
enhance their return or to diversify their portfolio. For instance, an investor in the United
States whose investment is predominantly in US assets can diversify by investing in
securities offered by an SPV in Asia.
•Risk Diversification: As the underlying pool of receivables is spread across diverse
customers the investors need not have a thorough understanding of the underlying assets.
The investor is insulated from customer specific event risk.
•Customisation: Securitisation of financial assets allows tailoring of cash flows to the risk
profile of the investors. A certain stream of cash flow coming from an underlying asset
pool can be broken into tranches and offered as per the investor risk appetite.
•Decoupling with Originator: The investor is insulated from the credit profile of the
Originator. This separation of the Originator and the investor helps at the time of
bankruptcy or default or credit downgrades.
Please read :
http://www.americansecuritization.com/uploadedfiles/ASF_NERA_Report.PDF
And http://fcic-static.law.stanford.edu/cdn_media/fcic-reports/2010-0407Preliminary_Staff_Report_-_Securitization_and_the_Mortgage_Crisis.pdf
And http://www.newyorkfed.org/research/epr/12v18n2/1207peri.pdf
Other sources of dollars that Payday lenders lend.
Public Pensions Finance Payday Lenders
Some of the nation’s largest banks, including Wells Fargo WFC +0.48% and U.S. Bank,
continue to offer payday loans despite growing regulatory scrutiny and mounting
criticism, according to a report issued earlier this year by the Center for Responsible
Lending. Evidently gouging low-income borrowers into long-term debt charging
outrageous interest rates of 500%, or more, is too good for big banks to resist.
Regulators have issued numerous warnings about abusive payday loan practices. Last
May, the Federal Deposit Insurance Corporation said the agency was “deeply concerned”
about payday lending. The Office of the Comptroller of the Currency, which oversees the
nation’s largest banks, said in June 2011 that the loans raised “operational and credit risks
and supervisory concerns.” The Consumer Finacial Protection Bureau has been
examining whether banks violate consumer protection laws in the marketing of these
products.
Unlike Louisiana Public Pensions, Some Fletcher Hedge Fund Investors Got Money Out
Edward "Ted" SiedleContributor
Kentucky Retirement System Whistleblower Sends Unite Here Union Report to SEC
Edward "Ted" SiedleContributor
Rhode Island Public Pension 'Reform' Looks More Like Wall Street Feeding Frenzy
Edward "Ted" SiedleContributor
AFSCME's Unstoppable Rhode Island Pension Forensic Investigation Edward "Ted"
SiedleContributor
Fifteen states have banned usurious payday lending to protect workers and just last week
state authorities took action against certain predatory payday lenders.
Obviously, included in the portfolios of most of the nation’s massive state and local
public pensions (whether through actively managed accounts or index funds), are stocks
of large banks which derive a portion of their earnings from fleecing payday borrowers. It
may be unreasonable to expect public pensions to forego investing in major banks, or
scrutinize every activity of the major banks in which they invest and object to banking
practices they find reprehensible.
However, according to industry sources, in addition to large banks, some of the largest
payday loan companies are publicly traded, such as Cash America (CSH), and Dollar
Financial (DFC). Some other large lenders include Community Choice Financial and
SpeedyCash. Other lenders, according to the industry, are backed by investors large and
small, such as hedge funds, private equity companies and family offices. For example,
Payday One, was formerly offered by Think Finance, a company which claims to be
“privately held and backed by some of Silicon Valley’s most respected venture capital
firms, including Sequoia Capital and Technology Crossover Ventures.”
It’s more than likely that public pensions loading-up on hedge funds and private equity
are, due to the lack of transparency related to alternative investments, inadvertently
financing payday marauders.
Virtually all public funds that invest with alternative managers agree to reduced
transparency regarding the investments held in alternative portfolios, including denying
public access to such information. I’ve witnessed alternative managers and investment
consultants advise public pensions that ignorance regarding strategies and investments is
beneficial, permitting plausible deniability and avoidance of headline risk. You’ll never
have to admit to things which you purposely do not know.
Among publicly-traded payday lender Cash America’s top institutional holders is Earnest
Partners LLC, which owned $75 million of the stock at June 30, 2013. (Other major
holders of Cash America and Dollar Financial stock with significant public pension
clients include Vanguard and BlackRock.) According to its website, Earnest Partners
manages approximately $20 billion in assets for clients around the world, including
corporate pension plans, state and municipal pension plans.
According to published reports, the firm was recently terminated as a domestic midcap
equity manager handling $514 million for the Ohio Police and Fire Pension. (Ironically,
earlier this year Ohio’s Supreme Court announced it would hear a payday lending case
that could close the licensing loophole payday stores use to charge borrowers triple-digit
interest. It seems Buckeyes can’t decide whether to prohibit, or profit from, payday
lending.)
I don’t know whether Cash America stock was included in the $514 million portfolio
Earnest Partners managed for the Ohio Police and Fire Pension but, given the outrageous
returns related to payday lending, as public pensions migrate further into alternative
investments, they should, in my opinion, determine whether they are, directly or
indirectly, financing the business of screwing the poor.
CHAPTER 10
ECONOMIC IMPACT
January 7, 2014
The goal of this chapter is to provide you a basis for understanding the economic impacts
of consumer borrowing and lending on individuals and households (“micro”) and on the
overall economy (“macro”) so you can figure in the good, the bad and the ugly and the
beautiful in your calculation for how much and how to regulate consumer
borrowing/lending.
The central questions for our inquiry are:
On a micro basis what is the economic impact of consumer lending or borrowing?
On individuals, on family et al.
On a macro basis what is the economic impact of consumer lending or borrowing opn the
overall economy?
Did the explosion in consumer lending cause the crash of 2007?
What effect did the explosion in subprime mortgages and credit card lending have?
To what extent, if any, can/do consumer lending developments have a major (macro)
effect on the overall economy.
If you knew that such an explosion would cause a crash every 80, or 50 or 10 years,
would that have any effect on your decisions regarding regulation??
Don't Expect Consumer Spending To Be the Engine of Economic Growth It Once Was
By William R. Emmons
http://www.stlouisfed.org/publications/re/articles/?id=2201
(may be a better way of reading this article because it includes helpful graphs, but it also
includes some complicated math and economic talk)
Can American consumers continue to serve as the engine of U.S. and global economic
growth as they did during recent decades? Several powerful trends suggest not, at least
for a while. Instead, new sources of demand, both domestic and foreign, are needed if we
are to maintain healthy rates of growth. Unfortunately, this won't be easy because
consumer spending constitutes the largest part of our economy, and replacements for it—
more investment, more government spending or more exports—either can't be increased
rapidly or might create unwanted consequences of their own.
How We Got Here: The Consumer-Driven U.S. Economy
It is no exaggeration to say that consumer spending was the dominant source of economic
growth in the United States during recent decades. For example:
During the 10 years ending in the last prerecession quarter (third quarter of 2007),
inflation-adjusted personal consumption expenditures (PCE) grew at a continuously
compounded annual rate of 3.47 percent, while overall inflation-adjusted annual growth
of gross domestic product (GDP) averaged only 2.91 percent.
During that period, the remainder of the economy—consisting of investment (I),
government purchases of goods and services (G), and net exports (NX)—grew at only a
1.70 percent inflation-adjusted annual rate.
Expressed in terms of its contribution to average quarterly real GDP growth
during the decade ending in the third quarter of 2007, PCE accounted for 81.3 percent,
while the other components (I, G and NX) contributed only 18.7 percent.
Over the quarter-century ending in the third quarter of 2007, consumer
expenditures grew, on average, at a 3.50 continuously compounded annual rate, while the
rest of the economy (I, G and NX) grew at a 2.79 percent annual rate.
PCE accounted for 70.8 percent of average real GDP growth during those 25
years (1982: Q3 through 2007: Q3), while all other components (I, G and NX)
contributed
29.2 percent.
Consumer spending accounts for a majority of spending in all advanced nations. What
makes the U.S. experience of recent decades unusual is that the share of consumer
spending in GDP was relatively high already before it began to increase substantially
further during the 1980s, 1990s and 2000s. In dollar terms, PCE's share of GDP in the
third quarters of 1977, 1987, 1997 and 2007 were 62.5, 65.9, 66.7 and 69.5 percent,
respectively. Thus, consumer spending was a large and increasingly important part of the
American economy during the decades preceding the recession and remains so today.
International dimensions of U.S. consumer spending. As consumer spending grew rapidly
in the U.S., we imported consumer-oriented goods and services even more rapidly.
Imports of all goods and services increased at an annual, inflation-adjusted rate of 6.5
percent during the decade ending in the third quarter of 2007. But imports of consumer
goods—44 percent of all imports—increased at an annual average rate of 7.5 percent.
U.S. imports contributed importantly to growth in many exporting countries around the
world. U.S. consumers, therefore, served as the locomotive not only for the U.S.
economy but for the global economy. Because we incurred large trade deficits, we
required a corresponding inflow of foreign capital to finance them.
These three facets of U.S. and global economic growth—high-spending and low-saving
American consumers, large U.S. trade deficits, and substantial inflows of foreign
capital—are important contributors to the so-called "global imbalances" long noted by
international economists and policymakers. These imbalances may have contributed to
the U.S. housing bubble, the global financial crisis and the ensuing Great Recession.
The correlation between the share of U.S. GDP accounted for by private investment
spending and the rate of economic growth generally has been positive. Looking at 10year periods, the correlation between the private investment-spending share of the
economy in any year and the economic growth rate in that year ranged between a low of
0.43 and a high of 0.68, with an overall value of 0.50 for the 60-year period 1951-2010.
The bottom panel of the table shows decade-long averages of the private investmentshare of GDP and decade averages of real economic growth rates. The correlation
between the variables in these two columns is 0.14, indicating a tendency, albeit a weak
one, for decades of relatively low private investment spending, such as in 2001-2010, to
also be decades in which economic growth was low.
In sum, the primary reason a consumer-dominated economy may not be desirable is that
consumer spending may crowd out investment spending, which is a key determinant of
long-term growth. Of course, the tendency of consumer spending in the U.S. to be high
when private investment spending and economic growth are low may be due to more
complex causes or pure chance, but the simple correlations presented here are at least
suggestive of a more direct connection.
Five Trends Working Against Consumer Spending
At least five major trends currently evident suggest that U.S. consumer spending may
grow more slowly in the near future than it has for decades.
Lower wealth. First and foremost, U.S. household wealth took a beating during the Great
Recession. The inflation-adjusted average wealth of an American citizen, which
plateaued at about $210,000 during the first half of 2007, remained about 24 percent
lower on Sept. 30, 2011 ($160,000), despite having rebounded from the depressed level
of the first quarter of 2009 ($152,000; all figures are expressed in terms of 2005
dollars).4 Many lower- and middle-income households are feeling especially strong
balance-sheet pressure as house prices—representing their principal asset in many
cases—continue to weaken even as stock-market values—overwhelmingly owned by
high-income households—have recovered some of their losses. Negative equity—a
situation in which a household's mortgage debt exceeds the market value of the house—
now affects between 22 and 29 percent of all households with mortgages, according to
various estimates.5 In sum, the loss of significant amounts of wealth and the severe
pressure in some households to deleverage their balance sheets (reduce debt) are likely to
contribute to restrained consumer spending for some time.
Stagnant incomes. The economic recovery under way since mid-2009 has been mediocre,
at best. Job growth barely matches population growth, while incomes of the typical
worker are barely keeping up with inflation. Average weekly earnings, after inflation
adjustment, for a private-sector worker increased just 12 cents, or 0.03 percent—from
$350.80 to $350.92—during the five years through October 2011.6 Continuing a trend in
evidence even before the recession, most of the overall gains in income appear to be
flowing to high-income workers.
Tight credit. Consumer lenders either have disappeared altogether or are offering credit
on a much more restricted basis than before the downturn. By all accounts, mortgage
credit is less available to all but the strongest borrowers than was the case just a few years
ago. Even borrowers with high credit scores need substantial equity in order to borrow
for house purchase or mortgage refinancing. According to Federal Reserve surveys of
banks' lending officers, credit standards for nonmortgage consumer loans have begun to
loosen only since 2010, after tightening for about four years.7 Credit standards for
mortgage loans have not loosened significantly, after having been tightened sharply
between 2006 and 2010.
Fragile confidence. Major consumer-confidence indexes have rebounded from their
lowest levels during 2009 in the immediate aftermath of the recession, but they remain
below the levels that prevailed just as the recession began in late 2007.8 Inflationadjusted per-capita consumption expenditures grew at a 2.4-percent annualized rate
during the decade ending in December 2007, but have grown at only a 1.4-percent
annualized rate in the 28 months since the recession ended (June 2009 through October
2011).
Looming reversal of stimulus. Unprecedented doses of monetary- and fiscal-policy
stimulus since the recession began partly offset the contractionary forces on consumer
spending noted above. Government support for consumer spending on this scale is not
feasible indefinitely, however. The Federal Reserve has explored options to "exit" its
extraordinarily accommodative monetary policy, while Congress and the president agree
that budget consolidation is necessary in the not-too-distant future. In both cases, a
tightening of policy measures represents a withdrawal of support for household incomes
and wealth and, therefore, consumer spending.
Individually, any of the five obstacles noted above might be surmountable. But
combined, these contractionary forces make the outlook for broad-based consumer
spending growth challenging. To be sure, some households weathered the economic and
financial storms well, but we can't count on these fortunate few to step up their spending
sufficiently to offset the lost spending caused by declines in wealth, income, access to
credit, confidence and government support.
Rebalancing the U.S. and Global Economies
Unfortunately, it will take time for business investment and exports—the sectors essential
for creating robust, sustainable growth for years to come—to expand sufficiently to
replace the spending power long provided by consumers. Business investment and
exports today are relatively small sectors of the U.S. economy.
To see the scale of the restructuring challenge, consider this simple thought experiment.
A sustained one percentage-point decline in the average growth rate of consumer
spending would require either business-investment growth or export growth to double
immediately from their prerecession long-term average rates in order to make up the
shortfall. More realistically, both investment and export growth might increase to offset
slower consumer-spending growth, but the required accelerations still would be
substantial.
If consumer spending indeed grows more slowly for some time than it did before the
recession, and if business investment and exports take some time to ramp up to become
permanently larger components of the U.S. economy, we are left with two undesirable
short-term alternatives. Either the overall economic growth rate will decline, as slower
consumer-spending growth cannot be fully compensated by faster investment and export
activity, or one could attempt to fill the private-demand shortfall with increased direct
government spending, tax cuts and transfer payments to households.
In fact, these dismal scenarios are not hypothetical; they've already happened. The
recession itself could be described as a period in which consumer spending contracted
sharply, while other sources of private demand were unable to offset the shortfall. The
subsequent recovery, such as it is, largely has been the result of massive government
interventions in the form of financial rescues, unprecedented monetary stimulus and
record-breaking government budget deficits. We're left with extremely low short-term
and long-term interest rates, as well as historically large budget deficits—all of which
must reverse at some point.
Only a few policymakers have discussed the significant challenges posed by our
consumer-dominated economy.9 Our objective is clear, if not easily attainable: We must
actively restructure our economy to become more friendly to business investment and
exports in order to put long-term growth on a sustainable foundation. We must come
closer to balancing our trade and our government budgets, and we must generate a far
higher share of the savings we need for investment in our own economy.10 Higher saving
rates also would insulate us somewhat from potential disruptive shifts in capital inflows
and outflows initiated by foreign investors.
It appears likely that consumer spending will recede as the main engine of U.S. economic
growth, at least for the near future. At the same time, other nations that depended heavily
on U.S. purchases of their consumer-focused exports for their own growth will need to
restructure their economies to promote alternative sources of long-run sustainable
economic growth—not least to provide growing markets for our exports. To assure
strong, sustainable growth in the long term, the U.S. economy needs to include a larger
role for business investment and exports than has been the case in recent decades.
Author
William R. Emmons
Assistant Vice President and Economist
Federal Reserve Bank of St. Louis
New St. Louis Fed Banking and Economic Research
US GDP is 70 Percent Personal Consumption: Inside the Numbers
Rick Mathews
US GDP is 70 Percent Personal Consumption Inside the Numbers
It seems most people understand, personal consumption drives the American economy.
Personal consumption historically represents 70% of our nation’s GDP.
In part II our series examining gross domestic product as a means to understand what is
holding back our nation’s economic recovery we will examine personal consumption
expenditures using the expenditure approach:
C + I + G + (X - M) = GDP
C = Personal Consumption Expenditures
I = Gross Private Fixed Investment
G = Government Expenditures and Investment
X = Net Exports
M = Net Imports
Attempting to balance the playing field for all readers, we will use the following
definitions which include hyperlinks for those wishing to enhance their comprehensive
knowledge of the material presented.
The personal consumption expenditures price index (PCE) measure is the component
statistic for consumption in GDP collected by the Bureau of Economic Analysis. It
consists of the actual and imputed expenditures of households and includes data
pertaining to durable and non-durable goods and services. It is essentially a measure of
goods and services targeted towards individuals and consumed by individuals.
Personal consumption expenditures are officially separated into three categories in the
national income and product accounts: durable goods, non-durable goods, and services.
Durable goods are the tangible goods purchased by consumers that tend to last for more
than a year. Common examples are cars, furniture, and appliances. The two most
important subcategories of durable goods in the National Income and Product Accounts
are "motor vehicles and parts" and "furniture and other household equipment." Durable
goods purchases are usually about 10 to 15 percent of personal consumption
expenditures. This percentage tends to be at the low end during business-cycle
contractions and at the high end during business-cycle expansion.
Non-durable goods are the tangible goods purchased by consumers that tend to last for
less than a year. Common examples are food, clothing, and gasoline. In fact, the three
most important subcategories of non-durable goods in the national income and product
accounts are listed as "food," "clothing and shoes," and "gasoline and oil." Non-durable
goods purchases are usually about 25 to 30 percent of personal consumption
expenditures.
Services are activities that provide direct satisfaction of wants and needs without the
production of tangible goods. Common examples are information, entertainment, and
education. The four primary subcategories of services in the National Income and
Product Accounts are "housing," "household operation," "transportation," and "medical
care." Expenditures on services are the largest of the three consumption categories,
coming in at about 55 to 60 percent of personal consumption expenditures.
By extension C = Durable goods + Non-durable goods + Services
To place the importance of personal consumption expenditures in context, during 2011
the nation’s GDP was $15.1 Trillion. Personal consumption expenditures accounted for
$10.7 trillion of that total!
While none can deny the critical role of personal consumption expenditures in our
economy, what far too many do not understand is how far and how fast expenditures have
changed
In 2011 expenditures on goods contributed $3.6 trillion in 2011, nearly one-fourth of total
GDP. That is a very significant portion of expenditure yet only 7% of GDP today is
expended on durable goods such as automobiles and furniture. Non-durable goods, such
as food, clothing and fuel contribute 16% toward GDP.
Per the U.S. Census Bureau’s September 2012 report, Americans spent $45.8 billion at
gas stations. That total actually exceeded what we spent as a nation in restaurants and bar
$44.1 billion. But for all the expenditures we make on goods, it is our service
expenditures which actually provide the bulk of personal consumer expenditures.
This was not always the case in America. As late as 1968, American expenditures on
total goods represented nearly 40% of GNP. Today, expenditure on services actually
exceeds that amount as they totaled 46% in 2011.
American expended more than $7 trillion on services in 2011. A large driver of this
growth has been the dramatic increase of the financial services and health care services
industries. If there is a positive note on this change in expenditures it might be services
are both consumed and produced domestically, as they are difficult to export. Housing
and utilities, health care expenditures, financial services and insurance, and food and
accommodations accounted for three-fourths of all service sector spending.
Which leads us to the premise of this essay series, if we understand what constitutes the
components of our GNP, Why haven’t we been able to more significantly enhance
economic growth and by extension lower unemployment?
Academics will contend, America has attempted both traditional and nontraditional
methods for stimulating economic growth. Multiple fiscal and monetary policies been run
out in succession trying to sway our nation’s purchasing decisions. Some have been more
effective than others such as Cash for Clunkers and the variety of federal mortgage
refinancing programs.
Yet even these have not achieved the levels of participation hoped for. As example, less
than a quarter of the hoped for federal mortgage refinances have been processed. Multiple
economic and psychological explanations have been put forth regarding the tightening of
America’s spending habits. Consumer confidence repeatedly is cited as an implement to
increased economic growth. Our ongoing rate of heightened
unemployment/underemployment is noted as limiting spending expansion. Retrenchment
of household debt garners support for reductions in discretionary spending by consumers.
Yet some small progress has continued as noted by the BEA’s September report, eal
gross domestic product — the output of goods and services produced by labor and
property located in the United States — increased at an annual rate of 1.7% in the second
quarter of 2012 (that is, from the first quarter to the second quarter), according to the
"second" estimate released by the Bureau of Economic Analysis. In the first quarter, real
GDP increased 2%.
The increase in real GDP in the second quarter primarily reflected positive contributions
from personal consumption expenditures (PCE), exports, non-residential fixed
investment, and residential fixed investment that were partly offset by negative
contributions from private inventory investment and from state and local government
For information on revisions, see "Revisions to GDP, GDI, and Their Major
Components."
All of which leads us into our investigation of I; gross private fixed Investment the next
essay of this series exploring Gross Domestic Product and its effect on the economic
recovery.
UNLV|
September 28, 2012
Where Is the U.S. Economy Headed?
Stephen P. A. Brown
The growth rate of U.S. real gross domestic product (GDP) slowed from a 4.0 percent
annualized rate in fourth quarter 2011 to a 2.0 percent rate in first quarter 2012 and then a
1.3 percent rate in second quarter 2012. As of second quarter 2012, U.S. real GDP
remained 6.0 percent below its potential (Chart). Is economic growth likely to accelerate
and close the gap with potential GDP, or is it likely to languish? To answer this question,
we examine the recent course of spending in the economy and its likely course over the
next few quarters.
Contributions to GDP Growth
In the first two quarters of 2012, much of the growth in U.S. economic activity was the
result of personal consumption spending (Table, page 2). In fact, consumption spending
grew at a faster rate than GDP in both quarters. In the first half of 2012, personal
consumption spending accounted for 1.8 percentage points more of GDP than it did over
the time period from 1995 through 2012.
Table. Contributions to the Growth of U.S. Real GDP
2011
Ql
2011
Q2
2011
Q3
2011
Q4
2012
Ql
2012
Q2
Real GDP (percent change annual rate)
0.1
2.5
Contributions to Real GDP Growth
Final Domestic Sales 0.59 1.93 2.32 2.21 2.29
Personal Consumption
2.22 0.70 1.18 1.45
Business Fixed Investment -0.11 1.30 1.71 0.93
Residential Investment
-0.03 0.09 0.03 0.26
Government Purchases
-1.49 -0.16 -0.60 -0.43
Net Exports -0.03 0.54 0.02 -0.64 0.06 0.23
Exports
0.75 0.56 0.83 0.21 0.60 0.72
Imports
-0.72 -0.02 -0.81 -0.85 -0.54 -0.49
Inventory Investment -0.54 0.01 -1.07 2.53 -0.39
Note: Data are reported at seasonally adjusted annual rates.
Source: U.S. Bureau of Economic Analysis
1.3
4.1
1.47
1.72
0.74
0.43
-0.60
1.06
0.36
0.19
-0.14
2.0
1.3
-0.46
Overall private investment—business fixed investment, residential investment, and
inventory investment—also contributed to GDP growth in the first half of 2012.
Dominated by the movements in business fixed investment and inventory investment,
total investment spending decelerated sharply from fourth quarter 2011 to second quarter
2012. Residential investment rose strongly from fourth quarter 2011 to first quarter 2012,
but saw slower growth in second quarter 2012.
The decline in total government purchases—including federal, state, and local—
contributed to a slowing of GDP growth from third quarter 2010 through second quarter
2012. From first quarter 2011 through first quarter 2012, much of the decline came from
the federal government. In second quarter 2012, most of the decline came from state and
local government.
The Necessity of a Spending Acceleration
For the economy to show stronger growth, we must see an acceleration of overall
spending— whether the spending comes from consumers, investors, the government, or
an improved export-import balance. In the next few sections, we examine the prospects
for accelerated spending in each of these categories.
The Outlook for Consumption Spending
Consumer spending, which excludes residential investment, accounts for about 71
percent of GDP. As such, it is the single largest component of spending. During the
recession and recovery, consumer spending maintained a slightly stronger pace than
overall GDP. Consumer spending didn't slip by as much as GDP during the recession,
and it didn't grow by as much during the recovery. In addition, the variation in
consumption spending during the recovery has contributed some of the volatility in GDP
growth.
As we look forward, personal consumption and retail sales show signs of strong
acceleration into third quarter 2012. Surveys of consumer attitudes offer conflicting
signals—with consumer sentiment rising and consumer confidence slipping. Slow
employment growth certainly remains a concern for consumer spending. Combined, these
indicators suggest strengthening consumption spending in third quarter with the
possibility of slower growth in fourth quarter.
Investment Spending
Investment spending currently accounts for about 14 percent of GDP. During the
recession and recovery, investment spending was much more volatile than GDP. It saw a
much sharper decline and a stronger recovery. Nonetheless, investment spending was
10.6 percent lower in second quarter 2012 than it was at GDP's prerecession peak (fourth
quarter 2007).
The outlook for investment spending depends on the type of investment. Business fixed
investment faces a number of near-term challenges from the industrial sector. Industrial
production remains below its prerecession levels; industrial capacity utilization remains
below its historical average; and the purchasing manager’s index is below 50. All of these
factors suggest relatively little reason for strong investment spending in the industrial
sector. On the other hand, private service-producing employment is relatively robust.
Together, these factors suggest a continuation of moderate growth in business fixed
investment spending.
On the other hand, the housing market is providing evidence of strengthening residential
investment Housing sales, starts, permits, and prices are on a general upward trend. The
number of months of existing supply for sale in many markets also suggests a need for
new construction. All these signs bode well for increasing residential investment.
After a strong buildup in fourth quarter 2011, inventory drawdowns have contributed to
weaker economic activity in the first two quarters of 2012. Even with strong retail sales,
the inventory-to-sales ratio remains high by post-recession standards. That ratio suggests
we can expect inventory investment to make small negative contributions in the
remainder of 2012 before turning positive in 2013.
Government Spending
When federal, state, and local government purchases of goods and services are combined
they currently account for about 18 percent of GDP. Over the course of the recession and
recovery government spending saw slightly stronger growth than GDP. Unlike other
sources of spending however, government spending increased during the recession and
decreased during the recovery. In fact, overall government spending has declined for
eight consecutive quarters, from third quarter 2010 through second quarter 2012.
Reduced federal government spending has been an important part of reduced government
spending, but state and local government spending also declined as state and local
governments faced declining revenues.
Looking forward, we see the potential for a sharp reduction in federal government
spending as the result of the so-called fiscal cliff. Otherwise, only moderate cuts in
federal government spending are likely. State government tax revenues are increasing
with economic activity, and increased spending seems likely as we move forward.
Local government spending is another issue. In most states, local governments rely
highly on property taxes. With property taxes lagging behind property values, local
governments are likely to see further reductions in revenues and face continued pressure
for fiscal austerity through 2013.
Net Exports
U.S. net exports are currently about minus 3 percent of U.S. GDP. In the first half of
2012, the United States saw gains in net exports, with a net stimulus to GDP growth.
Increases in exports more than offset increased imports. Looking forward, we can expect
weakness in the European and Asian economies to weaken export growth. At the same
time, however, a weak international economy will reduce the cost of U.S. oil imports.
These two factors will mostly offset each other, and changes in net exports will have little
effect on overall U.S. economic activity.
The Overall Direction of the U.S. Economy
Combining the outlooks for consumption, investment, and government spending with that
for net exports, we see the likelihood of a slow improvement in the growth rate of U.S.
GDP as we assess the second half of 2012 through the end of 2013. Consumer spending
is showing signs of acceleration. Investment spending—particularly residential
investment—is also evidencing gains. Barring a plunge off the fiscal cliff, government
spending is likely to be less of a drag. Net exports can be expected to make relatively
little contribution to the direction of the economy.
Third quarter 2012 is shaping up to be stronger than second quarter. Fourth quarter may
be a bit weaker than third. It still looks to be quite a few years before GDP closes the gap
with potential GDP.
¹Service production typically requires less capital investment than manufacturing.
2 This government spending figure excludes transfer payments, which account for about
17 percent of GDP.
3 See Brown, Stephen P. A. and Kylelar P. Maravich, "Fiscal Cliff Raises Specter of U.S.
Recession," Economic Commentary, Center for Business and Economic Research,
University of Nevada, Las Vegas, August 24, 2012.
http://cber.unlv.edu/commentary/CBER-24August2012.pdf.
Stephen P. A. Brown, Ph.D.
Director
Center for Business and Economic Research
University of Nevada, Las Vegas
The Consumer: A Supporting Part or the Lead Role?
For decades, the American consumer was the backbone of the economy. Buoyed by
rising home values, a decrease in the savings rate and an increase in debt, consumers
consistently increased their spending at a rate higher than the nation’s gross domestic
product (GDP). In fact, according to the Bureau of Economic Analysis, inflation-adjusted
personal consumer spending - a broad measure of consumer spending - grew at a
continuously compound annual rate of 3.47 percent versus an overall inflation-adjusted
GDP growth rate of 2.91 percent.
While consumer spending grew to a total of 70 percent of GDP during the last decade,
that increase wasn’t out of line with previous trends in the U.S. Between 1991 and 2000,
consumer spending composed 67.3 percent of GDP, slightly higher than the 64.6 percent
rate between 1981 and 1990. But when the global financial crisis hit in 2008, the
consumer was hit hard. With rising unemployment, plummeting home equity and overall
household indebtedness at all-time highs, consumers had to pull back and economic
growth contracted along with that pullback (fig. 1).
In the two years since the economy came out of the Great Recession, GDP growth has
been tepid, in large part because consumers aren’t spending as much as they did before.
Their share of GDP is stable, but since they aren’t spending as much, overall GDP
growth isn’t robust.
If consumers continue to constrain their spending as they pay down debt, increase their
savings and attempt to make up for shrunken paychecks and retirement accounts,
increases in GDP will have to be made up by other GDP components such as investment
spending, net exports or government spending. In the absence of a bigger contribution to
GDP from those sources - which doesn’t look likely in the near future - the decline in
consumer spending is likely to have ongoing implications for the U.S. and global
economies.
In this month’s commentary, we’ll discuss how consumer spending has historically
contributed to the U.S. economy, the pros and cons of consumer spending versus other
types of spending, the factors behind the decline in consumer spending, what consumer
spending and consumer confidence look like today and what economic growth might
look like in the near future in an environment where consumers spend less. We’ll also
discuss what this means for investors and how it might impact the markets.
Impact of Consumer Spending
In the last half century, consumer spending has increasingly driven U.S. economic
growth. Not only has the American consumer consistently fueled economic growth, that
spending has increased over the decades as other sources of traditional economic growth
have declined. In fact, during the 25 years between 1982 and 2007, consumer spending
grew at an annualized pace of 3.5 percent in contrast to the rest of the economy, which
grew at a rate of 2.79 percent (fig. 2).
Because the consumer spent so voraciously during these years, more goods and services
were imported, leading to an ongoing trade deficit. Exports are another component of
GDP; as consumer spending rose, the trade imbalance grew, leading to a decline in net
exports. Both business investment and government expenditures – the other two
components of GDP - have also fallen as consumer spending has increased, but not as
dramatically as net exports.
In theory, consumer spending is the same as any other component of GDP. However,
economists believe that business investment is a healthier driver of economic growth than
either consumer or government spending because economies that invest more grow at a
faster rate. When consumer spending dominates an economy, it can tend to crowd out
investment spending, ultimately impairing the economy’s ability to grow in a more
sustainable manner. Federal Reserve Board research revealed that higher investment
spending is associated with overall higher economic growth, while higher consumer
spending is associated with lower economic growth. This holds true when analyzing
short-term and long-term trends.
Factors Affecting Consumer Spending
A variety of factors are impacting the consumer’s ability and willingness to spend. These
include the housing bust, deleveraging, high unemployment, sluggish wage growth and
loss of net worth.
Economists agree that the housing bust has had the largest impact on the consumer. The
Fed reported that the median American home equity value fell by 42 percent in the threeyear period between 2007 and 2010 (fig. 3). Although the housing market has shown
signs of recovery this year, nearly 24 percent of all mortgage borrowers owe more than
their homes are worth. While those numbers are falling and more than 700,000
homeowners climbed into positive home equity in the first quarter of 2012, the amount of
equity that was wiped out during the housing bust has contributed to consumers feeling
poorer and wanting to deleverage further.
Total household debt nearly doubled between 2000 and 2008, fueled by rising home
equity. Americans took advantage of this seemingly easy source of credit, increasing total
overall consumer indebtedness to $13.8 trillion. Besides home equity and mortgage debt,
consumers also took on additional credit card and student loan debt.
Just when indebtedness reached its peak, credit tightened, and so another source of
spending power dried up. Some lenders went out of business, while others tightened
credit standards so that only the most creditworthy borrowers could get loans. Credit
standards for non-mortgage loans have loosened slightly since 2010, but mortgage
lending standards still remain tight, according to the Fed.
As far as deleveraging goes, consumers are making progress. Total household debt has
fallen for 16 straight quarters, declining by 0.4 percent in the first quarter of 2012. While
indebtedness is falling, the personal savings rate is climbing. It fell to less than 2 percent
in 2005 and has rebounded to 3.9 percent as of May 2012 (fig. 4). While this is a positive
for consumers - less debt and more savings - it isn’t encouraging for an economy
dependent on consumer spending.
One of the major factors contributing to a fall in consumer spending is a significant
decline in household wealth since the Great Recession. According to the U.S. Federal
Reserve, the inflation-adjusted net worth of the average American consumer has fallen 24
percent since 2007. This decline actually wiped out two decades of American wealth,
which puts the typical consumer’s net worth back where it was in 1992.
Major culprits in this decline in real wealth were the collapse of the housing market, an
increase in household debt - including credit card and student loan debt - and a decline in
wages. The income of the average American fell by 8 percent in 2010. Although the
wage picture has stabilized in the past few years, job growth has barely kept up with
population growth, and incomes are just pacing inflation. In fact, the average weekly
wage of an American consumer increased just 12 cents during the five years from
October 2006 to 2011. That means wages actually declined when taking inflation into
consideration.
The cumulative effect of these blows to the balance sheet and income statement of the
American consumer is akin to a reverse wealth effect, inhibiting their ability and
willingness to spend.
Consumer Spending & Confidence Today
Consumer spending increased at a rate of 2.5 percent in the first quarter of 2012,
according to the Commerce Department’s most recent data. This is below the recent
historic rate of 3.5 percent and was revised downward twice - from 2.9 to 2.7 percent,
then to the most recent 2.5 percent figure. On a positive note, U.S. household net worth
rose by 4.7 percent in the first quarter, fueled by a rising stock market and increases in
home equity, according to the Fed. However, household wealth still remains about 5
percent below its pre-Great Recession peak.
Overall, GDP increased 1.9 percent in the first quarter, down from 3 percent in the fourth
quarter, hardly a robust pace. This low economic growth rate is reflected in a persistently
high unemployment rate, anemic retail sales and low wage growth. In June, the economy
only added 80,000 jobs, the third month in a row of weak job growth. While the
unemployment rate has come down, it remains at 8.2 percent, and the economy employs
nearly 5 million fewer people than it did when the recession began. As of mid-July, 12.7
Americans remain out of work and millions more have dropped out of the workforce,
becoming so discouraged that they have given up looking for work.
With so many Americans looking for work and so few employers hiring, there is no
upward pressure on wages, so wage growth is virtually non-existent. Actually, when
adjusted for inflation, hourly wages are lower than they were when the recession
officially ended in June 2009 (fig. 5).
Despite these discouraging signals about the job market, there are some bright spots.
Unemployment claims dropped to their lowest level in four years in mid-July, and
companies hired more temps in June than they had since February. The housing market
has also been showing encouraging signs, with fewer foreclosures and an increase in
sales, leading many economists to conclude that this vital part of the economy is finally
starting to contribute to economic growth after years in the doldrums.
In more good news, a large surge in the amount of credit accessed by consumers in May
was a sign that financial institutions are granting more credit and that consumers may be
willing to spend some of that windfall. Overall consumer credit increased at an annual
rate of 8 percent, while revolving credit such as credit cards increased at a rate of 11.25
percent.
Still, consumer confidence remains fragile. The Conference Board reported that its
Consumer Confidence Index fell two months in a row. Consumers expressed slightly
more confidence about the current economic outlook but less confidence in the short-term
and long-term outlooks.
The Thomson Reuters/University of Michigan Index of Consumer Sentiment also fell,
with households reporting that they plan to cut back on spending. This index has fallen
four straight months and in June fell to its lowest level for 2012 (fig. 6).
Retail sales have reflected this sluggish mood. In early July, major retailers including
Macy’s, Costco, Kohl’s and Target reported disappointing sales. The only bright spot is
discount retailers, who are reporting sales increases as consumers continue to search for
bargains.
What to Watch For
If consumer spending continues at the anemic pace it has maintained during the past year,
it’s likely that GDP growth won’t accelerate. The Fed predicts that the U.S. economy will
grow at an annual rate of 2.5 percent, while the International Monetary Fund is less
optimistic, forecasting 2.1 percent growth through the end of this year. Neither rate is at a
pace that would significantly increase employment or tempt businesses to invest or
consumers to spend.
The interplay of forces in the U.S. economy can be reinforcing either in a positive or
negative way. For example, if consumers did significantly loosen their purse strings and
spend at a more robust pace, businesses might be more willing to invest, creating more
jobs. The resulting tax revenues would help local, state and federal government avoid
more job cuts and benefit cuts that could negatively impact the economy, at least in the
short run. The increase in jobs could further spark consumer confidence, thus increasing
spending, which would have a ripple effect on business investment and government tax
revenue. The reverse is also true - if consumers, businesses or the government won’t
spend, the economy doesn’t have much chance of growing.
To get a handle on whether the consumer is starting to spend, watch statistics such as
quarterly government reports on GDP, which contain information about consumer
spending. Monthly retail sales reports are also indicators of whether the consumer is in a
buying mood and, if so, exactly what types of goods and services they are buying. Energy
prices, if they continue to fall, are likely to provide some relief and dollars that
consumers can potentially deploy into spending in other areas.
Most economists believe that jobs are the key to increased consumer confidence and
hence consumer spending. If the pace of job creation picks up from current low levels
and unemployment claims continue to drop, employed consumers are more likely to
spend because they have confidence that they will have a paycheck and the ability to stay
afloat financially. The housing market is another key data point. A home is typically a
consumer’s largest source of wealth. The more homes that are underwater, the poorer
consumers feel and the less likely they are to spend, except where necessary.
Where We Go From Here
Absent an increase in consumer spending, the economy will likely continue to muddle
along at a low rate of growth. Combine this with the upcoming election, the uncertain
sovereign debt situation in Europe, expiring Bush tax cuts, and tax increases and budget
cuts set to take effect in January, and the overall outlook isn’t too rosy.
There are some positives. The election, regardless of its outcome, will resolve a lot of the
uncertainty that is plaguing the markets. And new political leadership will hopefully be
able to deal with the fiscal cliff issue in a politically responsible way, one that begins the
difficult work of cutting the budget deficit without applying severe cuts and tax increases
that could spark another recession.
The gross domestic product (GDP) is the amount of goods and services produced in a
year, in a country.
The Great Recession refers to the 2007-2012 global recession.
The Federal Reserve is the central banking system of the United States. The sevenmember Board of Governors is a federal agency charged with the overseeing the 12
District Reserve Banks and setting national monetary policy.
The Conference Board is a global, independent business membership and research
association working in the public interest. The Conference Board is a non-advocacy, notfor-profit entity holding 501 (c) (3) tax-exempt status in the United States.
The Consumer Confidence Index is issued monthly by the Conference Board. Based on
5,000 households, it is an indicator designed to measure consumer confidence, which is
defined as the degree of optimism on the state of the economy that consumers are
expressing through their activities of savings and spending.
The University of Michigan Consumer Sentiment Index is a consumer confidence index
published monthly by the University of Michigan and Thomson Reuters. At least 500
telephone interviews are conducted each month of a United States sample. 50 core
questions are asked.
The International Monetary Fund (IMF) is the intergovernmental organization that
oversees the global financial system by following the macroeconomic policies of its
member countries, in particular those with an impact on exchange rate and the balance of
payments.
Consider
Boshari Emmons work on the impact of the Crash on younger households and
households of color.
The Profitability to financial institutions of various aggressive pricing and practices
regarding consumer debt and particularly sub prime consumer debt.
http://www.lance-williams.com/files/22003/economic_commentary_0812.pdf
http://cber.unlv.edu/commentary/CBER-28Sept2012.pdf
http://www.mckinsey.com/insights/blobal_capital_markets/will_us_consumer_debt_redu
ction_cripple_the_economy
92-0381
Chapter 11 Sociological Impacts of More or less Consumer Credit
Our next three chapter move to the social sciences; we examine the sociological impacts
of consumer credit, then economic impacts and finally we look thoughtfully at consumer
behavior as it impacts whether or not to borrow and how much to borrow.
Remember you are the regulator and decision maker ; you know about various kinds of
consumer credit. In decided whether to regulate, if so, how and how much it is important
to evaluate the consequences of more or less credit availability.
So let’s start with this question.
QUESTION:
How do you decide the optimal amount of credit availability?
And the spread of that availability?
In your role as regulators/legislators, think about the benefits, risks and damages to
individuals, households and society in general of the consumer lending explosions
between 1980 and 2007. Please consider whether it is okay to create or to fail to take
action to stop a situation when you know the situation is likely to cause failure and
disruption to households and society and a reduction in class mobility. Think also about
the net damage/benefit for a family that borrowed to live in a safer neighborhood, lived
there for several years and lost their home to foreclosure.
Now, let’s move to the Benefits to the individuals and families of the availability of more
credit rather than less
To the extent possible let’s separate the sociological impacts into micro and macro
aspects. Of course, this is somewhat artificial and there are sociologists who feel it is
dishonest and wrong, but at least for these initial purposes it may be useful. By micro I
mean impacts on individuals and families and neighborhoods; by macro I mean impact
on the society in general and perhaps the entire community.
Examples include various aspects of credit such as risky home mortgages,
credit card debt expansion and payday lending.
Where is the line?
What is the balance?
How do we reduce the damage
What if that destroys the benefits?
Also we will need to break some of these issues down quintile by quintile.
Particularly on the most vulnerable lower quintiles.
How high must the sociological damage be in order to require regulation?
Soft dollars / hard dollars What are the primary benefits to individual consumers from
being able to obtain credit? Detriments?
What are the primary benefits to American society from millions of consumers who have
been precluded from legal borrowing being granted access to that market?
Detriments?
Measure the following according to benefits to individual, benefits to society
Risk or damage to individual,
Risk or damage to society
Vacations
3 days in the Ozarks
3 months in Tahiti
Buying good shoes
Buying good food
Attending sporting events
Purchasing jewelry
Lottery tickets
All types of legal gambling
Smoking
Illegal drugs
Contribution to the church
Going to law school
Paying for home improvements
How do we measure all of this?
Purchases beyond likely ability to pay
Home
Car
Credit cards
Other types of borrowing.
Education
How do we measure life satisfaction?
How do we measure life dissatisfaction or distress?
What does life satisfaction lead to?
Micro and macro
What does dissatisfaction with life lead to?
Micro and macro
Does over indebtedness cause illness?
Does it led to deterioration in mental health?
Does it cause family disruption or violence?
What can we document and how?
What do we know?
Quote from ??
Other families, long denied the benefits of homeownership, found opportunities to
purchase homes using loans with few underwriting standards and onerous terms.
Subprime lenders exploited the economic vulnerability of these marginalized families, a
vulnerability created by the policies of neoliberalism as well as the legacy of rec ism and
sexism inextricably intertwined with US capitalism. This side of the story of the
subprime boom and bust must be excavated to prevent increasing financial exclusion of
marginalized families, which is best fought with attention to labor and housing condition
and the challenges faced by different family groupings on the basis of their race and
gender configurations.
How do we define a society – happiness quotient.
Freedom from various harms
Discussion Questions: What are the detriments of increased consumer borrowing.
DETRIMENTS OR RISKS
Illness
Mental illness
Harmful conduct
Foreclosure
Cost to society
What is the relationship, if any between overindebtedness and class mobility
What is the relationship, if any between subprime borrowing and minority groups?
To what extent, if any is the pernicious effect of culture of advertising and survival needs
combine to overload low income consumers with debt ?
Please read:
http://www.moneyadvicetrust.org/images/DebtMentalHealthWhatDoWeKnow(FINAL).pdf
Please consider these issues and questions as you read the article that follows:
The drivers of consumption and the policy makers supporting them created a condition in
which high levels of consumer debt became necessary to sustain and support the growth
and transformation of the financial markets?
What is the effect of credit availability upon class mobility?
Overindebtedness reinforces existing class divisions and thwarts class mobility
The effects of reduced economic mobility
The effect of catching up and then falling back.
If credit is the only resource available then it will be accessed, whatever the cost.
Excerpts from
The Consumer Debt Crisis and the Reinforcement of
Class Position
By Lois R. Lupica*
Credit: “1526 . . . from pp. of credere ‘to trust, entrust, believe.’”
I. INTRODUCTION
Consumers are indebted to a degree never before seen in history.
While consumer over-indebtedness has been many years in the making, only recently has
this crisis attracted widespread public attention. The precipitous collapse of iconic
financial institutions and the corresponding seizure of the financial markets in the United
States, for the first time, have drawn widespread public attention to the operation of the
financial system and its connection to and relationship with consumer debt.
This public attention has resulted in initiatives launched in various directions to identify
the “causes” of the debt crisis in an effort to develop effective solutions. Intense scrutiny
has uncovered a multitude of structural and cultural causes of consumer overindebtedness, with a focus on consumer behavior, lender practices, market incentives,
and the public and private policies sustaining them. For example, shifts in consumptive
norms, erosion of the value of frugality and long-term savings, financial ignorance and
illiteracy, faulty judgment, and an increasing tolerance toward debt have all been
identified as consumer- driven causes of over-indebtedness.
.
An appraisal of these “causes” offers a chilling picture of how we got to this point of
crisis. Limiting consideration to these apparent and obvious causes of over-indebtedness,
however, results in an incomplete picture. A comprehensive map sketching the full
measure of factors contributing to the collapse of consumers’ “debt-supported house of
cards” reveals that the fundamental underlying cause of the consumer debt crisis is found
in the incentives that have shaped the very structure of the consumer marketplace. The
drivers of consumption and the policy-makers supporting them created a condition,
opportunistically or deliberately, in which high levels of consumer debt became
necessary to sustain and support the growth and transformation of the financial markets.
The markets affirmatively, aggressively, and insistently encouraged an ever-more rapid
and high-risk consumer lending and borrowing cycle, which in turn both fueled and was
fueled by ever- increasing levels of consumption and debt. Consumers acquiesced to the
efforts made to persuade them to buy and borrow more. Over the past few decades, these
dynamics became the established order, thus resulting in widespread consumer overindebtedness.
And yet the virtually unregulated financial market has, until recently, operated with
unquestioned legitimacy and invincibility. Against the backdrop of a reordered and
globalized economy, the past decades have seen financial wizardry transform simple
consumer credit transactions into complex securitized and collateralized debt instruments
and their derivatives—all conducted with little regulation, public scrutiny, or criticism.
Driven by fee income and high yields and unburdened by regulatory oversight,
originators, investors and participants at every level of the consumer-borrowing-andlending chain yielded to the incentives to alter the way the consumer lending and
financial markets operate. By creating a self-reinforcing supply and demand cycle,
investment banks and other participants in the securitized debt market have,
opportunistically or deliberately, encouraged retail lenders to make a high number of
risky loans to a broader array of consumers, which has created a seemingly insatiable
demand for the sale of this consumer debt in the public markets.
Such high levels of debt have adversely impacted countless consumers’ lives,
compounding existing social, economic, and political inequalities, and threatening
opportunities for mobility and advancement.
Debt has frustrated the chances for
countless Americans to exercise social, economic, and political power. It is this power—
to make choices, to realize opportunities, to be heard and to have realistic hope for a
future that is better than the past—that is at the core of our ostensibly mobile and open
society. Simply put, over- indebtedness reinforces existing class divisions and thwarts
class mobility.
Few concepts have been as fundamental to the study of cultural, sociological, political,
and economic forces as “class.” The role of class analysis in the development of social
and economic theory and even its continued relevance, however, remain contested.
Some believe that viewing social and economic policies and resulting structures through
the lens of class is irrelevant, or at the very least, passé. Yet others believe a study of
class dynamics is essential to understanding public and private policies that “make for
inequality of a normatively troubling kind.” This Article argues that in light of the
magnitude of the crisis and the fragmented approach with which solutions have been
offered to date, a broader examination of the relationship between factors, policies, and
practices that have caused the crisis—essentially an examination of the factors that
impact class creation, reinforcement, and mobility—becomes ever more essential.
The study of public and private policies and their impact on class mobility is closely
aligned with the issue of the appropriate relationship between government and the
marketplace. Over the past twenty years, the economy has, in a very real sense, been
reordered. The deregulatory efforts of recent years have opened up new opportunities
for many participants in the financial markets. This shifting landscape has also resulted,
however, in new disquiet and uncertainty, with initial unease evolving into fundamental
questions about the risk and even the legitimacy of essentially unregulated markets.
Particularly in light of the remote relationship between consumer borrowers and their
ultimate lenders, coupled with the credit market’s information asymmetries, the public’s
confidence in the unregulated markets in which consumer credit transactions take place
has been called into question.
This Article critically examines the public and private policies and practices that have
contributed to consumer over-indebtedness and discusses the relationship of these
policies to class creation, reinforcement, and mobility. It also explores the extent to
which these public and private policy decisions have acquiesced to and facilitated the
debt crisis and how this attendant impact on class mobility can be justified. Part II
explains the various conceptions of class recognized in the United States and outlines a
working definition of the factors that mark one’s class position. Part III analyzes the
multi-pronged origins of the current consumer debt crisis and also describes the
relationship between the insidious hegemonic forces that have aligned and thus
contributed to current day strengthening of class divisions and thwarted mobility. Part
III further discusses the role debt plays in the lives of low-means consumers. Part IV
describes the class-related effects of over-indebtedness.38 Because the public trust in
the credit markets has been eroded, and in light of the market’s negative externalities,
Part IV argues that broad-spectrum intervention and oversight is needed.
Finally, this Article concludes in Part V by arguing that understanding
the causes of consumer over-indebtedness and its impact on class mobility and
opportunity is essential to the question of whether existing policies and practices
supporting this system are defensible.
II. AN APPROACH TO CLASS ANALYSIS
Mapping the contours of class divisions in the United States is a “culturally complex
process,” and one that is often met with resistance. Confounding attempts to
explain the class impact of a given public policy is the ahistoric effort to deny that an
identifiable class structure even exists.
The media, politicians, and
Americans’ general optimism about prospect and advancement rebuff the public
recognition of class divisions in favor of the boundless opportunity myth. Pursuant to
this myth, reliance on a class-based conceptual framework to explain differences between
groups suggests acceptance of a permanence of one’s relative position along the
hierarchy.
Interestingly, while Americans balk at viewing social and economic hierarchies as classbased, we have an inherent cultural tolerance for high levels of inequality.47 The
corollary that balances this tolerance, however, is a deeply held belief in unlimited
prospect and opportunity. As such, to overtly acknowledge class distinctions and to
identify and analyze the forces that affect class creation, reinforcement, and mobility is
deemed by some to be an untenable concession that opportunity and advancement may
not be available to everyone. It is this ideological commitment to opportunity and
advancement that makes the analysis of public and private policies’ impact on class so
critical. Engaging in class analysis in a specific contextual realm not only affords an
opportunity to examine policy decisions and how they are operationalized, but also
allows for the normative evaluation of such policies. Answering the question of how and
to what extent given public and private policies adversely affect material standards of
living and inequalities in life chances not only aids in our understanding of these policies,
but also enables us to think expansively about the types of transformation that can
ameliorate or eliminate them.
The starting point in any class analysis is identification of the common elements
that contribute to the constitution of a class. For purposes of this Article, having access
to similar levels of rent-seeking assets, or wealth, is identified as the essential core
element members of a class hold in common. Wealth is defined, however, in a broad
conceptual way to include not only the typical capital-related markers, but also common
social, cultural, and political conditions that arise as a consequence of the accumulation
of assets, including human capital.
These conditions, taken as a whole, are tied directly to the capacity of a class to exercise
social, economic, and political power, and to commensurate restraints on such power.
This power and these constraints enable each class to flourish, as well as navigate and
endure societal exigencies, with a collective degree of capacity, autonomy, and
legitimacy.
Correspondingly, social, economic, and political opportunity allow persons within a class
to move to a higher rung and enjoy a more expansive choice of resource allocation and
greater degree of control over their lives. To illustrate, to be a member of a “lower
class” may mean one has diminished economic stability, fewer resources with which
to resist coercive influences, a greater susceptibility to market temptation, and less
confidence that hard work will lead to opportunity and transformation for current and
future generations. Accordingly, conditions creating opportunity and mobility would
enable a person to move from this “lower class” to a higher one within which he or she
would have more financial, social, and cultural capital and a commensurately greater
degree of autonomy and power.
III. THE “CAUSES” OF THE CONSUMER DEBT CRISIS
A. The Creation of Wants
2. The Rise of the Consumer Credit Industry: Deregulation and Credit’s
Democratization
The past decades’ expansion of a culture increasingly marked by consumerism has been
tracked by the parallel transformation of the consumer credit markets; consumer credit
has played a substantial role in enabling much of the increased cultural emphasis on
consumption.
As retailers of goods, services, and entertainment began to actively engage in the
aggressive and insistent encouragement of consumers to “consume more than they intend
and perhaps more than they can afford,” credit providers facilitated these purchases, by
“democratizing” the availability of credit.
The transformation of the consumer credit industry, however was an incremental process
and the market, as it exists in the United States today, did not develop in a social and
moral vacuum: the market has shaped and has been shaped by the values of the industry
and its constituent communities. Its evolutionary development has been
punctuated by deliberate strategic decision-making by both industry leaders and policymakers. Major policy shifts first began following the Great Depression of the
1930s. At that time, the government’s fiscal plan was focused upon stimulating
economic growth and one central target of this focus was
consumer credit. Government loan guarantees and other regulatory
structures were put into place to create a market for consumer lending. When the
revolving charge card was introduced in the early years following WWII, its debut
marked a pivotal and strategic turning point in the consumer credit market.
Timed to take advantage of the expanding economy, the credit card industry’s initial
business model focused upon the pursuit of economies of scale: increasing the number of
credit card holders, while at the same time maximizing the number of merchants who
accepted credit cards as a form of payment. Credit card lenders at this time, however,
took a comparatively conservative approach to lending: fixed interest rate loans
marketed to borrowers deemed creditworthy, judged according to strict underwriting
standards.
Aided by technological advances, national banking networks emerged in the
ensuing boom years, presenting the need to expand customer markets to maintain
profitability. Banks’ marketing methods became more targeted and aggressive: the first
mass-mailing credit card solicitation resulted in millions of new customers, although
largely confined to consumers with consistent records of reliable credit repayment.
Regulatory restrictions in the form of interest rate caps, however, kept strict limits on
credit card issuers’ potential for profitability.
It was not until the 1970s that regulatory, technological, and competitive forces aligned,
forever altering the fundamental structure of the consumer credit industry. The most
significant rule change arose out of the Supreme Court’s 1978 decision in Marquette
National Bank of Minneapolis v. First of Omaha Service Corp. This decision had the
effect of removing barriers to the consumer credit industry’s growth by allowing banks to
move their credit card headquarters to states with high usury caps. Banks were thus able
to raise interest rates on consumer credit by expanding their operations beyond state
borders.
The Marquette decision was followed over the next decade by the enactment of numerous
laws further deregulating the consumer credit industry. Despite a largely unregulated
environment, banks issued comparatively conservative credit products until as recently
as the late 1980s. For example, most credit cards continued to offer fixed
interest rates, charged annual fees, and were marketed to borrowers with strong credit
histories. It was not until the early 1990s that the consumer banking industry found the
good-credit-risk market close to saturated. New entrants into the consumer credit supply
market, including pay day lenders, rent-to-own centers, and other non-bank lenders, put
increasing pressure on traditional banks to increase their market share in order to
maintain profitability. The proliferation of the high-cost non-bank lenders began at the
same time the traditional banking industry was becoming increasingly consolidated.
In response to these competitive pressures, banks’ card issuers took measures to expand
their target markets to include less affluent households. Citicorp credit card division’s
decision to alter its business model is reflective of industry practice at that time:
After increasing the finance charges on its credit cards, Citicorp sought to expand the
social frontiers of its credit card portfolio by soliciting lower-income households. This
was an important marketing shift because the early focus on more affluent,
middle-class households produced large numbers of unprofitable, albeit low-risk,
convenience users. Bankers had hoped that a larger proportion of these cardholders
would revolve a portion of these purchases or occasionally forget to pay their credit card
bills. Instead, they soon realized that they were stuck with costly deadbeat clients, who
zealously paid off their charges within the specified grace period. As inflation rates
climbed to double digits, the architects of [this business model] encountered a crucial
institutional crossroads: continue losing even more money on large numbers of low-risk,
middle-class clients or increase their lending to higher-risk, lower-income households
that previously had been avoided.
Credit card issuers further sought to increase profits by raising interest rates and
charging higher fees and penalties following the Supreme Court’s decision in Smiley v.
Citibank. The Court held that late payment, over-limit, cash advance, returned check,
membership, and other fees fell within the definition of “interest”—making their
proliferation, as well as industry profits, virtually unhindered by regulation.
The consumer credit industry has continued to modify its business model and marketing
practices with the persistent goal of expanding demand and increasing profits. In
addition, the credit products currently offered more widely are far more expensive than
they were twenty years ago and “[the credit card industry] has shifted from a lending and
underwriting paradigm to a sales paradigm; penalties, fees, and default interest at rates
that were illegal a generation ago are no longer regrettable outcomes to be avoided but
central to the business model.” Credit cards have become as ubiquitous as cash and are
used ever- more commonly. According to the Federal Reserve, Americans are now
carrying $943.5 billion in revolving credit card debt, up 6.8% from a year ago:
[B]etween 1989 and 2001: Credit card debt among very low-income families grew by
an astonishing 184 percent. But middle-class families were also hit hard—their credit
card debt rose by 75 percent. Very low-income families are most likely to be in credit
card debt: 67 percent of cardholding families with incomes below $10,000 are affected.
Moderate-income families are not far behind: 62 percent of families earning between
$25,000 and $50,000 suffer from credit card debt.
Moreover, in the first quarter of 2008, consumers financing the purchase of a new car
through an auto finance company had an average outstanding balance of $28,174, with a
loan-to-value ratio of 94% and maturity of 62.6 months.140 In 2003, mortgage
originations and refinancings hit a decade high, with $3.802 trillion of housing-backed
loans made. These high debt levels have been incurred at a time where household savings
levels are at an all-time low, leaving many without a safety net in the event of an
unexpected expense or interruption in income. Enormous pressure has been brought to
bear on consumers to buy instead of save, and to borrow, rather than wait.
A similar culture of free borrowing has been encouraged by the mortgage banking
industry. Aided by rising real estate values, consumers have taken advantage of the
mortgage market’s liquidity, borrowing against their homes to a greater degree than
before seen in history. Seemingly under the impression that the market’s rising valuations
would continue forever, liberal mortgage underwriting, low introductory variable rate
products, and low- and no-documentation loans with high loan-to-value ratios led many
consumers to buy more house than they could afford and carry larger mortgages than
could be repaid. The present day escalation in the number of housing foreclosures - the
very issue that brought public attention to the crisis of consumer over-indebtedness—is a
consequence of the normalization of lax underwriting, overly optimistic value
projections, the conversion of unsecured debt into home-secured debt, and the lure of low
introductory rates for adjustable rate mortgages, as well as the escalation of subprime and
predatory lending. .The credit industry has created this pressure and knows where
consumers’ social, economic, and psychological vulnerabilities lie. It knows that
consumers tend to discount the long- and short-term consequences of credit use, due to
the temporal disconnect between the charge and receipt of a bill. This discounting and
underestimation extends to a number of features of credit use, including present and
future balances, the importance of interest rates, the likelihood of a late payment, the
speed at which interest accrues,152 the implications of merely making the minimum
payment due; as well as the likelihood of exceeding credit limits, and credit products
have been designed to opportunistically exploit these susceptibilities. As observed:
The adverse [sic] consequences for using credit cards is abstract (i.e., a printed bank
statement) and delayed, and thus is likely to have less of an impact on behavior. High
interest rates and penalties are present when payments are delinquent, often making it
difficult to reduce the total amount of debt for individuals who do make payments.
Thus, although not inevitable, credit cards allow for disadvantageous allocation of funds
by allowing immediate impulsive purchasing at high long-term cost.
Simply put, the credit industry knows that the classic economic model of the rational
market actor does not prove to be an accurate description of consumer behavior in
practice.
Moreover, the “consumer protection” regulatory model currently in place is premised on
the concepts of disclosure and private enforcement. With few meaningful limits placed
on the cost of credit, disclosure has proven to offer little consumer protection; the
display of onerous credit terms in the context of aggressive marketing has not corrected
the information asymmetries in access to information that characterize the consumer
lending market. Moreover, with recourse for abuses available only on the basis of
individual consumer transactions rather than on systemic flaws in the operation of the
market itself, consumers with relatively small claims and truncated access to information
are excluded from regulatory protections. Myriad reported cases have illuminated the
barriers consumers face in seeking a remedy for harms caused by creditor behavior or
industry practices.
Defending consumers’ affirmative responses to offers of credit as part of the supply and
demand cycle places the risk of loss solely and squarely on consumers. Thus, it is not
surprising that consumer financiers, in accounting for consumers’ systematic biases,
have reported record profits in recent years—profits which have been directly correlated
to record levels of consumer over-indebtedness.
B. Needs Financed by Debt
The tension between the desire and resistance to consume is felt by consumers at all
levels of the class spectrum. Among consumers in poverty, however, this tension creates
an even greater pull: studies have demonstrated that consumers often buy things to
“compensate for worries and doubts about their self-worth, their ability to cope
effectively with challenges, and their safety in a relatively unpredictable
world.” The world is a far less predictable place for people lacking resources. Economic
and social stability is compromised, as is the ability to hope and plan for the future.
Consumption can act as a salve, a way of feeling as if one has a degree of control over a
world that too often feels out of control.
When debt is used in an attempt to escape extreme financial exigency, however,
consumers are seeking more than a mere salve. In such circumstances, consumers are not
primarily concerned with emotional comfort, the satisfaction of material desires, or the
creation of an identity; they are concerned with the basics of survival. The prescription
has to get filled, groceries have to be bought, the baby needs a crib, and the car needs
gas—today. If credit is the only resource available, failing sufficient income, assets or
public assistance, it is accessed—whatever its cost. Lower-wealth consumers are caught
in a vise: wedged between desiring the material goods that have become part of the
American identity, and needing to use credit for fundamental subsistence. The decline in
real wages, particularly in the service sector, coupled with increases in part-time
employment and layoffs have meant that workers’ relationships with their employers
have become progressively more tenuous. Jobs are less likely to offer health insurance or
long-term wage and retirement security than they were in decades past.Moreover, an
estimated twelve million renter and homeowner households now pay more than fifty
percent of their annual incomes for housing, and a family with one full-time worker
earning the minimum wage cannot afford the local fair-market rent for a two-bedroom
apartment anywhere in the United States. The dearth of affordable housing presents a
significant hardship for low-income households, preventing them from meeting their
other basic needs, such as nutrition and healthcare, or saving for their future. The spike
in the price of gasoline has had an enormous impact on poor families, many of whom
own older, less efficient vehicles.
When unexpected expenses arise, many families are forced to “dissave” (withdraw
savings, sell assets, or borrow) to meet their obligations. With few assets, the vast
segment left out of the so- called “ownership society”179 has strained to bridge the
divide between income and expenses. In the absence of savings, a living wage or public
assistance, credit becomes what enables many families to survive.
At the time the traditional credit industry relaxed its underwriting standards and made
credit more widely available, it also created new credit products tailored for the lowincome consumer. The credit aggressively offered to low-income and low-means
consumers is categorically different than that used by middle-class consumers.
These products have higher interest and fee rates, more onerous terms, and are
designed for long-term borrowing, rather than convenience use. Easy access to this credit
has significantly contributed to high consumer debt levels.
In addition to credit issued by the traditional banking sector, an entire sector of the credit
industry has emerged in recent decades specifically designed to serve the “need
borrower.” Known colloquially as “fringe bankers, ”these lenders offer credit to
augment other lending sources. Marked by convenience of location, lax underwriting,
and high interest rates, these lenders have identified their target market as those
consumers who need credit for the basics of subsistence.
Lower-income homeowners are also vulnerable to predatory mortgage lenders, who offer
easy but expensive money to purchase homes, pay property taxes, make home repairs,
and pay other household expenses. These predatory loans are distinguished by high
interest rates, unnecessary fees, risky terms,and low- to no-credit underwriting
standards.192 Like other post-credit democratization credit offers, these loans are
distinguished by information asymmetries and consumer manipulation in the loan
origination process.193Not surprisingly,the incidence of home foreclosures in the
subprime market over the past eighteen months has reached record highs. It is projected
that one in five subprime mortgage loans made in 2005–2006 will end in foreclosure,
which means that over two million families will lose their homes in the next few years.
The equity that will be lost through these foreclosures is projected to be in excess of $160
billion.
The classical economic argument that consumers as self-determined agents reap benefits
from markets that are free of regulatory constraints does not hold for consumers driven to
borrow by coercion and need. As observed:
Agency does not [allow for] choice for individuals who are powerless. What it does
represent is a perpetual marginality. Contrary to notions of agency, individuals have little
power to make sustaining transformations when the underlying structure is flawed. . . .
Hierarchical decision-making results in policies and laws that exclude the group of
persons who are powerless to oppose those laws and policies that are not in their best
interests.
Borrowers who are driven by need, however, know that payday lenders are exploiting
them, that credit cards are a trap, and that rent-to- own stores are a rip-off, but in the face
of such dire need, the price of credit and the effects of indebtedness become irrelevant.
In the absence of alternatives, these borrowers do not have the luxury to meaningfully
consider the long-term consequences of incurring high priced debt.
C. The Secondary Market for Consumer Credit
Driven by commercial and investment bankers, speculators, traders, lawyers, accountants,
investors, and other participants, the financial markets have experienced a massive
transformation in virtually every respect over the past decade and a half. Advanced
information systems have led to the invention of innovative investment products,
including complex securitized assets and their derivatives, backed by mortgage-related
loans and other consumer credit receivables Unprecedented economic growth has
enabled the utilization of new technologies and opened myriad new markets and
opportunities.
The invention of these securitized and derivative products has allowed
both financiers and investors to hedge market and currency risk, further enabling the
meeting of financial institutions’ goals of borrowing cheaply, transferring and
diversifying risk, accessing new sources of capital, and taking advantages of economies
of scale.
Such market innovations have also fundamentally altered long-held retail consumer
lending policies and practices.For example, lenders’ compensation models shifted in
response to changes in risk exposure; once the risk is removed from the loan originator’s
balance sheet via the securitization transfer, lenders are incentivized to focus on the
volume of loan originations, not necessarily the quality or default risk of each loan. This
led to the implementation of numerous measures designed to expand the consumer
borrowing base and to increase both consumption and consumer borrowing.
Accordingly, consumer credit, including credit cards, became more widely and
aggressively marketed, and home purchase loans, refinancings, and equity lines of credit
became increasingly and insistently promoted to ever-riskier borrowers. Many of the
mortgage loans currently in default were written in compliance with industry and
“market sanctioned underwriting guidelines”— notwithstanding the fact that they were
no- document, 100% loan-to-value ratio loans. With the risk of consumer default
shifting to investors in the secondary market, the potential for lost accountability on the
part of front-line lenders arose, resulting in an agency problem. The strategy to both
expand consumption and borrowing and transform these loans into low-risk, high yield
securities has also resulted, until recently, in the banking industry’s booking
unprecedented profits in recent years.
While minimizing risk and making money is what the banking industry does—with
rewards meted out based on who does this best— with escalating profits comes the risk
of complacency. As a result of this complacency, originators, investors, rating agencies,
insurers, lawyers, accountants, and regulators failed to recognize some of securitization’s
fault lines and failings in its market’s operation. A central failing of the market is
directly tied to the “too-clever-by- half”structure of many of these transactions: few
investors and other participants in the market truly understood these transactions, the
nature of the investments being sold, or how to evaluate the quality and value of the
underlying assets.
Appreciating and accurately valuing the assets supporting asset- backed securities (ABS)
is fundamental to structured finance. In the absence of a precise understanding and
valuation of a securitized asset, the exercise in arbitrage fails, and the credit rating ends
up being based upon a misunderstanding that in turn determines the faulty ABS’s pricing.
This has the potential to further lead to failings in the
fundamental structuring of transactions, with, for example, senior tranches’ fallibility
far greater than their rating (and pricing) suggests.
Originators, bond insurers, investors, and rating agencies all got caught up in the
exuberance of this re-imagined market The rapidity with which the market moved, the
long runs of high yields, and the complexity of the investments led to overdependence on rating agencies to evaluate risk. Rating agencies, in relying upon
originators to pay their fees, were faced with conflicting loyalties.
Moreover, it has been exposed, with the benefit of hindsight, that rating agencies relied
upon financial models that were alternately based on incomplete and dated assumptions
about asset value and performance. Investors blindly accepted the rating agencies’
assessments and substituted the agencies’ evaluations as a proxy for their own diligence.
The confluence of these market failings has resulted in what has alternately been
described as a “credit crisis,” a “melt-down” and even a “conflagration,” leading to the
quest for answers to the questions of what, how, and why things went so wrong. When
viewed in hindsight, however, it is just these factors—“the collective misjudgment of
risk; a zealous search for yield; and the failure of oversight”—that constitute the
foundation of this market’s current failure. Paradoxically, however, it is the very same
factors—a willingness to bear extraordinary market risk in exchange for high return,
without the burden of regulatory constraints—that were the central reasons for the
market’s success.
IV. THE CLASS-IMPACT OF CURRENT DAY CREDIT POLICY: THE
“EFFECTS” OF OVER-INDEBTEDNESS AND A FRAMEWORK FOR OVERSIGHT
The connection between consumer over-indebtedness, the disruptions in the financial
markets, and the adverse impact the debt crisis has had on consumers’ lives has finally
been recognized, sparking much heated public and private discussion about how to “solve
the problem.” As part of the effort to find effective solutions, a host of proposals have
recently been put forth by scholars, journalists, legislators, and the credit industry,
primarily focusing on remedies at the consumer borrowing and lending level. These
proposals include (i) greater scrutiny of sub- prime mortgage loans and the curtailment of
predatory mortgage lending, (ii) the imposition of substantive restrictions on the price
and terms of credit, (iii) voluntary changes in the credit card industry’sbusiness practices,
(iv) adjustments to the Bankruptcy Code, (v) governmental refinancing of mortgage
loans, (vi) the prohibition of mandatory arbitration provisions in consumer loan
contracts, and (vii) early financial literacy education for consumers. The events of late
2008, including the demise and near-demise of iconic investment banks, the breakdown
of Fannie Mae, Freddie Mac and the American Insurance Group (AIG), the
unprecedented volatility in the stock market,and corresponding freeze in the credit
markets have all resulted in additional enactments and proposals designed to “fix” the
damaged credit markets. The government takeover of Fannie Mae and Freddie Mac, the
infusion of over $250 billion from the United States Treasury into American banks, the
“bailout” of AIG, the commercial paper back-stop program, and the proposal to expand
the reach of the Federal Deposit Insurance Corporation are now being trumpeted as the
way out of this crisis.
While, to varying degrees, each one of these ideas has merit, in the absence of a broadbased comprehensive plan to address past harms to consumers, coupled with a wideranging strategy for ensuring that a crisis of the present magnitude does not happen again,
these proposals being sold as “solutions” ring hollow. They will have nothing more than
a palliative effect because they fail to reflect a full recognition of the essential problem
at the foundation of the crisis: that the fundamental underlying cause of the
consumer debt crisis is found in the incentives that have shaped the very structure of the
consumer and credit marketplaces. Consumer debt provided the fuel for the explosion of
the markets for consumer goods, services, and credit. Debt became necessary to sustain
the markets’ very existence, and thus
widespread incentives to increase consumer debt levels emerged. Accordingly, without
an alteration of market incentives and a major re- tooling of expectations at every level,
the problem will not be solved and the current crisis will repeat itself.
At a minimum, greater public oversight of credit transactions at every level is necessary
to address many of the debt crisis’s causes and effects. The thorny issue, however,
is the nature and degree of such oversight. The concern, of course, is that greater
regulation of the consumer credit markets will adversely impact the lives of consumers,
particularly financially marginal consumers, by limiting or cutting off a source of needed
funds.
For all of the harms that flow from easy credit access, credit serves a very important
function: it acts as a private safety net, often necessary for short and long-term well
being. As noted, in many circumstances, credit is needed to navigate financial
hardships and cash- flow interruptions. Particularly for consumers with lesser means,
credit can be and is used when food stamp or other public assistance payments are
interrupted, upon threats of, or actual eviction, when the car breaks down, and at times of
disruption of health care coverage.
Moreover, one of the oft-cited benefits of access to credit, particularly in the
form of credit cards, is the private nature of the loan. Unlike emergency public assistance,
no “criteria of need” must be met, nor must the nature of the emergency be disclosed.
Credit card transactions are private and anonymous, void of any stigma at the point of
borrowing or purchase. Needed funds can be obtained immediately, without any
bureaucratic delay or obstacle.
Furthermore, credit cards have become essential for many transactions common to
consumers of all classes. Necessary to rent a car, check into a motel, rent a video, and
make on-line purchases, in their absence, many opportunities that fall both in the “needs”
and “wants” categories are foreclosed. Particularly for low-means consumers without
access to a full range of traditional banking services, curtailing access to credit may cause
those already marginalized to “fall further out of the mainstream.”
With respect to mortgage-related credit, without its reasonable availability, it would not
be possible for many to purchase a home. Many studies document the individual and
community benefits of home ownership, including its encouragement of family stability
and responsibility. Additionally, as the largest asset held by most families,
homeownership has a direct impact upon inter-generational wealth transfers.
Without a doubt, credit has become an essential part of the consumer economy and is
relied upon by many as both a convenience and a necessity. But with increasingly
creative and complex credit transactions taking place in a virtually unregulated
environment, the fallacy that the transformed and liberalized market offers more good
than harm to consumers has been exposed. As noted:
Of course, [market] liberalizing measures were pursued in the belief that they would
generate positive effects. Classical economic philosophy holds that the liberalization of
market activity will increase both national and international efficiency. Because
efficiency maximizes wealth creation, such policies could also be said to maximize social
welfare. To equate social welfare with aggregate social wealth, however, is to adopt only
one of a number of potential measures of social welfare. Even if one ignores measures of
welfare not related to wealth, the equation of social welfare with national wealth
overlooks distributive concerns. Indeed, efficiency-increasing measures such as
economic liberalization may exacerbate preexisting distributive inequalities. Classical
economic measures of efficiency and welfare are simply “indifferent to the distribution of
income and wealth.
The past months have exposed not simply credit market inefficiencies, but credit market
dysfunction of the highest order.
Notwithstanding the magnitude of the crisis, however, any regulatory proposals will be
greeted with resistance: a classic response to any new regulatory proposal is the cry of
“the sky is falling,” and in this context, the cry will be, “credit will dry up.” Studies have
demonstrated, however, that regulation does not always and necessarily have such
anticipated and predicted effects. For example, when the United States Court of Appeals
for the Fifth Circuit announced a new rule limiting the terms pursuant to which nonbankruptcy mortgage foreclosures would be allowable, immediate predictions that this
rule would shut down the consumer home mortgage market were made.
Pundits called for an emergency statutory amendment that would, in essence, repeal the
rule. In the interim, however, when there was no such repealing legislation, the market
adjusted and the home lending market, both pre- and post-rule, was unaffected.
The popular wisdom associated with the enactment of Sarbanes- Oxley Act provides a
more recent example of an overstated prediction of the impact of a regulatory scheme.
As noted in a recent article:
It has become received wisdom on Wall Street that the Sarbanes- Oxley Act has damaged
American competitiveness. It made listing in the American market less attractive to
foreign companies and drove initial public offerings overseas. It raised costs for
American companies without providing any significant benefit.
A new study, however, found that among the sample of foreign companies studied, the
wisdom that greater regulation adversely impacted a firm’s performance turned out to be
false: those firms with good growth prospects suffered a decline in stock price upon
leaving the American markets in an effort to avoid the reach of Sarbanes-Oxley.
Sarbanes-Oxley was enacted largely in response to a crisis of confidence in the public
markets. We are currently seeing a similar erosion of confidence in the credit markets at
every level. The financial markets’ imperfections have created rents that have been
captured by creditors and related parties at the expense of consumers. The shift of these
rents has adversely affected consumers’ market choices, as well as “economic
opportunities and the investments that maximize these opportunities.” Thwarted
opportunities and extreme imbalances in information and power destabilize the
legitimacy that a market-oriented system demands. Markets gain legitimacy from the
public’s trust, and when such trust is undermined, intervention becomes necessary.
Economic growth and profits drove the design of the financial system, and in light of the
markets’ externalities, limits on the design must be crafted.
As a threshold matter, a number of fundamental measures must be put in place to alter
the incentives driving the participants in the financial markets. Higher capital
requirements must be imposed upon banks, in light of the revealed inadequacy of the
levels currently required. Greater retained capital will go a long way toward ensuring
greater stability among lenders. Second, securitizing originators must be required to
retain a significant portion of the securities they originate. In this way, credit
underwriting risk is shared, and not simply transferred. Moreover, pricing models for
mortgage-backed securities must reflect the market reality that real estate values
cyclically fall—as well as rise. Disclosure and oversight of derivative transactions,
including credit default swaps, must be regulated under federal securities laws, not
simply by state law insurance statutes, if at all. Additionally, credit rating agencies’ role
in the markets must be dramatically re-imagined. With their “reputational capital”
dissipated, they must labor to regain their credibility by, at a minimum, erasing any
potential for the appearance of or actual conflicts of interest. Ultimately,
because the collapse of the financial markets has demonstrated that faulty and inadequate
pricing and risk assessment holds the potential for catastrophic and wide-ranging thirdparty effects, regulation must require that the transaction parties bear the financial
consequences for their misjudgment.
This pervasive misjudgment among the players in the borrowing- lending-sellinginvesting cycle has impacted consumers’ lives with the force of a hurricane.272 In the
absence of adequate income, assets, or public financial safety net to meet basic
needs, consumers have accessed the credit markets. While ensnared in the cycle of
indebtedness, many families have been forced into a position of further reliance upon
ever-more debt. At the point where a consumer’s liabilities eclipse his or her assets, the
indicators of upward class mobility—economic equilibrium and stability, the ability to
enhance human capital in order to specialize, the wherewithal to take risks and have a
positive vision of the future, as well as the capacity to offer future generations greater
opportunities—correspondingly disappear.
By sanctioning levels of indebtedness beyond consumers’ ability to repay, these policies
have shifted the risk of loss from the financial industry to the consumer. This risk shift
and corresponding losses have resulted in skewed allocations of social, economic, and
political power at the macro level and autonomy at the micro level.
Moreover, these losses have directly foreclosed many consumers’ opportunities for future
asset accumulation and wealth, thus making transformations difficult to effectuate and
sustain. It is the accumulation of assets—both intra and inter-generationally—that
results in fluid opportunity and class mobility. Furthermore:
[A]ssets have a variety of important social, psychological, and economic effects. Simply
put, people think and behave differently when they are accumulating assets, and the
world responds to them differently as well. More specifically, assets improve economic
stability; connect people with a viable, hopeful future; stimulate development of human
and other capital; enable people to focus and specialize; provide a foundation for risk
taking; yield personal, social, and political dividends; and enhance the welfare of
offspring.
At the most fundamental level, class positioning is reflective of wealth: “the inherited
accumulation of property, competencies, beliefs, tastes, and manners that determines, for
most of us, our socioeconomic lot and our share of civic power.” While wealth is keyed
to class position, “the distribution of opportunity follows that of wealth.” In
addition, “[w]hen too many economic resources are held by too few, when the benefits of
growth elude broad swaths of working families, opportunity itself becomes a rare
commodity, out of the reach of the majority. Too much inequality precludes a
meritocracy.”
The idea that America is a meritocracy lies at the foundation of our society. Inequality is
tolerated so long as hard work will result in the improvement of one’s location along
the class continuum.
Paradoxically, as citizens and consumers, we claim to believe in the importance of
opportunity and mobility, but at the same time we have acquiesced to the public and
private policies that have foreclosed them.
V. CONCLUSION
Over the past decades, consumer spending and corresponding indebtedness have
provided the central source of fuel for the country’s economic growth: as a collective
resource, consumers have been the chief target of exploitation by the providers of goods,
services, and credit.
The enormous investments made in the creation and
maintenance of the transformed consumer markets have driven this exploitation. As the
supporters of the policies behind the markets’ transformation began to affirmatively
recognize that high levels of consumer debt were necessary to sustain the markets’
unprecedented profitability, a relentless campaign was waged to convince, cajole, and
coerce consumers to build their lives around consumption through the routine use of
credit. The hegemony of the markets has proven to be a powerful force, inexorably
altering cultural norms, consumer behaviors, and attitudes toward debt.
The forces that have created this condition must be acknowledged before steps can be
taken to address them. If these policies and their impact on class mobility are not
acknowledged, they cannot be discussed. If these issues are not discussed, the larger
forces that have created the current debt crisis will not be identified or acknowledged
And naïve, confined, palliative and ineffectual solutions will be the only one offered.
Only when we see the connection between the myth of classlessness and the privilege
enjoyed by those with social, economic, and political power can we begin to
systematically address the major spheres.
Sociology of the Credit Card:
Private Troubles and
Public Issues
By Ritzer
A SOCIOLOGY OF CREDIT CARDS
Sociology in general, and sociological theory in particular, offers a number of ways of
dealing with the credit card industry and the individuals affected by it. Throughout much
of the 20th century sociological theory has been divided between macro theories (such as
structural functionalism and con¬flict theory) that would be most useful in analyzing the
credit card industry itself and micro theories (such as symbolic interactionism and
phenomenological sociology) that would be most helpful in analyzing individuals within
our consumer society. However, sociological theory has generally been plagued by an
inability to deal in a fully adequate manner with micro-macro relationships, such as the
relationships between the credit card industry and individuals. Sociologists have grown
increasingly dissatisfied with having to choose between large-scale, macroscopic theories
and small-scale, microscopic theories. Thus, there has been a growing interest in theories
that integrate micro and macro concerns. In Europe, expanding interest in what is known
there as agency-structure integration parallels the increasing American preoccupation
with micro-macro integration.
Mills: Personal Troubles, Public Issues
This new theoretical approach has important implications for the study of sociological
issues in general – and in particular for the kinds of social problems discussed in this
book.27 Micro-macro integration leads the sociological study of social problems28 back
to one of its roots in the work of the American social critic and theorist C. Wright Mills
(1916–1962).
Mills is important to us here for two reasons. First, in 1953 Mills coauthored, with Hans
Gerth, a now almost-forgotten theory of micro-macro integration: Character and Social
Structure. As the title suggests, the authors were interested in the relationship between
micro-level character and macro-level social structure. According to Gerth and Mills, one
of their goals was “to link the private and the public, the innermost acts of the individual
with the widest kinds of socio-historical phenomena. Thus, their thinking is in line with
the most recent developments in sociological theory.
Of more direct importance here is the now-famous distinction made by Mills in his 1959
work, The Sociological Imagination, between micro-level personal troubles and macrolevel public issues Personal troubles tend to be problems that affect an individual and
those immediately around him or her. For example, a father who commits incest with his
daughter is creating personal troubles for the daughter, other members of the family, and
perhaps himself. However, that single father’s actions are not going to create a public
issue that is, they are not likely to lead to a public outcry that society ought to abandon
the family as a social institution. Public issues, in comparison, tend to be problems that
affect large numbers of people and perhaps society as a whole. The disintegration of the
nuclear family would be such a public issue.
What, then, is the relationship between these two sets of distinctions—personal
troubles/public issues and character/social structure—derived from the work of C. Wright
Mills? The character of an individual can certainly cause personal troubles. For example,
a psychotic individual can cause problems for himself and those immediately around him.
When many individuals have the same character disorder (psychosis, for example), they
can cause problems for the larger social structure (overtax the mental health system),
thereby creating a public issue. The structure of society can also cause personal troubles
for the individual. An example might be a person’s depression resulting from the
disjunction between the culturally instilled desire for economic success and the scarcity
of well-paying jobs. And the structure of society can create public issues, as exemplified
by the tendency of the capitalist economy to generate periodic recessions and
depressions. All these connections and, more generally, a wide array of macro-micro
relationships are possible. However, the focus of this book is the credit card industry as
an element of social structure and the way it generates both personal troubles and public
issues.
A useful parallel can be drawn between the credit card and cigarette industries. The
practices of the cigarette industry create a variety of personal troubles, especially illness
and early death. Furthermore, those practices have created a number of public issues (the
cost to society of death and illness traceable to cigarette smoke), and thus many people
have come to see cigarette industry practices themselves as public issues. Examples of
industry practices that have become public issues are the aggressive marketing of
cigarettes overseas, where restrictions on such marketing are limited or nonexistent, as
well as the marketing of cigarettes to young people in this country (for example, through
advertisements featuring the controversial “Joe Camel”). Similarly, the practices of the
credit card industry help to create personal problems (such as indebtedness) and public
issues (such as the relatively low national savings rate). Furthermore, some industry
practices—such as the aggressive marketing of credit cards to teenagers—have
themselves become public issues.
One of the premises of this book is that we need to begin adopting the same kind of
critical outlook toward the credit-card industry that we use in scrutinizing the cigarette
industry. Interestingly, Galanoy has suggested a warning label for credit cards, like the
ones found on cigarette packets:
Caution. Financial experts have determined that continued bank card use can lead to debt,
loss of property, bankruptcy plus unhealthful efforts on long-lived standards ad virtues.33
Mills’s ideas give us remarkably contemporary theoretical tools for understanding a
critical analysis of the credit card industry and the problems it generates. His conception
of the relationship between personal troubles and public issues is the major (although not
the only) theory undergirding this book.
Marx: Capitalist Exploitation
In addition to adopting Mills’s general approach, I will draw on several other
important theoretical sources to deal with more specific aspects of the relationship
between people and the credit card industry. One is the work of the German social
theorist Karl Marx (1818-1881), especially his ideas on the exploitation that he saw as
endemic to capitalist society. To Marx, this exploitation takes place in the labor market
and the workplace, where capitalistic firms exploit their workers by paying them far less
in wages than the value of what they produce. In Mills’ terms, Marx believe that
capitalistic firms create personal troubles for workers by exploiting them so greatly, and
the impoverished state of the workers eventually becomes such an important public issue
that the workers are likely to rise, up and overthrow the capitalist system and replace it
with a communist system.
Mills was in fact one of the first major American sociologists to be drawn in the
direction of Marxian theory. However; time has not been kind to Marxian theory, and
many of Marx’s predictions have not come to pass. There have been many changes in the
capitalist system, and a variety of issues have come to the fore that did not exist in
Marx’s day. As a result, a variety of neo-Marxian memories have arisen to deal with
these new capitalist realities. One that concerns us here is the increasing importance to
capitalists of the market for goods and services. According to neo-Marxian’s exploitation
of the worker continues in the labor market, but capitalists also devote increasing
attention to getting consumers to buy more goods and services. Higher, profits can come
from both cutting costs and selling more products.
The credit card industry plays a role by encouraging consumers to spend more money, in
many cases, far beyond their available cash, on the capitalists’ goods, and services. In a
sense, the credit card companies have helped medalists to exploit consumers. Indeed, one
could argue that modern capitalism has come to depend on a high level of consumer
indebtedness. Capitalism could have progressed, only so far by extracting cash from the
consumers. It had to find a way to go further.
Capitalists’ reliance on widespread consumer credit parallels early capitalists’
exploitation of the labor market. In an effort to in increase profits, they sought to
progressively lengthen the workday in order to exploit more of the laborer’s time and
effort. When they had pushed the workday to unconscionable lengths, the government
was forced to intervene by restricting work hours. The capitalists then sought new ways
to exploit workers, and they eventually did so with technological advances that allowed
workers to produce more in less time. When capitalists reached a point of diminishing
returns in their efforts to squeeze more out of workers for less, they turned their attention
to consumers. With the aid of the credit card industry as well as advertising and
marketing industries, they eventually discovered new ways of acquiring more of the
consumer economic resources, even resources the consumers did not yet have.
Simmel: The Money Economy
A second German social theorist, Georg Simmel (1858-1918), can also help us
understand the personal troubles created by credit cards. Writing more than 40 years
before the invention of the credit card, Simmel focused (as mentioned earlier in this
chapter) on money, but much of what he had to say about the money, economy and the
personal troubles it creates are of help to us in understanding the modern world of credit
cards.35 Simmel pointed to many problems associated with a money economy, but here
of special concern in this book.
•
The first problem, similar to one discussed in Marxian theory, is the “temptation
to imprudence" associated with a money economy. Simmel argued that money in
comparison to its predecessors, such as barter, tends to tempt people into spending more
and going into debt. My view is that credit cards are even more likely than money to
make people imprudent. People using credit cards are not only likely to spend more but
are also more likely to go deeply into debt. Thus, Simmel’s work, like Marx’s leads us to
a concern with the way in which the credit card industry creates personal troubles of
overspending and indebtedness.
•
Second, Simmel believed that money makes possible many types of "mean
machinations" that were not possible, or were more difficult, in earlier economies. For
example, bribes for political influence or payments for assassinations are more easily
made with money than with barter. Clearly, bribery and assassination are public issues
but they also cause personal troubles for large numbers of people. Although bribes or
"assassinations are generally less likely to be paid for with a credit card than with cash,
other types of mean machinations become more likely with credit cards. For example,
some organizations associated with the credit card industry engage in fraudulent or
deceptive practices in order to maximize their income from credit card users. Again, such
practices are clearly public issues (or at least they should be) that cause personal troubles
for the many victims.
•
The third problem with a money economy that concerned Simmel was the issue of
secrecy, especially the fact that a money economy makes payments of bribes and other
types of secret, transactions more possible. However, our main concern in this book is the
increasing lack of secrecy and the invasion of privacy associated with the growth of the
credit card industry. That industry, as well as other entities within society have been able
to collect vast amounts of very personal information on millions of citizens. The
existence of that information, and the ability of various agents to access some or all of it,
is a major public issue. They way that information has been used has also created
personal troubles for many individuals.
Weber: Rationalization
The next issue of concern has to do with the "rationalization" of society and its
relationship to creditcards. Although Simmel wrote on rationalization, the premier
theorist on the rationalization process was the German sociologist and economist Max
Weber (1864-1920). Weber defined rationalization as the process by which the modern
world has come to be increasingly dominated by structures devoted to efficiency,
predictability, calculability, and technological control Those rational structures (for
example, the capitalist marketplace and the bureaucracy) have had a progressively
negative effect on individuals. Weber described a process by which more and more of us
would come to be locked in an “iron cage of rationalization.” This public issue can be
seen as creating a variety of personal troubles, especially the dehumanization of daily
life. For example, Weber saw the bureaucrat as becoming a little more than a faceless
cog in a bureaucratic machine. The credit card industry has also been an integral part of
the rationalization process. By rationalizing the process by which consumer loans are
made, the credit card industry has contributed to our society’s dehumanization.
Interestingly, one school of neo-Marxian theory, critical theory, has brought
together ideas from both Marx and Weber that are relevant to this analysis of the credit
card industry. While building on Mark’s concern with the economy, the critical school
focuses on culture. Mass culture is seen as pacifying and stupefying. It could be argued
that the consumer culture that credit cards help foster has such effects on people by
helping to keep them immersed in the endless and mindless pursuit of goods and services.
The critical school also disparages the rationalization process—especially the tendency to
engage in technocratic thinking, in which the focus is merely the discovery of the
optimum means to ends that are defined by those in control of the larger society. The
credit card can be seen as a product of such thinking. Because it works so well as a
means, people are discouraged from reflecting on the value of the ends (the goods and
services of a consumer society), critically analyzing those ends, and finding alternatives
to them.
Globalization and Americanization
A sociology of credit cards requires a look at the relationship among the credit
card industry, personal troubles, and public issues on a global scale. It is not just the
United States, but also much of the rest of the world, that is being affected by the credit
card industry and the social problems it helps create. To some degree, this development
is a result of globalization, a process that is at least partially autonomous of any single
nation and that involves a reciprocal impact of many economies.In the main, however,
American credit card companies dominate the global market. Thus, in this book I will
deal with the spread of the credit card industry around the world under the heading of
Americanization rather than globalization. For this issue, instead of drawing on the ideas
of long-dead thinkers like Mills, Marx, Simmel, and Weber, I will rely on more
contemporary work.
The central point is that, in many countries around the world, Americanization is
a public issue that is causing personal troubles for their citizens. This book addresses the
role played by the credit card industry in this process of Americanization and in the
homogenization of life around the world, with the attendant loss of cultural and
individual differences.
Micro-Macro Relationships
The various theoretical resources underpinning this book are all brought to bear
on a central issue in the sociological study of a particular social problem: personal
troubles, public issues, and the burgeoning credit card industry. Along the way, I will
have a number of things to say about responses to these problems—which brings us back
to the theory of micro-macro relationships. Although the book’s focus is the way the
macro-level credit card industry creates a variety of public issues and personal troubles, it
is important to realize that people, at the micro level, create and re-create that industry by
their actions. Not only did people create the industry historically, but they help to recreate it daily by acting in accord with its demands and expectations. However, people
also have the capacity to refuse to conform to the demands of the credit card industry. If
they were to do so on a reasonably large scale, the industry would be forced to alter the
way it operates. People can also be more proactive in their effects to change the credit
card industry.
However, there are limits to what individuals, even when acting in concert, can do
about macro-level problems. In many cases, macro-level problems require macro-level
solutions. Thus, I will also deal with actions that the credit card industry, as well as the
government, can take to deal with the public issues and personal trouble s discussed
throughout this book. The theoretical approach underlying this analysis allows us to
understand both the adverse effects of the credit card industry and the steps that people
and larger social structures can take to ameliorate or eliminate them.
OTHER REASONS FOR DEVOTING A BOOK
TO CREDIT CARDS
Although problems associated with the credit card society are the major focus of
this book, there are several other reasons credit cards are worthy of such extensive
treatment. First, credit cards represent something new in the history of money. In fact, as
I will discuss below, they might not even be subsumable under the heading of money.
Second, since they burst on the American scene in mid-century, credit cards have
experienced enormous growth, both in this country and around the world. Anything that
has grown so rapidly and has become so ubiquitous, demands attention. Third, credit
cards are not only of monumental material significance but are also of great cultural, or
symbolic, importance. As a well-known motivational researcher put it, “a credit card is a
symbol of this age.”
Please read :
Race, Power and the Subprime Foreclosure Crisis: a Mesoanalysis
http://www.levyinstitute.org/pubs/wp_669.pdf
Chapter 12
Behavioral Economics
In order to develop a system of rational regulation of consumer lending and consumer
borrowing it is essential to understand whether consumers might borrow when that
borrowing is reasonably likely to be to their detriment. If that is the case then it is also
essential to understand why consumers might make decisions that are reasonable likely to
cause them damage. This field of study is roughly called behavioral economics.
Historically, economists have based their theories of consumer borrowing behavior
on the fact that consumers are rational actors. Under this assumption the only reason that
people would make unwise borrowing decisions is that they lack the knowledge or
information necessary to make a wise decision. In a few chapters we will look at various
financial literacy efforts and at laws that require disclosure about borrowing transaction.
Such efforts seek to address this weak spot in consumer decision- making.
More recently, the field of economic psychology in Europe and behavioral economics in
the US has begun examining other reasons that consumers might make borrowing
decision that seem not to be objectively in their interests.
In this chapter we endeavor to consider the following Discussion Questions:
What are some of the human characteristics that lead people to borrow unwisely, to their
detriment?
How might a society choose to remedy this situation?
What is the role of faulty perceptions, undue optimism and hyperbolic discounting?
Regarding hyperbolic discounting read:
http://economics.mit.edu/files/328
What is the downside of or objection to protecting the consumer who is likely to make a
mistake from making such a mistake?
Are these objections philosophical, or practical or financial or ???
Why is behavioral economics important to understand in the formulation of public policy
regarding consumer credit?
Is this unique to the USA?
Are the answers different in Germany? In Canada?
Is it unique to the 21st century?
What is the public policy question?
Whom to protect? i.e keeping the problem gambler out of the casino?
How much to regulate?
Whether to use soft paternalism?
Please read one of the following articles:
A.
Classical: The Neo Classical Economics of Consumer Contracts by Richard
Epstein http://papers.ssrn.com/so13/papers.cfm?abstract_id=982527
B.
Predatory Plastic by Oren Bar Gill- excerpts follow
C.
After the Great Recession: Regulating Financial Services for Low and Middle
Income Communities by Ronald Mann
http://scholarlycommons.law.wlu.edu/cgi/viewcontent.cgi?article=4275&context=wlulr
D.
Sunstein http://papers.ssrn.com/so13/papers.cfm?abstract_id=2182619
EXCERPTS FROM BAR GILL ARTICLE TO FOLLOW
Chapter 13
Introduction to the regulation of Consumer Credit; Disclosure Requirements, Financial Literacy
Education, and who counsels the borrower that is in financial distress.
We began our study with the history of consumer finance in the U.S. and the peculiar nuances of various
types of consumer borrowing and lending. We moved for last three chapters to the world of social
science as we analyzed the economic and sociological impacts of the considerable increases in the
amount of consumer lending and consumer borrowing in the late twentieth and early twenty first
centuries, and we have looked at how and why American consumers borrow as they do. We have also
looked at the pressure to lend that may inflame the situation. Now, with all that in mind, we are ready
to decide how much regulation we think this world cries out for and what types.
A.
Cultural of Borrowing / Purchasing
Remember the introductory readings from Schor, Warren and Caldor. The essential notion is that
before we can decide how much and what kinds of regulations will be optimal for a particular country
we need to understand the borrowing behaviors of folks in that country. There are at least two basic
reasons to regulate consumer borrowing/lending. The first worry is that if it is unregulated it will lead to
frequent economic crashes which will cause massive damage. Hyman Minsky asserts that overspending
by consumers will inevitably lead to an economic crash when the bubble bursts. Is this every eighty
years (1929 -2005) or every fifty years or every decade?
The second worry is micro rather than macro; unless we regulate, individual citizens will make decisions
which will cause each of them harm. In a society where neither of those harms is likely to occur, then
the need for regulation is reduced. If we conclude that consumer behavior is likely to lead to both of
these results then the need for such regulation is heightened.
Once we decide on the level of regulation we need to decide what kind. For example, if we think
consumers will act in their interests if they understand financial decision making and the essence of the
specific borrowing transaction then we might increase the level of financial literacy education and the
amount of disclosure requirements.
If we think the problem is not one that can be ameliorated by disclosure or education then we might
need to prohibit certain kinds of credit offerings such as payday loans or invoke doctrines such as the
denying enforcement of credit transactions where the consumer should not have been eligible for the
credit extension or limit costs or fees for various kinds of credit offerings. If we think that the source of
the problem is too much investment capital chasing above market returns we might consider regulating
investment vehicles such as securitization.
So, the first item on our survey might be aimed at evaluating the proclivity of consumers in that country
to borrow beyond their ability to repay or to use a dangerous borrowing product. We might inquire
about the following topics:
Degree of Financial Literacy;
Vulnerability to Peer pressure ;
Extent of Undue optimism;
Extent of Hyperbolic discounting; and
Extent of income and asset disparity
You will recall the distinctions drawn by behavioral economists between soft paternalism and hard
paternalism; in this chapter we will look at three areas of “soft” paternalism, disclosure, financial literacy
education, and counseling. We begin with disclosure.
B. Disclosure Study Questions
How does disclosure fit in?
What problem is it intended to help with?
Why should we require disclosure?
What value might it have?
How will we know if it is working?
What have we tried?
Is the goal attainable?
Is the ultimate decision to which the disclosure is aimed:
(1)
to borrow or not to borrow; or
(2)
is this the appropriate borrowing vehicle or lender once I decide to borrow?
What is the optimal method of enforcing effective disclosure?
To whom does the creditor owe a duty?
What is the creditors' likely response to disclosure measures?
If we cannot meaningfully disclose what should we do?
Ban the product??
Penalize the Lender?
What are the benefits and dangers of prohibiting or discouraging transactions that are “too” complex?
What is soft paternalism?
Is it possible to provide meaningful disclosure to consumers?
C. A bit of history
In 1960 Senator Paul Douglas of Illinois introduced a "truth in interest" bill designed to provide
consumers with accurate information about the interest charged by various lending institutions. In most
instances, borrowers did not know the total cost of receiving loans, and in many cases this ignorance
resulted from the widespread use of deceptive methods of reporting interest rates and the price of
credit. Often the practice of quoting monthly interest rates rather than annual percentages misled
debtors; at other times, lenders quoted loans as "so much down and so much per month" but never
revealed the actual interest rate. Unscrupulous lenders employed a host of other tactics to mislead
potential customers. Douglas's bill stipulated that lenders provide all borrowers with two basic facts: the
total charges for the cost of money being lent and an expression of these charges as an annual interest
rate on the unpaid balance of the loan.
Douglas's bill received the avid support of labor unions, credit unions, and other consumer groups, but
met vigorous opposition from banks and other lending institutions. He emphasized that his disclosure
bill would not regulate credit or impose any ceilings on interest rates but only sought to provide
consumers with full and accurate information so that they could make informed choices. Nevertheless,
critics charged that such disclosure would confuse the public and saddle purveyors of credit with
needless costs. Douglas labored unsuccessfully for truth in lending legislation for the remainder of his
senatorial career, attracting increasing support but never amassing the necessary votes for passage of a
bill which was stalled in the Banking Committee by chairman A Willis Robertson (D.Va. ) father of Pat
Robertson. In 1967, the year AFTER Senator Douglas left the Senate and the year after Sen. Robertson
lost his primary, the legislative logjam broke, and Wisconsin Senator William Proxmire's truth-in-lending
bill passed. When President Johnson signed the measure, Proxmire attributed the achievement to the
indefatigable efforts of Paul Douglas.
In the 1970’s the Truth in Lending Act was a powerful tool for consumers and their advocates. As
financial transactions have become more complex and as the statute and regulations have been
amended it has become less effective as a weapon and more difficult intellectually to develop the right
mix of information and clarity.
D. Before we look at the present or the future let’s look at the past.
Here are two looks by authors who write from the creditors’ point of view.
Truth in Lending Simplification (described in an article in 1981)
By TIMOTHY D. MARRINAN* and PETER D. SCHELLIE**
37 Bus. Law. [ix] (1981-1982) page 1297
Date:
IX. THE FUTURE OF CREDIT COST DISCLOSURES
A. Immediate Future
There are two activities under way right now, one legislative and one regulatory,
that will affect the Simplification Act. The first involves legislation introduced by
Senator Jake Garn to make four amendments to the Truth in Lending Act. The four
amendments contain changes that would cut down on civil liability in cases involving
nonsubstantial violations, absolving creditor of statutory damage liability, and that would
remove the minimum recovery in truth in lending cases. The pending legislation would
amend the law by removing arrangers of credit altogether from coverage under the Truth
in Lending Act. It would clarify the relationship between state and federal law, and
generally, would displace all similar state laws subject to an override. And, finally, it
would defer the effective date until October 1, 1982.
At the regulatory level, the Federal Reserve Board is also looking at the question
of the arranger of credit definition. Its response, at least as contained in its proposal, was
not to exempt altogether arrangers of credit who have been brought in under the new lawreal estate brokers being the largest category of affected persons-but rather to clarify
when these people are involved in arranging credit. The proposal did, however, contain a
request for comments
on the alternative of exclusion as well.
B. Near Future
It seems very likely that at the congressional level we're not going to see very
much activity very soon. Congress has worked on the Truth in Lending Act for almost
five years, and has worked through the issue very carefully. Now, despite the fact that
some, including Senator Garn, have an earnest belief that the current law does not serve
the consumer simply because it delivers too much information, Congress seems to be
ready to leave the Act alone.
Mention was made earlier of the information overload concept that seemed to
undergird the whole simplification effort. The term information overload is not
intuitively clear, and there remains a great lack of information about the concept. Indeed,
the only testimony that has been presented on it was presented by one witness who talked
about labelling canned goods. That was the extent of the information overload data
presented to Congress that helped
to lead to the Simplification Act. So the pieces of information, the data that have been
compiled, are simply not very adequate to make further changes unless there's a quantum
leap in what is known about human reaction to information. Midterm changes or
corrections will most likely not be made by Congress, other than possibly some very fine
tuning.
By the same token, the Federal Reserve Board is in a wait-and-see position. It is
waiting to see what kind of problems will arise-how many problems will be legitimate
problems with which it must deal-before it revises the Official Staff Commentary. The
Federal Reserve Board has announced that it's going to follow a new course in providing
guidance with respect to requirements under the Truth in Lending Act. Instead of issuing
interpretations, it will periodically revise the commentary, which will provide all of the
interpretations in one place. Presumably, the timing of those updates will be responsive
to the volume and nature of problems that come up both in the creditor community and in
the courts as the Simplification Act is implemented in day-to-day activities.
C. Long Term
In the 1980s, generally, consumer credit cost disclosure will most likely continue
to play a critically important role, and, with the possible exception of discovering that far
too much information is being provided, disclosure will probably continue in a form very
similar to what exists now.
It is interesting to note that in terms of credit cost disclosures, the deregulation
dynamic cuts both ways. There is increasing sentiment and widening support for
deregulation. On the other hand, there is a parallel movement that involves ensuring that
the market is in a position to regulate itself after the government's influence has been
displaced. In the credit area, traditionally, that goal of market regulation has been
thought of as being achievable only if consumers have information-meaningful, useful,
comparable information-that they can use in making judgments that will assure that the
market works efficiently. So for disclosure issues in the credit area, at least, deregulation
will mean different things to different people. If the industry is saying to government,
"Let the market operate," a legitimate response that one can expect to hear is, "The
market can't operate unless consumers are provided with information that's good enough
to allow it to operate efficiently."
At the same time, activity will continue on the part of both major constituencies
on consumer credit cost matters. Both of the constituencies, consumer groups and
creditor groups, see pros and cons in the role of credit cost disclosure.
The sentiment in the credit industry against cost disclosure is based on real
skepticism as to whether it is effective, whether it does any good, and whether the benefit
derived is worth the cost. In effect, the time and expense of making these comprehensive
disclosures are being questioned in the face of the results. The consumer group is
concerned about whether those who are in most need of assistance in credit transactions
are able to understand and use the disclosures that they do receive. This has come out
recently in connection with
the discussion of overriding state usury ceilings. To an industry argument that the Truth
in Lending Act will prevent abuses if there are no usury ceilings, consumer groups have
countered that this is not so because a large portion of the consumer market cannot, will
not, or does not use the disclosure information available. Therefore, disclosure is an
ineffective method of consumer protection, at least as to some segments of the consuming
public.
There are, however, people from both of those credit constituencies who actively
support disclosure. Industry groups have supported it in many cases since it was deemed
to be a desirable alternative to substantive regulation. In some cases the argument has
been, "Allow us to undertake a specified practice but make us disclose it fully." A recent
example is the Comptroller of the Currency's adjustable rate mortgage regulation in
which not consumer lenders but mortgage lenders went to the comptroller's office and
said, "We'll
disclose anything, just give us freedom and flexibility in fashioning our variable rate
mortgage programs." The response in large part was, "All right, we will permit that." So,
in that respect, the industry has used disclosure as a bargaining tool to avoid substantive
regulation.
By the same token, of course, consumer groups generally have been supportive of
disclosure because it does produce desirable results, at least to some extent. Again one
must return to the question whether a large number of people have to use disclosure in
credit shopping in order for it to influence market behavior. The answer to that is
probably no. It seems likely that the creditor community can be effectively influenced by
only a small segment of its target market in pricing and setting those decisions, and
doesn't require 100% market awareness in order to influence market behavior.
Those are the factors that are going to affect both the legislative and regulatory
processes. But there is a third element and that is the litigation aspect. Again, it's
difficult to judge how this litigation context will be affected by the Simplification Act.
The narrowing of the statutory damage liability in closed-end credit and the simplified
approach that has been reflected through the revised regulation and the final commentary
will mean that there will not be the same magnitude of litigation in the future as in the
past. Most
assuredly, if legislation is passed doing away with the driving force for lawsuits, that is,
a minimum guaranteed recovery and the concept of technical violations giving rise to that
recovery, there will be even less. But the net result will be that there won't be the same
kind of extensive litigation that we have had under the original act.
CONSUMER DISCLOSURE IN THE 1990s
Griffith L. Garwood, Robert J. Hobbs, and Fred H. Miller
Georgia State University Law Review June 1, 1993
Vol 9 page 777
INTRODUCTION
Disclosure has long been a cornerstone of consumer protection. Disclosure is an
important component-and even the primary purpose-of numerous federal laws, including
the Truth in Lending (TIL), Truth in Savings, Equal Credit Opportunity, Fair Credit
Billing, Consumer Leasing, Fair Debt Collection Practices, Electronic Fund Transfers,
and Magnuson-Moss Acts and the Federal Trade Commission's Holder in Due Course,
Door to Door Solicitation, and Credit Practices Rules. Disclosure is also a feature of
state consumer protection laws, although these laws more and more tend not to overlap
the federal enactments, and instead focus on substantive regulation such as deceptive
practices, the regulation of interest and charges, and matters of that sort.
Although disclosure is by now a well established concept,
debate continues whether the concept is working in all contexts,
and whether the benefits of disclosure always outweigh the societal costs. This Article
reviews the perceived successes and the difficulties of disclosure. It attempts to identify
lessons that may be learned from looking at disclosure patterns, and to discern future
trends and directions for disclosure requirements.
I. CONTEXTS FOR AND TYPES OF CONSUMER DISCLOSURES
Disclosure as a consumer protection device is employed in many contexts, sometimes
with different objectives. To illustrate, disclosure may be directed at the general public
with the goal of facilitating individual decision making, or it may be designed to generate
general public discussion to formulate policy. Obvious examples are the regulation of
credit and demand and interest bearing account solicitation advertising, intended to help
the public at large with individual shopping decisions, and the statistical data on lending
activity required by the Home Mortgage Disclosure Act directed at letting a community
assess the performance of an institution in generally serving that community.1 A more
modest aim is disclosure that targets specific groups of individuals. An example is
disclosure with respect to credit and charge card solicitations and applications, where
those who have been selected for solicitation by the card issuer are provided specific
information.2 Disclosures may be focused more directly at persons already expressing
interest in a product. An illustration is the home equity line application disclosures,
where disclosures must be given with the application.3 The narrowest context is the
requirement that new customers be afforded disclosure in connection with, for example,
the installment sale or loan contract or note and mortgage they are signing or a schedule
of fees and charges, interest rates, and terms of a new account they are opening.4
Not all disclosures are directed at potential or new customers. For example, existing
customers are afforded disclosure on or with the periodic statement in open end credit
and with respect to their asset accounts.5 Even former customers may be due disclosure;
for example, they may be provided an "adverse action" notice under laws protecting
against credit discrimination when accounts are terminated.6
Within the above contexts, the types of mandated disclosures may also vary. For
example, some disclosures are quite general in describing a product. An illustration is the
pamphlet required for home equity lines which discusses the general characteristics of
home equity loans rather than any individual plan.7 A somewhat more specific type of
disclosure, that still is not transaction specific, is the preprinted early adjustable rate
mortgage (ARM) disclosure where the disclosure is related to the specific type of ARM
of interest to the borrower.8 At the other end of the spectrum are the very specific
disclosures required on open end monthly statements9 and in automatic teller machine
(ATM) receipts that reflect individual account activity.10
Other types of disclosures are general in nature, but focus to a degree on general policies
or terms, as well as on specific product information-for example, the initial disclosure in
connection with an electronic fund transfer service.11 Most disclosures must be prepared
for the consumer.12 A few disclosures, however, really are instructions on how to
prepare the information yourself. For example, the ARM disclosures must contain an
example of the calculations for a sample $10,000 loan with instructions for the user on
how to calculate a possible worst case scenario for an individual loan.13 One constant,
nonetheless, is the complexity of the rules that cover these diverse examples. To make
the point, Truth in Lending alone, as embodied in
Regulation Z and its staff commentary, contains some 125,000 words.
II. BASIC OBSERVATIONS ABOUT THE DISCLOSURE APPROACH
Notwithstanding the diversity of consumer disclosures and the complexity of the rules,
some basic observations seem possible as to why disclosure has long been, and is likely
to continue to be, a fundamental consumer protection device. We can also identify some
prerequisites to effective disclosure.
A Policies Behind Disclosure
All mandated disclosure in whatever context and of whatever type in the consumer
financial services provider-consumer relationship reflects two ideas that seem well
accepted. First, it recognizes that consumers are less knowledgeable than is the provider
about possible or existing terms of the relationship. The disclosure approach is based on
the assumption that if appropriate information is provided, the consumer may use the
information to avoid deleterious, uninformed, or unwise action, and to obtain better
terms-thus making best use of the market mechanism.14 Both those who see disclosure as
necessary to protect the consumer and those who see information as necessary to protect
the functioning of the market are likely to support the concept.
B. Disclosure as an Alternative
Second, in the United States, disclosure as a consumer protection device is seen as
consistent with our form of government, which is premised on an informed electorate.
Thus disclosure serves as an attractive alternative to the substantive regulation of
agreements and conduct as a method of achieving a balanced relationship between the
service provider and the consumer. Consumer agreements normally are forms prepared
by the service provider, and thus initially favor that party; the forms are often couched in
legal language, absent "plain English" laws. They are often of considerable length.
Normal legal principles favor allowing rules and standards to be set by the agreement of
the parties rather than by regulation. But, if strictly adhered to, this may allow the
provider to prevail unless the consumer reviews and understands the contract before
signing. This is impractical. Disclosure can highlight the important terms and present
them in intelligible language so that the consumer may quickly understand and bargain
for a more balanced relationship-at least in theory. More realistically, the consumer can
at least avoid an imbalanced relationship by choosing not to consummate the deal on the
basis of the disclosures.
Advance disclosure before the transaction is finalized allows the consumer to shop for
advantageous terms and, because it fosters competition, facilitates market regulation of
terms. This lessens the need to regulate agreements and practices by law. Evidence of
effectiveness of disclosure acting as a market regulator exists, for example, in the Federal
Reserve Board's Annual Percentage Rate Demonstration Project (1987), which tested the
effect of publication of "shoppers guides" listing creditors' annual percentage rates. The
Board found that the dispersion of interest rates declined in the markets with guides, as to
some extent did their average level. Some evidence for this idea also exists in the
legislative history of the Fair Credit and Charge Card Disclosure Act.15 The Act requires
more information to be provided with credit card solicitations based in part on concerns
about the level of credit card interest rates. Its proponents thought that better information
would help drive down rates. The Act was supported by many persons as an alternative
to federal rate regulation. Finally, one response to the disclosure requirements of
Regulation CC16 may also make the point. Many institutions have chosen to provide
prompt availability of funds with limited exceptions, rather than utilizing the more
extensive exceptions allowed by the funds availability law.17
C. Prerequisites for Effective Disclosure
A third observation is that, for any type of disclosure to serve its purpose, certain
prerequisites must exist. These prerequisites include appropriate timing. Thus,
disclosure generally should come at a time to permit the utilization of alternative sources
to obtain the consumer financial services sought. A successful example of this concept in
present law is the "advance" disclosure for closed-end residential mortgage transactions
subject to the Real Estate Settlement Procedures Act and for ARMs where disclosure
must be provided within three days of receipt of an application.18 This disclosure is
obviously more beneficial than the "contract" disclosure permitted for other closed-end
transactions where disclosure typically comes at closing.
Another prerequisite of effective disclosure is that it must be uniform and clear.
Generally this suggests the need for specified terminology or format to aid comparison.
It also requires a format that distinguishes the disclosures from other material, facilitating
consumer understanding of the disclosures. illustrations of these propositions include the
required Truth in Lending terminology and the Federal Trade Commission Rule on
Preservation of Consumers' Claims and Defenses,21 which requires specific terminology
and type standards for a mandated notice. The rules concerning funds availability are
also an example in requiring disclosures to be grouped together, unrelated information to
be excluded, disclosures to be highlighted when they appear in another document, and
certain phrases to be used.22 Of course, not all disclosure rules are so specific. Certain
Truth in Lending disclosure rules in open end credit do not require segregation,23 a
particular location or type size,24 or uniform terminology (except as between initial and
periodic disclosure).
An additional prerequisite of effective disclosure is that it
should avoid "information overload." Generally, to be effective, disclosures must be brief
and simple enough to be readily assimilated. This means that certain details must be
omitted. The failure to meet this prerequisite risks destroying the utility
of disclosure. A disclosure that is not read at all or is too complex for practical use is no
disclosure. Thus, sometimes summary disclosure rather than detailed descriptions are
best. An illustration of this concept is the initial disclosure in relation to acquiring an
electronic fund transfer service,26 where only a summary of information is required-such
as a summary of the consumer's liability for unauthorized electronic funds transfers, the
financial institution's liability for certain failures, and so on. Another illustration is the
disclosure concerning the reasons for adverse action taken on credit transactions required
under the Equal Credit Opportunity Act.27 While creditors must give the principal
reasons, the staff commentary to Regulation B suggests that giving more than four
reasons is not likely to be helpful to applicants.28 The commentary further takes the
position that a creditor need not explain how or why a factor adversely affected an
applicant.29 A final example is rebate disclosure. Under Truth in Lending, a disclosure
is required of whether or not the consumer is entitled to a rebate of any finance charge
upon prepayment, but not a description of the method of computing the earned or
unearned finance charge, which would be unduly complicated.
D. Myths
A final general observation that may be made is that the rhetoric about disclosure often is
at least part myth. For example, it is commonly proclaimed that disclosure laws are not
substantive limitations and that disclosures don't change products. While this often is
accurate, it is not invariably true. Increasingly, disclosure laws and disclosure formulate
substantive rules. Two illustrations will suffice: (1) the home equity disclosure law in
fact contained numerous limitations on contractual terms for home equity lines,31 and (2)
the necessity to give detailed ARM disclosures for each variable rate mortgage program
offered32 has undoubtedly limited product variation and offerings.
Another assumption is that we can identify the truth and fully disclose it. Alfred North
Whitehead once said that all truths are only half truths. He reasoned that trying to treat
half truths as whole truths causes our problems. Many of the problems labored over in
the discussions of truth in lending "simplification" reflect this phenomenon.33 In actual
fact, Congress and the Federal Reserve Board have picked certain standards and levels of
disclosure, which, although nominally referred to as representing the "truth" and "full
disclosure," in fact represent neither. 34 On the other hand, the chosen standards may
represent an acceptable balance, for an extreme pursuit of "truth" or full disclosure is
probably neither workable nor desirable. If disclosure demands too much complexity,
as observed, it is self defeating. Thus, Whitehead's half truths may be the only
understandable ones.
III.
INHERENT ELEMENTS OF SELF DEFEAT
As suggested above, it can be persuasively argued that the constant pursuit of ever more
disclosures may diminish their effectiveness. Moreover, the cost of preparing forms,
training personnel, monitoring compliance attempts, and the like for disclosure is not
cheap. While effective disclosure allocates resources and produces other benefits that
probably justify such expenditures,35 ineffective disclosure produces little to justify its
cost, and may even misallocate resources.
What factors lead to ineffective disclosure? First, disclosure
that depends on voluntary action may not be very successful. For example, since credit
advertising is not mandatory, detailed advertising rules that are "triggered" by certain
statements may either simply suppress advertising or drive it to generalized statements.
Voluntary "early" contract disclosure merely raises the risk that two rather than one set of
disclosures may be necessary and that, if misdisclosure occurs, may be there additional
risk of liability to noncustomers. Consequently, it is rarely used.
Second, the technical requirements for uniform and clear disclosure, as well as the
complexity of the disclosures themselves, tend to produce litigation that in turn may
prompt further complexity and "over compliance."36 The civil liability37 and
restitution38 rules for TIL disclosure violations encourage zero tolerance for ambiguity
and thus prompt evermore complex rules to provide certainty in evermore complex
transactions.
A third factor is that as products evolve in more complex permutations and legislative or
regulatory focus centers upon them, the inevitable trend is to longer and more complex
disclosure. Perhaps the best illustration comes from a comparison of the early and later
disclosure requirements for variable rate transactions.39 As ARM's became more
common and complex, a simple three point disclosure (which many felt was ineffective
in alerting borrowers to their risk) was broadened into a full blown set of new separate
disclosures. Other examples include the disclosures in consumer buy downs and
discounted and premium variable rate transactions,40 which have increased in
complexity over the years, and the evolution from simple state disclosures in connection
with credit card solicitations and applications to the subsequent broader federal activity in
this area.
IV.
THE TRUTH IN LENDING EXPERIENCE
Perhaps aspects of the above discussion can be highlighted by further examination of the
primary federal credit disclosure law, the Truth in Lending Act.
It took the decade of the 1960s to enact TIL and the decade of
the 1970s to refine and simplify it. However, in the 1980s as credit products continued to
evolve, it became more difficult to simply advise a consumer to shop for the lower APR.
In the 1980s, the APRs on two major types of consumer credit
sometimes became incomparable. For example, in the automobile finance area, 2.9% or
0% financing provided by dealers who sell their contracts to captive finance companies
will not reflect the fact that consumers who choose this financing forego receiving a cash
payment from the manufacturer. Legal and practical problems hinder imputing such
additional amounts to the credit purchaser's APR. In contrast, third party lender finance
charges would all be included in the APR.
The inability of consumers to compare APRs at car dealers and
lenders is not the only aspect of the problem today, however. APRs on open end home
equity lines of credit (the most rapidly growing type of consumer credit in the 1980s),
closed-end second mortgages, and unsecured loans also cannot be compared with
confidence because open-end credit APRs are calculated differently than those for
closed-end contracts.42 The gap in comparability of what some might think are "true"
APRs on credit cards and personal loans has widened as well, as fees on
credit cards have escalated and additional credit insurance products have proliferated for
personal loans. Real estate closing costs, credit card annual fees, and credit insurance
premiums, in the minds of some, are not part of the "real" APR even though they increase
the actual cost of credit. Some believe that one of the primary benefits of TIL, providing
a precise measure of the cost of alternative sources of credit, is now somewhat at risk.43
AB a result, some would suggest that changes in the consumer credit market may require
a reexamination of the law. The current incomparability of APRs between major types
of consumer credit is a troubling problem. AB a starting point, the compromises
embedded in TIL as exceptions to the general TIL definition of the "finance charge"-both
in the beginning and as a result of simplification-might be reexamined if the APR is to
regain its full comparability. Some have suggested that inclusion of closing costs, credit
insurance, broker's fees, application charges, seller's points, and filing fees in the finance
charge might increase the comparability of APRs between transactions and reduce
unseemly practices in the credit industry.
Fictitious "cash" down payments are becoming more frequent in the car industry. The
result may be consumers' confusion, improvident extensions of credit, and the
undermining of the financier's underwriting criteria. Reinclusion of TIL statutory
damages for misdisclosure of down payments might put a quick end to this deception.
That would benefit consumers and financiers alike.
Home improvement scams are staging a small comeback. A two contract, low-ball
scheme is being used to circumvent the homeowners' TIL right to cancel during the three
day cooling-off period. The second, higher-priced finance contract that will replace the
cheaper contract under which work was begun complies with TIL, but is presented
only after work is substantially completed. At this point, courts may require the
consumer to tender the value of the work performed to rescind that second contract under
Truth in Lending. This leaves the homeowner with a rescission right that may involve
the obligation to refinance part of the home improvement transaction. This is
substantially less protection than a right to cancel before any work is performed.
Unfortunately, many of the victims of this scam seem to be particularly vulnerable
elderly homeowners on fixed incomes who can ill afford the losses. TIL rescission rules
could be tightened to protect against the scam. One idea might be to have a broader
rescission right before any work is started; this would provide enough of a cloud on these
transactions to make them less likely.
Another potential challenge for TIL in the 1990s could be
providing the consumer with better information to evaluate loan consolidations secured
by a first or second mortgage on the borrower's home. Increasingly, consumers seeking
a small personal loan are being switched into large, often high-rate, consolidation loans.
For many consumers a disclosure comparing installments, total of payments, and finance
charges between the consolidation loan and the credit to be consolidated might be
sufficient to help them avoid improvidently putting their home on the line for an
excessive mortgage. Some notice pointing out the effect of loan consolidation might be
effective for other consumers.
The 1980s witnessed two important improvements to TIL. The first, early .
disclosure44-presented at the time the consumer may still be shopping for credit termswas introduced for certain types of credit, e.g., ARMs, credit cards, and home equity lines
of credit. As noted earlier, the lateness of other TIL disclosure remains a problem, since
most TIL disclosures are presented only after the consumer is psychologically bound to
the transaction and the disclosures may be obscured by a sheaf of other documents.
Earlier disclosure might enhance competition for other types of credit and the feasibility
of this approach on a broader scale could be reevaluated. Unfortunately, early disclosure
also means imprecise disclosure, since in many transactions the precise terms are not all
known until near closing.
Awareness of Typical Credit Rates
1969 1970 1977
Closed-end credit
14.5% 38.3% 54.5%
Open-end credit
30.9% 59.5% 68.0%
There also was a comparable increase in the sensitivity of consumers to interest rates and
declining loyalty to prior lenders. See Fed. Res. Bd. ANNUAL PERCENTAGE RATE
DEMONSTRATION PROJECT (Mar. 1987), which shows:
Reasons for Choice of Credit for a Recent Credit Transaction
1977 1984-5
Low interest rate
6.8% 24.3%
Previous experience 53.6% 39.3%
Reference
8.1% 24.3%
Availability of credit 7.3% 10.3%
Convenience 3.7% 7.7%
The second enhancement of the 1980s was requiring informational brochures for all
ARM and home equity loans. These brochures provide more in-depth information than
may be presented in the necessarily simplified disclosures for complex transactions.
While the brochures, like the simple disclosures, will not be used by all consumers, they
are a step forward in providing greater consumer information at a time useful to
consumers. They may well represent a solution to the inherent problem of "truth" versus
information overload. If some way could be found to test their effectiveness, additional
opportunities to use them profitably might be identified.
The early 1990s would also be an appropriate time to reassess
the various TIL disclosure approaches with other consumer testing. The effectiveness of
the model payments box,46 introduced in TIL simplification, should be verified. How
well model disclosures (like "This obligation has a demand feature")47 have worked
should be assessed. If the scheme is not working, alternatives could be explored.
The experiment of the Federal Reserve Board with APR shoppers' guides in local
newspapers demonstrated that savings may be enjoyed through increased competition
spurred by this low-cost device. Part of the Massachusetts and New York consumer
education effort for years, credit shoppers' guides list average rates for typical credit
transactions in the local market by each credit extender. The Federal Reserve Board
study demonstrated that proliferation of shoppers' guides has the potential to save
consumers millions of dollars in finance charges each year.48 Encouraging credit
extenders to provide their typical rates in response to a publisher's request could spur an
increase in this most effective consumer education mechanism.
Finally, disclosure of credit criteria might be useful. There appear to be no significant
financial or demographic differences between finance company and bank borrowers. But
finance company borrowers often pay substantially more for the money they borrow.
One explanation may be an assumption that a bank's standards for eligibility are higher
and a deep seated aversion by a substantial portion of the credit worthy population to
having their credit application rejected. However, creditors' eligibility standards are
almost universally considered proprietary and secret. Factors that credit scoring models
find predictive may be so counter-intuitive that their disclosure would do no more than
confuse, and the need for secrecy of the standards is understandable. But as a result,
consumers cannot know which eligibility standards they will meet without actually
applying and risking rejection. The effect of not making them public may diminish
competitiveness in the industry. Some type of early Equal Credit Opportunity Act
"reasons for action" notice on the application may encourage some high rate borrowers to
increase their credit shopping. Alternatively, a more general disclosure might be
considered along the lines of: "Studies have shown that applicants rejected by one
creditor are often acceptable to other creditors at the same or lower rates." However,
such a disclosure may well lack credibility when dispensed to high- and low-risk
applicants alike.
V.
CONSUMER DISCLOSURE IN THE 1990s
More disclosure may be inevitable and necessary in the 1990s; we have already seen one
major addition in the Truth in Savings Act. But as previously discussed, merely adding
more disclosure can amount to less effective disclosure. Adding more detail or volume
of information with no change in approach is probably not the answer. What are possible
answers? Sometimes imprecise information may serve better than detailed information
that is ignored or is not understood because of length or complexity. An illustration may
be the limited information49 now required by TIL about charges for late payments, which
is likely to be useful even though a contractual or statutory grace period is not required to
be disclosed. Similarly, the required security interest information also is probably useful
even if details about after-acquired property and other incidental interests are not
permitted to be disclosed. There is evidence, however, that the need to keep things
simple is a lesson that needs to be constantly relearned.
In part, demands for more disclosures are the understandable
result of the expanding choice of product variations for consumers. A case in point are
mortgages. Once mortgages were of a common type-fixed rate and of 25 to 30 years
maturity. Today, there are variable as well as fixed rate mortgages, 15 year maturities,
monthly and bi-weekly payment schedules, a wide variety of indices, margins, caps, and'
shared equity, price adjusted, and other types of mortgages. We also see more variety
and options in credit cards and deposit accounts. Following the old path raises the
specter of even more complex disclosures as they try to keep up with new products.
What this suggests is the need for a variety of new approaches like brochures, early
disclosures, and shoppers' guides, each tailored to the particular situation.
A second pressure for more disclosure comes from concern
about increased risk for consumers. Variable interest rate
transactions are inherently more risky than fixed rate ones in terms of default potential.
The popular home equity line places at risk the consumer's principal asset, and the home
has a long history of protection in the United States. Many programs, of course, have
other built in credit risks, such as "teaser" rates. These risks are not all in the credit
context; for example, if deposit insurance coverage is scaled back it might lead to
demand for more extensive deposit account and investment disclosures.
A third factor propelling more disclosure is the decline in local
relationships between customers and financial institutions. These old relationships often
produced informal information. Today, many consumers deal with out-of-state and
impersonal creditors as mortgage servicing and credit card portfolios are sold. This had
led, for example, to amendments to the Real Estate Settlement Procedures Act that
require mortgage lenders to provide disclosures to loan applicants that explain the
lender's likelihood of transferring servicing during the life of the loan.
That law also requires servicers to provide additional disclosures at the time of any
subsequent transfer of that servicing.
A fourth factor that might encourage more disclosure is regulatory ideas from abroad. In
Europe, for example, variable rates are prohibited in Belgium, mortgages are limited to
fifty percent of the purchase price in Italy, and in Holland all consumer credit extensions
are registered and the lender is under a duty not to grant credit that would overextend the
borrower. These restrictions are not likely to prove acceptable in the United States. But
the disclosure alternative may have to be shown to be effective as further world
integration occurs, and cross-border transactions raise ideas like these.
In the disclosure context, some European ideas might be feasible. In Belgium,
membership in a consumer organization enables the member to select the financial
institution that will grant a loan on the most favorable terms, taking into account personal
factors such as the number of children, income bracket, tax situation, grants, subsidies,
insurance, and so on. In fact, the computer print-out furnished to the member supplies
much more information, such as how to spread the loan over both partners in a family, a
loan redemption chart, the difference between the "best buy" institution and those rated
second, third, fourth, fifth, and so on. Another computer program enables the consumer
to work out whether it would be advantageous to replace an existing loan with a new one.
If a refinancing is advantageous, the program gives details of the institution at which the
transactions should be carried out and how big the annual net benefit would be. This is a
disclosure approach that might find wide acceptance in the United States.
Finally, the source of credit may change, and this too may encourage new disclosure
rules. In the future, there is likely to be more globalization of financial services. For
example, if there now is a Citicorp, South Dakota, doing business with consumers across
the country, why not a Citicorp, London or a Citicorp, Paris doing the same thing in the
future? The prospect of a developed "European Financial Area" composed of twelve
nations and 320 million people competing for American consumers raises some
interesting questions that have bearing for Americans that might be doing business in
these markets. These countries have different banking laws with different disclosure and
consumer protection requirements. While a "banking directive" has been issued by the
European Community to harmonize the essential rules,55 there still will exist some
recognition of local concerns. Although the law of a financial institution's "home"
country will generally prevail, the directive still leaves to the consumer's country some
latitude as to regulating for the "public good," which rules may be enforced in the
European Court of Justice. Should the future see American consumers dealing with
European institutions under such a scheme both foreign and domestic law may be
applicable. Will it be presumed that U.S. consumers are adequately protected by this
structure? It is likely that additional disclosure, concerning at least such "choice of law"
problems, may be called for as a condition to entry into United States markets.
Particularly, if all these forces generate any substantial amount of new disclosures in the
1990s, it will be important to focus on eliminating outdated rules. The regulatory and
legislative bodies that promulgate disclosure rules have begun to review the rules
periodically to determine whether they still are needed and whether they are working
appropriately. If not, they should be changed or repealed. A proposal by the Treasury
calls for a comprehensive review of existing rules to identify possible places to reduce the
burden of compliance.56 The FFIEC (which coordinates the activities of federal financial
institution regulators) has recently completed a review of agency regulations to identify
opportunities for burden reduction.57 It is now working on a subsequent review of the
underlying statutes. There is always great inertia attached to eliminating disclosures, but
it has been done. The old Regulation Z, section 226.8(o), governing disclosure of
discounts for prompt payment, and section 226.11, on the comparative index of credit
cost for open end credit, are history. In this regard, one subject for review might include
the rule that a minimum finance charge is a penalty58 as no state law treats it as such. If
this disclosure concept must be retained, the optional disclosure, that the consumer may
be charged a minimum finance charge,59 may be the preferable formulation. A second
candidate certainly is the boiler-plate disclosures about assumptions and spreader
clauses.60 Any review, of course, alternatively may indicate that further disclosures are
necessary. An example of this result is the enhanced disclosure for adverse action in
business credit.61 In all of this, it must be kept in mind, however, that change itself can
be burdensome-sometimes to the extent that it is not worth the effort.
Another possible trend that may develop in the 1990s is further work to eliminate
disclosure complexity generated through litigation in favor of a more orderly regulatory
and statutory development of disclosure rules. This trend was inaugurated in the
reduction of the kinds of disclosures for which statutory damages can be recovered under
TIL.62 That effort appears to have been a factor in dramatically reduced TIL litigation.
This helped to slow the prior trend to increased complexity and over compliance in
disclosure. But much remains to be done in this regard. The current remedy scheme
under the Fair Debt Collection Practices Act,63 for example, is not so limited. Here
litigation has proliferated. Some would argue that this has resulted in hair splitting
reminiscent of the finest (or worst) days-depending on one's perspective-under old TIL.
Reliance on administrative enforcement, except in cases of actual damages, allows the
focus to be upon whether the correct disclosure was made, and not on infinite
interpretations of disclosure requirements to obtain settlement leverage or damages to
offset owed debts. A downside of administrative enforcement, however, is it often is too
infrequent to be effective, is only feasible for "mass wrongs," and, at times, may force
inappropriate settlement due to inadequate resources on one side.
A final possible trend may stem from the recognition that state
disclosures added to federal disclosures sometimes provide very little additional benefit
to consumers, and may be lost as attention is focused on the federal information. Some
would argue that additional state disclosures can be counterproductive if they detract
attention from the federal disclosures that are deemed important as a matter of national
consensus, or if they so lengthen the mandated overall material as to diminish its
effectiveness.65 There is evidence that both Congress and the states gradually are
arriving at this conclusion. To illustrate, in essence Congress and the Federal Reserve
Board have preempted all state disclosure rules relating to funds availability,66 and the
same has occurred under the Fair Credit and Charge Card Disclosure Act.67
On the other hand, states sometimes are more aggressive in entering a field. In the
absence of Congressional action concerning "credit repair" organizations which charge
to provide information about-and may in fact often misrepresent-rights under the Fair
Credit Reporting Act,68 a number of states have acted. Also, in the absence of
Congressional action, a number of states have mandated disclosure and other rights
concerning "rent-to-own" operations that constitute neither consumer credit sales nor
leases under the Consumer Leasing Act.69 In some other areas, there is uncertainty as to
the most effective disclosure approach. State disclosure schemes can test what is most
effective. It may be appropriate for the federal law to set the "floor" for adequate
consumer protection standards with the states permitted to experiment with yet better
solutions.
CONCLUSION
Disclosure as a consumer protection tool is here to stay. However, for the law to
continue to work effectively it is necessary to devote constant attention to its operation
and development. We need to be open to ideas about how it can best work with respect
to new contexts and products. We also need to assess past performance and decide
whether existing rules remain viable.
E. Now, on to the present and the future.
i.
First a post on Creditslips.org by a professor who is a consumer advocate.
National Consumer Protection Week and Disclosure
posted by Jean Braucher
date of blog entry in Creditslips.org
DATE???
It’s National Consumer Protection Week (NCPW)! Federal, state, local, and nonprofit
consumer protection agencies and organizations are making extra efforts to promote
consumer awareness.
First I have to get out of my system thoughts of Tom Lehrer’s song, National
Brotherhood Week:
Step up and shake the hand/Of someone you can’t stand . . .
It’s only for a week so have no fear/Be grateful that it doesn’t last all year.
But to get back on message, of particular interest to Credit Slips readers is this part of the
mission of consumer protection described on the NCPW website:
"Financial Fraud Scams: American consumers owe a whopping $11.31 trillion dollars
in debt and are behind on paying about $1.01 trillion of that amount. Mortgages, student
loans, and credit cards account for a large portion of that debt. Consumers are often
haunted with huge monthly payments, and fraudsters take advantage of that with debt
relief scams, tax scams, and other financial fraud scams. Scams target individuals who
are in financial distress, but they fail to fulfill their promises, and typically leave
consumers worse off than when they started."
Let me say that Lauren Willis has done a great job on this site recently taking us,
patiently and painstakingly, through the many problems with the idea that disclosure can
be refined into a digital juggernaut to protect consumers.
I’m all for disclosure as a first line of consumer defense, particularly useful to the most
savvy, but let’s do it simply and quickly, recognizing its limits, and get back to the main
task of going after scammers and exploiters who systematically study human weaknesses
and then harness them for their own gain. Disclosure can't do much about that, so we’re
always going to need a lot of substantive consumer protection, too.
A central idea in disclosure 3.0 is facilitating apps for evaluating credit products. So let
the products get more and more intricate and then provide consumers with data dumps on
their own usage, to be passed by them to app platforms. Really? Smart phone usage is
growing (but app usage is growing more slowly. Even once everyone is tech ready for
this brave new world, what a great new line for scammers, especially those who are also
hackers. Access to all information about a consumer’s credit use! Oh boy! Have we got
a deal for you!
Millions of people a year are tricked into sending money over the Internet and by wire
and check for nothing in return. My favorite is the “free puppy” scam (just wire money
first for shots and shipping and perhaps surgery for the poor sick puppy). Millions more
consumers end up in high-cost debt traps carefully designed and then redesigned to be
one step ahead of consumer understanding and regulatory enforcement. More refined
disclosure is not the solution to these problems. Warnings and preventive examination
for too much complexity are more like it. See Scam Alert! And the CFPB examination
manual.
“We are all consumers” is a line I hear much too often from lawyers and law professors,
and it's about as accurate as “One size fits all.” Disclosure can only do a small amount to
advance the core mission of consumer protection, which is to prevent as much
exploitation as possible of the most vulnerable consumers.
ii.
Next a look at a recent action by the Bureau: March, 2014
United States: CFPB Seeks Input On Proposed Model Forms For Prepaid Cards
On March 18, 2014, the Consumer Financial Protection Bureau ("CFPB" or the
"Bureau") announced that it is seeking feedback about "potential disclosures" that the
Bureau "may propose to be used on the packaging of prepaid cards," in connection with
an expected rulemaking in the spring.
As it has done before, the Bureau is looking to develop a "model form" that would
standardize financial product disclosures. Specifically, as to prepaid cards, the Bureau
has explained that it wants its model form to "clearly present a prepaid card's most
important fees." To this end, the Bureau has begun to consumer test its proposed
disclosure forms. In February, the Bureau conducted its first round of interview testing in
Baltimore, and on March 18, the Bureau tested its proposed disclosure forms with
consumers in Los Angeles.
Since its inception, the Bureau has focused its regulatory efforts on product disclosures.
Indeed, the Consumer Financial Protection Act, which is Title X of the Dodd-Frank Act,
mandates this focus. Section 1032 of the Dodd-Frank Act, 12 U.S.C. §5532, provides
that the "Bureau may prescribe rules to ensure that the features of any consumer financial
product or service, both initially and over the term of the product or service, are fully,
accurately, and effectively disclosed to consumers in a manner that permits consumers to
understand the costs, benefits, and risks associated with the product or service." And any
final Bureau rule concerning mandated product disclosures also might include a model
form that is consumer-tested. Section 1032, in turn, provides that when a "covered
person" – that is a bank or nonbank regulated by the Bureau – "uses a model form
included with a rule . . . . [that entity] shall be deemed to be in compliance with the
disclosure requirements" of the proposed rule. In other words, using the model form
provides a legal safe harbor.
Any model form will reflect input that addresses the following questions:
1."Do you understand how much each of these cards will cost to use?"
2."What would you like to see added or changed? Is there some way to make the
information clearer?"
3."Is there anything you find confusing?"
iii.
Next a look at What Disclosure Legislation Should Look Like from Consumer
Advocates who are else experts in the field.
The Truth, the Whole Truth, and Nothing But the Truth: Fulfilling the Promise of Truth
in Lending
Elizabeth Renuart
Albany Law School
Diane E. Thompson
National Consumer Law Center
October 12, 2007
Yale Journal on Regulation, Vol. 25, Summer 2008
Abstract:
Evaluating the cost of credit and comparison shopping in the modern credit environment
can be a daunting task, even for the most sophisticated shoppers. Lenders increasingly
unbundle the costs of their loans from the interest rate into an array of fees, outsource
their overhead to third parties who add to the consumer's cost, and unveil amazingly
complex loan products that dazzle and confuse borrowers.
At the same time, the preemption of state usury and consumer protection laws by
Congress and the federal banking agencies spurred deregulation at the state level. Today,
the consumer credit marketplace is governed almost exclusively by disclosure rules. The
subprime mortgage crisis of 2007 resulted from allowing the market to police itself and
from the failure of disclosure to curb abuses.
Nearly forty years ago, Congress addressed the problems caused by lack of transparency
in credit pricing when it enacted the Truth in Lending Act (TILA). Congress intended to
promote informed consumer shopping and a level playing field for lenders by requiring
standard disclosure of the cost of credit, most simply through the annual percentage rate
(APR) and the finance charges upon which the APR is based. The value of the APR
disclosure has deteriorated since 1968 due to exclusions from the finance charge
definition created primarily by the Federal Reserve Board.
The article documents the history of this decline for the first time and describes the
consequences of an APR disclosure that has become incrementally weaker as an indicator
of the true cost of the credit. This article draws upon financial literacy, cognitive
psychology, and behavioral economics literature to justify the need for a more effective
APR.
The authors posit a simple litmus test for the finance charge that creates a more effective
APR. They discuss why this test is superior to other proposed definitions of the finance
charge and respond to arguments that a fee-inclusive APR is unhelpful to consumers and
harms the industry.
This article is particularly timely because the Federal Reserve Board is currently
undertaking a sweeping overhaul of TILA disclosure regulations, including the finance
charge definition. Given the state of the credit marketplace, the authors conclude that a
robust APR is more critical now than it was in 1968.
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1021318
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1021318
THIS ARTICLE WAS ORIGINALLY PUBLISHED IN VOLUME 25 (SUMMER 2008)
OF THE YALE JOURNAL ON REGULATION
Xlll. Conclusion
The drafters of TILA were aware that disclosures grounded in even basic computational
skills were inadequate for most of the population 354 The creation of the APR was an
attempt to provide one simple, comparable number that did not require any intermediate
computational steps. The credit industry has transformed the market in the intervening
forty years through unbundling, outsourcing of credit functions, and complex pricing
structures. These changes should not be allowed to undermine a standardized, inclusive
measure of the cost of credit.
Does "fixing" the APR need congressional attention or can much of the slippage in the
effectiveness of the APR be accomplished by Board action? To the extent that the Act
contains explicit exceptions to the general finance charge definition, which it does,
Congress bears the responsibility of fixing those loopholes. In light of our suggested
litmus test, Congress should repeal provisions in section 1605 that exclude credit
insurance premiums and certain real estate related fees when imposed only in credit
transactions.
Short of congressional action, however, the Board can and should pump up the utility of
the APR to effectuate the goals of TILA. The responsibility for much of the leakage rests
with the Board. The Act also gives the Board the authority to address the timing of the
disclosures so consumers can be well informed earlier in the evaluation process.
The moment is right, given the regulatory review process commenced by the Board in
2004-a process that is still in its early stages. The Board has already recognized that the
APR is weakened by the unbundling of fees. If the Board is serious about financial
literacy and informed consumer choice, it should embrace a "fully loaded" APR.
iv.
Next a letter to the Bureau from a creditor group.
THE FINANCIAL SERVICES ROUNDTABLE
Financing Americas Economy
• HPC HOUSING POLICY
COUNCIL
March 7, 2013
Mr. Darrin King
PRA Office
Bureau of Consumer Financial Protection
1700 G Street NW Washington, DC 20552
Re:
Quantitative Testing of integrated Mortgage Loan Disclosure Forms
Dear Mr. King,
The Financial Services Roundtable1 and its Housing Policy Council 2 (collectively, the
Roundtable) thank the Consumer Financial Protection Bureau (Bureau) for the
opportunity to provide comments on the Bureau's proposed quantitative testing of
integrated mortgage loan disclosure forms.
Disclosures are critical to consumer financial empowerment; clear and effective
disclosures can, and should, help consumers understand key terms and the options
available to them. Disclosures are especially important in residential mortgage lending
inasmuch as buying or refinancing a home typically is the largest financial transaction a
consumer undertakes. The Roundtable has consistently supported testing because we
believe testing improves the clarity and effectiveness of disclosure.
Below are several suggestions that we believe will enhance the Bureau's testing.
1. Focus on the proposed disclosures' impact on consumer understanding of costs and
terms
We believe that the Bureau's proposed TILA-RESPA forms4 are more effective than the
current forms5 and further testing is not needed on this point. Both the Federal Trade
Commission and Federal Reserve Board studies have shown that the current TILA
disclosures do not help borrowers understand the terms and cost of their loans. And, as
the CFPB notes, it
cannot establish a "baseline" test because currently there are no combined TILA-RESPA
disclosures to test against. The CFPB's proposed forms are, in many respects,
improvements over the current forms, but we remain concerned about the amount of
information on the forms and whether items such as the "total interest percentage" and
"lender's cost of funds" present information that is useful to consumers. Therefore, we
encourage the Bureau to focus on consumer understanding of the key loan terms and
settlement costs after reviewing the proposed mortgage disclosures. In other words, the
testing should explore the extent to which the content in the proposed forms results in
consumer understanding of the settlement costs and loan features.
2. Pose objective questions to measure consumer comprehension
As proposed, the questions ask respondents to provide qualitative, opinion-based
responses. The test asks the respondent to review two mortgage disclosures for different
mortgages and then choose which mortgage they would prefer and why. There is no
clear fact- or science-based "right" answer to the questions posed, and any choice the
respondent makes would be subjective. The questionnaire also includes space for the
respondent to explain her reasoning. The Supporting Statement does not explain what
criteria the CFPB's contractor will use to evaluate the respondents' choices and
explanations nor is it clear how the contractor and CFPB will ensure data derived from
the testing is quantitative.
To provide a sound basis for decision-making, the questionnaire must include objective
questions from which data can be extrapolated and used by the CFPB to make informed
decisions about the proposed mortgage disclosures.
3. Adjust methodology and timing
The testing involves several variables, including two types of disclosures (current and
proposed), two loan types (fixed-rate and adjustable-rate), two loan levels for each loan
type (easy-to-understand and difficult-to-understand) and two consumer types (those with
no prior mortgage experience and those with prior mortgage experience). The same
questionnaire and time limitations are provided in each instance, no matter which type of
consumer is given which disclosure for which loan type or level. This one-size-fits-all
approach may not fully capture a respondent's understanding of the disclosures.
For example, assume a consumer with no mortgage experience is asked to evaluate the
current disclosures for a complex adjustable-rate mortgage, while an experienced
respondent is evaluating the proposed disclosures for a less complicated fixed rate
mortgage. The latter respondent presumably will finish her questionnaire within the
allotted time without any difficulty, while the former respondent would likely have
difficulty finishing her questionnaire in the allotted time. Respondents who are asked to
evaluate more complex disclosures should be allowed additional time to ensure they have
sufficient time to express their understanding.
4. Probe consumer's understanding of risk factors.
While the Supporting Statement indicates that the survey will evaluate how well the
proposed disclosures promote consumer awareness and understanding of risk factors in
mortgages,6 only a few questions address that aspect. The Supporting Statement
mentions interest-only payments, prepayment penalties, negative amortization, and
optional payments as features that present unique risks to consumers, but only three
questions ask about these risk features and each is a simple yes/no question.7 These
questions do not evaluate whether a consumer understands the actual risk posed by these
features or what the outcome might be if a loan has such features. We urge the CFPB to
include questions that probe the respondents' understanding of the items it has identified
as risk factors.
5. Remove biases in the survey questions and survey population
Part 4 of the questionnaire asks respondents to first compare the application disclosure
form to the final disclosure form for a given loan. Then, in pairs of questions, the
respondents are asked whether various factors in the disclosures are "the same" or are
"not the same" and then, in
a follow-up question, explain what accounts for the differences. The follow-up question
automatically assumes there is a difference between the two forms, and that assumption
will likely bias the respondent to answer "not the same" to the first question. All the
questions in this part should follow the model used in Question 30 in Part 4, which starts
with, "If you answered
'not the same' above," and then asks for a response. This will eliminate the potential bias
in the first set of questions.
Survey respondents will include those with no mortgage experience, meaning those that
have never bought a home but plan to, and those with mortgage experience, meaning
those who have bought a home or refinanced in the past 5 years (2008 or 2009). Due to
the financial crisis, many potential homebuyers have not engaged in home buying or
refinancing in the past 5 years. This 5-year requirement narrows the pool of home buyer
respondents to a detrimental degree by excluding those that have not invested in real
estate since the market collapse. To prevent this bias, the survey should define those with
mortgage experience as those who have bought or refinanced in the past 7 to 10 years.
6. Clarify the survey instructions
The testing will be conducted in in-person group sessions of twelve persons or less.
Thus, by design, the testing experience of each survey respondent in a group will be
different. The Statement of Purpose states that respondents "will be told that each set of
materials used by each respondent in the session is different."8 However, the read aloud
instructions for the study proctor phrase this fact as conditional; for example, the proctor
must say "your documents may look different than those provided to other participants,
and you may receive a different number of documents for each part."9 It is natural for
test-takers to look around the room to see if other people are finding a test is as hard or
easy as they are, or if others are finishing faster or slower than they are. The instructions
the proctor reads should include an explicit statement that each set of materials used by
each respondent is different. This would alleviate anxiety among respondents.
Sincerely,
John Dalton
President
The Housing Policy Council
Executive Director, General Counsel
v.
An Op Ed by a consumer advocate on the Bureau.
Thanks largely to new rules from the Consumer Financial Protection Bureau, taking out a
mortgage is not the risky business it was during the bubble. But it is still the largest and
most complex financial transaction in the lives of most people. And it still involves
inherent imbalances in expertise between lenders and borrowers, including the use of
intermediaries who may or may not be trustworthy. In short, conditions for abuse still
exist.
That is why the bureau’s new and long-awaited mortgage disclosure forms are important.
It is also why they are disappointing. Required by the Dodd-Frank financial reform law,
the new forms use an easy-to-read format to disclose complex terms; in addition to clear
entries of principal, interest and closing costs, there is information on prepayment
penalties and other complicated loan features. But the forms fall short in the crucial task
of helping consumers assess and compare the total cost of various loans. Without that
information, it is difficult for borrowers to know whether they are getting the best deal.
What’s needed, as the National Consumer Law Center has pointed out, is prominent
display of the loan’s full annual percentage rate, a single measure of the cost of credit that
incorporates the interest rate, closing costs and other fees. On the new forms, that number
is not reported until Page 3. Worse, it is calculated in a way that understates the loan’s
cost, because it omits the cost of title insurance and some other closing charges.
Both the bureau and the Federal Reserve had earlier proposed to include all closing costs
in the annual percentage rate. The bureau says it changed its mind because including all
costs might reduce the availability of certain kinds of loans. That may be true, but the
loans it would restrict, in general, would be higher-priced loans, which would be subject
to more regulation than lower priced ones. So lenders who resist regulation may resist
offering them — which is as it should be. Better disclosure in itself does not restrict
access to credit and, in fact, has been linked to reductions in the cost of credit because
transparency fosters competition among lenders.
The new disclosures are weaker than the earlier proposal in other ways. The agency had
proposed that lenders be required to give borrowers a three-day review period whenever
the loan terms were changed. The aim was to ensure that lenders would not spring new
loan terms on borrowers at the last minute. The final rule limits but does not eliminate the
lenders’ ability to introduce last-minute changes at the closing table. That’s too lenient.
Lenders must be held to their promises.
The bureau has stumbled on this one. The agency should act quickly to fix the flaws
before the new rules and forms take effect, in 2015.
vi.
An editorial
Reining in Payday Lenders
By THE EDITORIAL BOARD
•
At some point — soon, we hope — the Federal Consumer Financial Protection Bureau
will issue regulations for the payday lending industry. The bureau took an important step
in that direction when it announced earlier this month that it would begin collecting
complaints from borrowers who may have been hit with unreasonable fees, unauthorized
withdrawals from their checking accounts or other abuses. The bureau should rein in all
of these practices, but its most important task is to ensure that the loans are affordable —
which means requiring lenders to determine in advance that the borrower has the ability
to repay.
Payday loans, used by 12 million borrowers annually, are not what they seem. They are
advertised as convenient short-term transactions, but in fact the lenders generate profit by
trapping borrowers in debt for as long as five months. The way it works is that borrowers
take out small loans (averaging $375) and promise to repay the entire amount on payday,
typically two weeks later.
But only about 14 percent of the borrowers can afford to repay the loan in full, according
to a new study by the Pew Charitable Trusts. The rest can only afford to repay part of the
loan, which forces them to renew the loan again and again, at a cost of about $50 a pop.
In the meantime, lenders often trigger overdraft fees by trying to withdraw money from
the accounts of borrowers who have too little on hand to meet the obligation. In the end,
the hapless borrower can pay as much as 400 percent in interest.
Fifteen states have outlawed such exploitive lending. But the remaining 35 still allow
payday lending that requires the full amount to be paid at once. After analyzing data from
all over the country, Pew sensibly recommends that state and federal regulators forbid
lump-sum repayment requirements, ensure that lenders clearly disclosure terms and
require lenders to spread out payments over months rather than weeks.
Regulators should also limit high-cost upfront fees, because they create an incentive for
lenders to push borrowers into new loans as a way of driving up profit. These changes
would mean less profit for the lenders but would protect low-income borrowers from
being bled dry.
We developed a shorter, simpler credit card agreement that spells out the terms for the
consumer. Note that this is not a model form, and use is not mandatory. Our prototype is
shown here. We believe our approach will help consumers better understand their credit
card agreements. Tell us what you think of it.
Review the sample agreement below. (You can also view a PDF copy.) The terms that
are underlined in the agreement are defined in a separate list of definitions of credit card
contract terms. Click any section of the agreement to learn more about it. Then leave your
comments about the agreement or the definitions at the bottom of the page.
If you want to see what current agreements look like, check out our Credit Card
Agreement Database.
II. Financial Literacy
a. Financial Literacy Discussion Questions;
WHAT IS IT?
Why should we teach financial literacy?
Which problem is it intended to remedy?
How much should we spend on it and what might we expect from it?
How shall we teach it? and
How shall we measure what we are teaching and its impact and effect.
Should we take any of this on faith?
If not, how do we prove it and what is the standard?
What is the downside of trying it?
What are the reasons it may not work?
How can it take into account or otherwise deal with new developments in products??
What is the impact of the bankruptcy education program?
b. Two views of the value of financial literacy education
Anna Lusardi is an outstanding spokesperson for the proponents of financial literacy
education and Lauren Willis is the leading spokesperson for those who question the
value and the priority of financial literacy education. Please read the following
articles by them and make up your own mind.
View 1.
http://www.chicagofed.org/digital_assets/others/region/foreclosure_resource_center/more
_financial_literacy.pdf
View 2 selections from .
Against Financial-Literacy Education
By
ABSTRACT: The dominant model of regulation in the United States for consumer credit,
insurance, and investment products is disclosure and unfettered choice. As these
products have become more complex, consumers’ inability to understand them has
become increasingly apparent, and the consequences of this inability more dire. In
response, policymakers have embraced financial-literacy education as a necessary
corollary to the disclosure model of regulation. This education is widely believed to turn
consumers into “responsible” and “empowered” market players, motivated and
competent to make financial decisions that increase their own welfare. The vision
created is of educated consumers handling their own credit, insurance, and retirement
planning matters by confidently navigating the bountiful unrestricted marketplace.
Although this vision is seductive, promising both a free market and increased consumer
welfare, the predicate belief in the effectiveness of financial-literacy education lacks
empirical support. Moreover, the belief is implausible, given the velocity of change in
the financial marketplace, the gulf between current consumer skills and those needed to
understand today’s complex nonstandardized financial products, the persistence of biases
in financial decisionmaking, and the disparity between educators and financial-services
firms in resources with which to reach consumers.
Harboring this belief may be innocent, but it is not harmless; the pursuit of financial
literacy poses costs that almost certainly swamp any benefits. For some consumers,
financial education appears to increase confidence without
I. INTRODUCTION .......................................................................................199
II. DOES FINANCIAL-LITERACY EDUCATION WORK? ....................................202
A.
WHAT IS FINANCIAL-LITERACY EDUCATION? ......................................202
B.
WHAT DO WE KNOW ABOUT THE EFFECTIVENESS OF FINANCIALLITERACY EDUCATION? .....................................................................204
III. IS FINANCIAL-LITERACY EDUCATION LIKELY TO WORK?
.........................211
A.
INFORMATION ASYMMETRIES AND CHASING MOVING TARGETS
...........212
B.
INSURMOUNTABLE KNOWLEDGE, COMPREHENSION, AND NUMERICSKILL LIMITATIONS ...........................................................................219
C.
THE PREVALENCE OF BIASES IN PERSONAL-FINANCE
DECISIONMAKING ..............................................................................226
1. The Intangible-Transaction-Costs Schematic........................226
2. Overwhelming Information and Choices..............................228
3. High Financial and Emotional Stakes ...................................230
4. Discomforting Thoughts ........................................................234
5. Uncertainty and the Future ....................................................237
6. Opaque Attributes and Incommensurate Tradeoffs ............240
7. The Passivity Alternative: Defaults and “Experts” .................245
8. The Difficulty of Debiasing Personal-Finance
Decisionmaking.......................................................................248 a. Poor Conditions for
Debiasing ..............................................249 b.
Individual
Differences..........................................................252
D.
REACHING CONSUMERS AT TEACHABLE AND VULNERABLE
MOMENTS.........................................................................................253
IV. THE COSTS OF FINANCIAL-LITERACY EDUCATION ..................................260
A.
TIME, EXPENSE, AND INEFFICIENT DIVISION OF
LABOR.........................261
B.
REGULATORY OPPORTUNITY COSTS ...................................................264
C.
PARADOXICAL EFFECTS ON CONSUMER DECISIONMAKING
....................272
D.
BLAMING THE CONSUMER .................................................................275
V. CONCLUSION ..........................................................................................283
AGAINST FINANCIAL-LITERACY EDUCATION
283
V. CONCLUSION
Financial education can be compared to a road map to the American Dream. I believe
that we need to teach all Americans the necessary tools to read that map, so that they can
reach the Dream.
—Secretary of the Treasury Paul O’Neill390
The financial-literacy education policy model locates the problem of and the solution to
poor financial outcomes in the consumer, but these can be conceptualized just as easily as
part of the choice architecture of personal-finance decisions. Because changing the
consumer does not look promising, consumer financial woes are more tractably
understood as the result of a government that fails to regulate, an industry that hawks
inappropriate products, and a deluge of complex products that change quickly. Nothing
is inherently wrong with consumers or the modern marketplace, but the largely
deregulated interaction between the two creates welfare-reducing outcomes.
Potential general approaches to improve that interaction include substantive prohibitions
and mandates, enhancing the resources with which consumers approach the market,
changing consumer financial-decision environments, or bringing seller incentives in line
with consumer needs.391
Without regulation through education, all is not lost for public policy to improve
consumer finances—we do have alternatives, and we should explore them. Nearly every
promising public policy to improve consumer credit, insurance, and retirement
investment behaviors would limit “choice” in some respect, yet all have the potential to
enhance both consumers’ financial outcomes and consumers’ functional autonomy, in
terms of reflecting the individual’s own goals and values and providing her with a sense
of control over her decisions, actions, environment, and life path. These limits on
individual choice present the central paradox of the ownership society in the modern
marketplace of consumer financial services: to enhance true consumer autonomy, to give
people more ownership and control over their own daily lives and ultimate destinies,
requires regulatory interventions in that marketplace that limit formal choice.
A stark example is the recent drop in the U.S. homeownership rate. The Federal Reserve
Board’s decision not to regulate the subprime- mortgage market allowed consumers to
obtain mortgages they could not afford , leading to a net loss of homeownership among
users of subprime loans.392 Giving borrowers apparent control over whether, how much,
and on what terms they could borrow against their homes has sent many of them to
bankruptcy and turned others into renters, with substantially less control over their
financial lives and living environment than they had before they obtained these loans.
Ultimately, to have true control over their lives, consumers need to have less formal
control over some decisions in their lives.
The failed social policy of financial-literacy education denies this paradox and diverts
attention from more creative approaches to improve consumer financial transactions. The
challenge now is to develop and implement policies and legal rules that will reshape the
consumer financial- services market into a landscape conducive to good consumer
decisions and outcomes. Such regulatory interventions must navigate the heterogeneity
of consumer knowledge, skills, and behavioral traits, while at the same time taking care
not to hinder marketplace changes that would enhance consumer welfare. All approaches
have costs and benefits that must be investigated before wholesale implementation. To
be successful, each legal intervention will undoubtedly need to be both context-specific
and amenable to change as the market evolves. This is a delicate, challenging, timeintensive and costly task, requiring requisition of the resources currently spent on
financial education and more.
In an idealized first-best world, where all people are far above average, education would
train every consumer to be financially literate and motivate every consumer to use that
literacy to make good choices. The costs of the education model would be low enough
and the benefits high enough that citizens of the ownership society could flourish, and
more rather than less education would be desirable. Regulation through education in
such a world promises a free market and increased consumer welfare, seducing
conservatives and liberals alike. Unfortunately, such an education is not possible, or, if it
were possible, the price of such an education would be so high as to reduce social
welfare. In the real, second-best world, less rather than more financial-literacy education
may be better.393
The financial-literacy education model is premised on the promise of consumer
sovereignty, that consumers can be taught to make welfare- enhancing choices in the
insurance, credit, and investment marketplace, trained to read and travel “the road map to
the American Dream.” Ironically, the model ensures instead the sovereignty of the
market. Overtly, the model is an attempt at social engineering, trying to change not only
consumers’ skills, but their thought processes, feelings, motivations, and ultimately their
values.394 In the world that financial-literacy education advocates, consumers are but
wealth maximizers, looking out for their own financial interests rather than shared
societal and civic goals. Covertly, the model dupes consumers into thinking they can
master the financial-services market, while placing blame upon them for their failure to
do so, deflecting political pressure for change. But changing the personal-finance market
or the manner in which consumers must maneuver in it—making the map easier to read
and follow, giving them a guide, or building more direct routes to the American Dream—
is likely to be more efficacious, and at a lower cost. Consumers can make welfareenhancing choices, but to be truly autonomous, those choices must be made in a context
that consumers can navigate.
c. Evaluating the effectiveness of financial literacy education. Effects of mandatory
financial education on low- income clients
J. Michael Collins
J. Michael Collins is Assistant Professor of Consumer Science at the University of
Wisconsin–Madison, Faculty Director of the Center for Financial Security, and an IRP
affiliate.
Public policies mandate financial education for financially distressed consumers in a
variety of contexts, including bankruptcy and foreclosure, as well as for consumers faced
with impending financial decisions. Financial education and counseling are provided in
the workplace, in schools, by community groups, and as part of public programs. The
impact of financial education on credit behavior is relatively untested. This article
summarizes a randomized field study that evaluates a highly targeted mandatory financial
education curriculum for very low-income clients in a housing voucher program.
Prior research
Several studies have documented the extent to which consumers in the United States and
other countries fail to demonstrate financial literacy, numeracy, or both.1 Financial
knowledge measures tend to be higher for more-educated consumers and lower for lowerincome consumers.2 Con- sumers’ understanding of interest and interest rates tend to be
particular areas of weakness.3
One problem in financial literacy research is establishing ac- curate measures of financial
knowledge. Many studies utilize self-reported knowledge scales (“how confident are you
in your knowledge of…”). At least one study found that people tend to overestimate their
financial knowledge relative to what they actually know.4 Thus, studies that rely on selfreported data may yield ambiguous findings. Selection bias is an even more significant
problem within existing financial education evaluations.5 Unobserved characteristics
including greater motivation and patience levels may drive certain individuals to seek out
financial education or counseling. If these same characteristics also facilitate financial
success, then selection effects and not financial education may be responsible for positive
findings associated with financial literacy education.
The types of services examined in previous studies include short programs delivered in
the context of a particular deci- sion, more intensive one-to-one counseling, and longerterm formal education programs. The clients targeted are
often moderate-income individuals faced with impending financial decisions, such as
buying a home, investing for retirement, or correcting credit problems. Few evaluations
have analyzed financial education programs targeted to very low-income families, and
few have evaluated mandatory financial education programs delivered over several
weeks. Furthermore, no evaluations have randomly assigned clients into treatment and
control groups, so selection effects may have biased past evaluations.
Overall, the evaluation literature suggests that financial edu- cation can help individuals
gain financial knowledge and that financial knowledge is linked to financial behavior.
Possible outcomes from financial education include greater levels of savings, use of bank
accounts, and improved credit behavior. Because of selection effects, however, further
studies are needed for better estimates of the causal impacts of financial literacy
education.
Modeling the effects of financial education
The literature on financial literacy education lacks a strong theoretical framework. Most
studies rely on a “black box” model such that information or counseling is the input and
the expected outcome is a measurable effect on knowledge and/or behavior. In general,
theories of behavior change in the financial education field are derived from the health
literature. These approaches all emphasize that behavior change results from a
combination of attitudes, social norms, and intentions; knowledge gains alone are
insufficient. The model of behavior change that underlies this study is based largely on
Ajzen’s Theory of Planned Behavior.6 It is expect- ed that housing voucher clients who
complete a mandatory financial education program will exhibit greater improve- ments in
three areas than a control group. First, consumers who complete a mandatory financial
education program are expected to report greater increases in their self-assessed
knowledge of financial issues. Second, they are expected to report greater improvements
in their attitudes about saving and budgeting. Third, they are expected to exhibit greater
improvements in objective measures of financial behavior including credit reports and
bank statements. This model is admittedly simplistic, as it does not include social norms
and instead assumes that social norms are similar across participants and are unaffected
by the financial literacy pro- gram. This model recognizes that knowledge and behavior
may interact through unobserved feedback mechanisms. For example, financial
knowledge gained through past behavior may influence future behavior.
The Long Island Community Development
Corporation study
I report here on a recent study that addresses some of the deficiencies in the financial
education literature. Data for this study were provided by the Community Development
Corporation of Long Island, New York (CDCLI). This non- profit agency is the regional
administrator of federal rental housing vouchers. Low-income families receive vouchers
to subsidize rental payments made to private landlords. Recipi- ents are also enrolled in
the federal Family Self-Sufficiency (FSS) program. The FSS program allows families to
earn additional income without losing their housing subsidies. All housing voucher
clients in the FSS program are required to complete a financial education course,
although clients have up to five years to complete the course. The CDCLI created a
financial literacy program called “Financial Fit- ness” for these clients. Financial Fitness
is delivered over five sessions and covers a range of topics including credit, savings, and
budgeting. For this study, 144 very low-income housing voucher clients who needed to
take the Financial Fitness course were randomly assigned to either a treatment group
(which was required to take the course within one year of randomization) or a control
group (which was prohibited from taking the course for one year). The majority of
clients in the treatment group completed the five class sessions in one month or less.7
Due to attrition, 17 of the 144 clients who initially agreed to participate in the study were
dropped from the final sample. The final sample comprised 60 clients in the treatment
group and 67 clients in the control group. Multiple statistical techniques were used to
address the differential rate of attrition between the treatment and control groups.
Baseline characteristics
Table 1 shows that clients in both the treatment and control groups had little savings and
poor credit ratings at baseline (FICO scores below 680 are considered “subprime” in this
study). Average outstanding debt was higher for the treat- ment group than for the
control group, but not at statistically significant levels. However, the treatment group’s
mean in- come was significantly higher than the control group’s mean income at baseline.
As a reference point, federal guidelines define very low-income as income below 30
percent of an area’s median income, which equates to $24,000 for a family of four in this
region (the mean family size for the entire sam- ple is four). A higher percentage of the
treatment group had subprime credit scores than the control group (83 percent compared
to 73 percent), a difference that was statistically significant at the 10 percent level. The
treatment group was also more likely to be employed full time (52 percent com- pared to
39 percent), which was significant at the 10 percent level. Although not reported in
Table 1, about one-half of the clients in both groups were African American, one in ten
were Latino or Hispanic, and the remaining one-third were white. Two composite
indices aggregated questions concern- ing clients’ self-reported financial knowledge and
behavior.
The statistical models indicate that financial education influnces clients’ self-reported
financial knowledge and ulti- mately results in improvements in their financial behaviors.
Although this study measured changes in clients’ attitudes and perceptions, these findings
were largely nonsignificant and are therefore not reported. Effects are estimated using
difference-in-differences specifications across 35 measures. The measures include data
from credit reports and bank ac- counts, as well as clients’ responses to baseline and
follow- up surveys. The surveys asked clients to rate their financial knowledge and
behavior.8
Financial knowledge estimates
Based on prior studies, financial knowledge has a strong association with financial
behavior. It is expected that cli- ents who completed the financial education program
would report greater increases in their understanding of a variety
.
of financial topics compared to clients in the control group. Clients completed a series of
questions about how much they understood interest rates, credit ratings, managing
finances, investing, and what is on their credit reports. Responses ranged from “nothing”
(0) to “a lot” (4). A composite index was created that aggregates clients’ scores across
the self- reported knowledge measures. Figure 1 shows the estimated effect of financial
education on the aggregate index, as well as on three specific questions that were
statistically signifi- cant. The baseline mean for the composite knowledge index was
1.75, and the difference-in-differences estimation indi- cates that the financial education
program led to a 27 percent increase in this index at follow-up (to 2.23). The program
was also associated with increases in clients’ knowledge of money management, what is
on their credit reports, and current interest rates. Consistent with the program’s scope,
Financial Fitness was not associated with improvements in clients’ self-reported
knowledge of investing. While these self-reported knowledge gains are promising, the
program’s ultimate goal was facilitating behavior change.
Financial behavior estimates
Clients answered a series of questions about their self- reported financial behaviors.
Responses to these questions ranged from “poor” (0) to “excellent” (4). A composite
index aggregates clients’ responses to the self-reported behavior questions. Figure 2
shows the estimated impact of the Financial Fitness program on the self-reported
behavior index, as well as on three specific behaviors that were statistically significant.
The mean score on the composite index was 1.22 at baseline. The statistical analysis
indicates that the financial education program led to a 38 percent increase in the
composite score at follow-up (to 1.68). Clients’ self-reported ability to control their
spending, pay their bills on time, and budget were also significantly higher at follow-up.
Savings account and credit report data contain two objective measures of clients’
financial behavior. The mean savings
balance was $286 at baseline. The regression analysis indi- cates that the Financial
Fitness program led to an increase of $362 in savings, an increase that was significant at
the
1 percent level. Over one-third of the curriculum used in this study focused on managing
credit and debt, a typical topic for courses provided to low-income families. Credit report
data include a FICO score—named for the Fair Isaac Corporation, which developed the
score. FICO scores range from 300 to 800 and are based on a proprietary formula using
multiple variables contained in the credit report, including the number of accounts,
amount and age of debt, and share of available credit in use by the individual. The
statistical analysis indicates that the financial education program led to a statistically
significant decrease in the percentage of clients with credit scores in the subprime range
(again defined as
680 in this study). The marginal effect of the financial edu- cation program on the
percentage of clients with subprime credit scores was estimated to be a decrease of 13
percent. Improvements in credit scores may allow clients to qualify for lower interest
rates and help clients access additional credit.
Discussion
The Financial Fitness program was designed to help clients access basic banking
services, learn budgeting skills, boost savings, and repair credit problems. This study
shows that financial literacy education is indeed related to improved financial behavior
among the program’s very low-income clients. The primary evidence of behavior change
is the sig- nificant increase in savings account balances (an additional
$362), as well as the modest decrease in the percentage of clients whose FICO scores
were below 680. Clients’ self- reported knowledge gains were also greater for the
treatment group than for the control group, especially in the areas of credit and money
management. In contrast to the improve- ments in clients’ financial knowledge and
behavior, the findings concerning financial attitudes were largely nonsignifi- cant. In the end, many of the
findings are surprisingly robust given the relatively small sample size and the weak
impacts reported in past studies.
This study has several advantages over previous studies. It includes objective measures
of behavior from bank accounts and credit reports, rather than relying solely on selfreported data. The financial education program was mandatory, which reduces the
potential bias introduced when clients select into a program. Clients were randomly
assigned to the treatment group or the waitlisted control group. This design minimizes
concerns about withholding services, and randomization allows for better causal
estimates than descriptive (e.g., pre-post) or quasi-experimental evaluations.
Furthermore, the one-year follow-up period gave clients enough time to incorporate
knowledge gains into their behavior. Behavior changes could then be documented in
credit report and bank account data. Finally, because clients were enrolled in a housing
voucher subsidy program, they were closely monitored and data were regularly available
as part of the program’s administrative process.
Despite these advantages, several caveats are worthy of discussion. Generalizing these
results to other programs requires caution. Because clients’ initial financial circumstances were particularly dire, they may have responded more strongly to financial
education than consumers with more stable financial situations. On the other hand,
administrative notes suggest that clients experienced a variety of obstacles including
domestic violence, unstable employment, drug and alcohol abuse, and problems finding
and maintaining adequate day care. Given the array of problems clients confronted, one
may expect that the Financial Fitness course would have more limited impacts. This
study is also specific to very low-income households in a housing subsidy pro- gram that
included a financial self-sufficiency component, which raises further questions about the
study’s generaliz- ability. Because clients were enrolled in other programming, they may
respond differently to financial education than cli- ents who are enrolled in housing
subsidy programs that lack a self-sufficiency component, or clients who are not part of
any type of housing subsidy program.
There are also problems related to the study’s design. First, the sample is small and was
reduced considerably by the consent process and attrition. The effects of consent and
attrition are only partially observable. While an analysis of the consent process indicated
that it did not bias the results, attrition was not random. Clients in the treatment group
were more likely to leave the program. While the statistical mod- els included observable
characteristics in order to minimize attrition bias, the models cannot account for
unobserved characteristics related to clients’ decisions to leave the pro- gram. The
second problem with the design is that members of the control group were aware of their
participation in the study. The consent process alerted clients that they needed to
complete the Financial Fitness course. Clients who were waitlisted and told they could
not attend Financial Fitness
classes for one year may have reacted to this information in ways that affected their
survey responses and even their behavior. For example, clients in the control group may
have initially intended to create a budget but upon being waitlisted decided to wait until
they took the course. Program staff suggested that while some clients were excited about
the program, most clients viewed it as just another requirement to remain eligible for
their housing vouchers. Nonetheless, the design may have introduced some unobserved
bias.
Directions for future research
This study has three primary implications. First, mandating financial education can have
positive effects on savings and credit outcomes among very low-income individuals.
Finan- cial education can also lead to improvements in clients’ self- reported
understanding of financial issues. If increasing sav- ings levels and improving credit
outcomes are policy goals, then incorporating mandatory financial education courses into
public programs may be a successful public policy.
Second, from a social welfare perspective, mandatory fi- nancial education programs may
lead to improvements in savings levels and credit quality that are more valuable than the
costs of service delivery. Additional benefits will be realized as improvements in clients’
credit ratings yield lower borrowing costs and greater access to credit. To the extent that
financial education can be delivered at a cost equal to or below its marginal benefit,
financial education is a good investment of public and private resources if improving
low- income families’ financial status is a policy goal.
Third, this study indicates that if influencing clients’ attitudes and perceptions is deemed
important—and the literature suggests beliefs are a precursor to behavior change—then
the content of financial literacy efforts should focus more on examining attitudes toward
spending, saving, incurring debt, and taking financial risks. Providers of such courses
should focus on the use of debt, planning for financial risks, and weighing the costs and
benefits of taking on various types of debt versus paying off existing debt or saving.
Teaching “values” is challenging, however, and may require innova- tive new
approaches.
It may also be possible to complement educational efforts with longer-term “coaching”
services. Using regular check-ins, a financial coach can help clients implement the skills
and knowledge they gain from formal financial education programs, as well as monitor
clients’ progress over time. Coaches can help clients formulate and achieve financial
goals and provide support for maintaining desired behaviors.9 Programs could also use
peer groups as a sup- port structure to help clients adhere to financial goals and develop
positive attitudes about money and savings. These approaches may help provide selfcontrol and impose con- straints on people who want to save and pay off debt, but who
have difficulty putting their newfound knowledge and skills into action.
Future research on financial literacy education could expand on these findings by
examining longer time periods. A longer study period would allow for further analysis of
the impact of financial education on credit and savings outcomes. Given the increased
risk of attrition as the study period is lengthened, however, such an approach would
require a substantially larger initial sample to allow for more extensive modeling.n
1For a review, see A. Lusardi and O. Mitchell, “Financial Literacy and Retirement
Preparedness: Evidence and Implications for Financial Education,” Business Economics,
42, No. 1 (2007), 35–44.
2J. Agnew and L. R. Szykman, “Asset Allocation and Information Overload: The
Influence of Information Display, Asset Choice and Investor Experience,” Journal of
Behavioral Finance, 6, No. 2 (2005): 57–70.
3D. Moore, Survey of Financial Literacy in Washington State: Knowledge, Behavior,
Attitudes, and Experiences, Technical Report No. 03-39, Social and Economic Sciences
Research Center, Washington State University,
2003.
4Agnew and Szykman, “Asset Allocation and Information Overload.”
5S. Meier and C. Sprenger, Selection into Financial Literacy Programs: Evidence from a
Field Study, Policy Discussion Papers, Boston: Federal Reserve Bank of Boston, 2007.
6I. Ajzen, “From Intentions to Actions: A Theory of Planned Behavior,” in J. Kuhl and
J. Beckmann (Eds.), Action Control: From Cognition to Behavior (pp. 1 l–39)
(Heidelberg:
Springer, 1985).
7Completing the course was mandatory. All clients were required to fill out baseline and
follow-up surveys. The follow-up survey was administered 12 months after the baseline
data collection for each client. The sample was completed in September 2007. Clients
received a total of $60 dollars if they completed both surveys ($30 each survey).
8The original paper uses three difference-in-differences specifications, only one of which
is reported in this article. The first specification is a traditional difference-in-differences
experimental estimator. This approach estimates the difference in changes between the
treatment and control groups from baseline to follow-up, using an indicator for
assignment into the treatment group. The second specification uses propensity score
matching to weight the traditional difference-in-differences experimental estimator. This
speci- fication attempts to balance the treatment and control groups due to the differential level of attrition. The third specification, reported here, includes control
variables to account for differences in the baseline values for each group that may be
associated with the intensity of other services received. In most cases the results become
more robust using the weighted estimator with controls, as might be expected.
9See, for example, A. Minzner, .S. Hebert, A. St. George, and L. LoConte, Evaluation
of the CWF Coaching Pilot (Cambridge, MA: Abt Associates, Inc., 2006).
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the Institute for Research on Poverty. All rights reserved.
Do Financial Education Programs
Work?
by lan Hathaway and Sameer Khatiwada
April2008
Do Financial Education Programs Work?
by Ian Hathaway and Sameer Khatiwada
In this paper we provide a comprehensive critical analysis of research that has
investigated the impact of financial education programs on consumer financial behavior.
In light of the evidence, we recommend that future programs be highly targeted towards a
specific audience and area of financial activity (e.g. home- ownership or credit card
counseling, etc.), and that this training occurs just before the corresponding financial
event (e.g. purchase of a home or use of a credit card, etc.). Similarly, in light of a Jack
of evidence, we also recommend that program evaluation be taken as an essential element
of any program, and that it be included in the design of the programs before they are
introduced.
Jan Hathaway is a senior policy analyst in the Research Department at the Federal
Reserve Bank of Cleveland. He can be reached at ian.hathaway@clev.frb.org. Sameer
Khatiwada is a candidate for master of public policy at the John F. Kennedy School of
Government at Harvard University and a former intern at the Bank. He can be reached at
sameer_khatiwada@ksg08.harvard.edu.
The authors describe five major steps they believe should be included when evaluating
financial education programs: pre-implementation (and needs assessment),
accountability, program clarification, progress towards objectives, program impact. In
the pre-implementation stage, the target group is identified, needs are assessed, and goals
are specified. Administering literacy tests on the target group is a good proxy for a needs
assessment. General indicators of needs could be high rates of non-business bankruptcy
filings, defaults on loans, and high consumer debt levels, among others. The
accountability stage involves the collection of information on education and services
provided, program cost, and basic information on program participants. The objective
here is to determine who has been reached by the program and in what way; that is,
whether the population in need is the population actually served. The program
clarification stage helps the program planners review an ongoing program's goals and
objectives and assess whether these goals and objectives should be revised. Next, the
progress towards objectives stage involves obtaining objective measures (quantified data)
of the impact of the program on the participants, and how those impacts relate to program
goals. Finally, the program impact stage involves an experimental approach (comparing
sample and control groups) to assess both the short-term and long-term effects of the
program. Information collected in the previous stage (progress towards objectives) helps
assess whether there were long-term and short-term effects. According to the authors,
there is scarce evidence of evaluation of financial literacy programs at the final stage
(program impact) because most financial education programs do not include impact
evaluation as a component of their program design.
5. Conclusions
So, do financial education programs work? The answer is: we can't say for sure one way
or the other.Working backwards in our framework (see Figure 1), it does appear as
though financial knowledge (i.e., financial literacy) does in fact lead to better financial
behavior. This of course brings us to the question of whether those who are financially
illiterate (i.e. lacking knowledge) are able to fill these knowledge gaps with financial
education programs. Unfortunately, we do not find conclusive evidence that, in general,
financial education programs do lead to greater financial knowledge, and ultimately, to
better financial behavior. However, this is not the same as saying that they do not nor
could not - it is just that current studies, while at times illustrating some success, leave us
with an unclear feeling about whether we can grant a blanket application of these results
specifically, to financial education programs more generally.
There are two likely reasons that we don't see the conclusive evidence on the
effectiveness of financial education programs that we are looking for. One possibility is
that the programs are simply not effective at transferring knowledge. That is, it is not that
financial education programs could not work, but rather, it is that they do not work,
perhaps because they are poorly designed or administered. A second explanation is that
because the formal evaluations of the programs that we examined earlier were completed
ex post, it is the inability of these evaluations to capture whether the programs worked or
not. The point here is that we just don't know if the programs are not working or if we'
just don't understand whether they are working because they are not being evaluated
properly.
In light of this, we offer two suggestions for improving the impact of financial education
programs on consumer behavior. First, while the overall evidence in favor of financial
education remains unclear, we do see a pattern that highly targeted programs, unlike
general programs, tend to be effective in changing people's financial behavior. As a
result, we contend that programs should be highly targeted toward a specific audience
and area of financial activity (e.g. home-ownership or credit card counseling, etc.), and
that this training occurs just before the corresponding financial event (e.g. purchase of a
home or use of a credit card, etc.).
Secondly, we recommend that including formal program evaluation methods in the
design of the program itself is critical in being able to measure whether the programs are
achieving intended outcomes. As we stated before, the evidence in favor of financial
education programs is unclear, and a major reason for this could simply lie in the
measurement of impacts. It is critical that we get a handle on what works and what
doesn't; effective program evaluation can do this.
Finally, we note that research on effectiveness of financial education is relatively new,
and thus limited. Similarly, it hasn't been until recently that we have seen important
advances in better understanding household financial decisions; that is, how households
decide how much to spend, how much to save, how to invest that savings, and ultimately,
and how to finance these investment portfolios through some combination of income and
borrowing.10 Progress on research in these areas is important because we need to
understand how consumers behave and how they make decisions in the area of personal
finance. Understanding this is critical in order to design programs that will influence
these behaviors for better financial outcomes. Similarly, better understanding what
works and what does not in financial education programs, through program evaluation
and experimentation, is crucial in successfully filling financial knowledge gaps.
10 For more, see Campbell (2006), Guiso, Haliassos and Japelli (2002), and Athreya
(2007)
C, A study of counseling provided to consumers in financial distress.
i. An assignment to be done in class.
You and the other members of your group are staff to a Senator and have been given an
assignment regarding consumer credit education. Please spend the first five minutes of
your time becoming better acquainted with one another by each stating your name and
answering a question such as: What is your favorite all time law school course or your
least favorite all time law school course?
Altogether you will have fifty minutes to develop your response to the Senator. After
that time each of the three groups will report to the class and we will discuss each of the
reports. Each group has been asked to develop a consumer credit course for a particular
segment of society and we will compare and evaluate the similarities and differences for
each target segment. We will spend about forty minutes making the reports and
discussing them.
Congress is about to pass a new bankruptcy law and the chair of the key committee in the
Senate has become aware that in Canada bankruptcy debtors must go through an
educational program in order to receive a bankruptcy discharge of their unsecured debts.
You and your fellow group members are staff to this Senator and you must draft a memo
to her indicating The following with regard to the curriculum for the bankruptcy
education program.
1. What would be the goal of requiring bankruptcy debtors to take the course?
2. What topics would you cover and how would you cover them?
3. What problems do you believe you would encounter in developing and teaching this
curriculum?
4. How would you evaluate whether the course is successful?
ii. Study Questions
What is the value of counseling and who should receive it? First time home buyers?
People in default? People who file bankruptcy?
What are we trying to do?
What is the problem it is intended to remedy?
Is it intended to change conduct;
what can we learn from health issues?
Bankruptcy debtors are required to obtain a “briefing” from a curtained counseling
agency within six months before they file or their filing is defective.
They are also required to receive an educational session from a certified provider before
they receive their discharge.
iii. Who are the counselors?
Please read the following articles. NORTON BANKRUPTCY LAW ADVISER MAY
2010
Has SUN SET ON TRADITIONAL CREDIT
COUNSELING AND IS THAT GOOD, BAD OR BOTH WHAT WILL RISE IN
ITS PLACE?
David Lander Thompson Coburn St. Louis, MO
The 1990s were the heyday of the consumer credit counseling industry. Twenty years
before, retail creditors and early credit card lenders had combined to equip a series of
separate nonprofit organizations with the wherewithal to help both consumers and
creditors. Consumers worried about their debt but not yet in serious difficulty received
advice about paying bills and budgeting purchases and that advice was generally without
charge (financial counseling only or FCO). Consumers often got relief from worry from
FCO and creditors were satisfied because counseled consumers were less likely to
default.
Consumers with debt problems too serious to be solved by FCO were "sold" a free debt
man- agreement plan (DMP). By pre-arrangement, most creditors offered valuable
interest rate and installment concessions in return for enrollment in a 1 00% payment plan
for unsecured creditors. Consumers for whom a DMP was the right choice benefitted
from the concessions and from the fact that the agency dealt with all of their creditors. It
was a great deal for creditors because it turned likely defaulters into likely payers. About
the same percentage of folks who typically complete Chapter 13 plans would complete
DMPs.
The DMP was so valuable to creditors that they returned what they called "Fair Share"
payments back to the agencies. From 1970 to the mid 1990s those•Fair Share payments
(others labeled them collection fees) amounted to 15% of the amount collected.
Miraculously, this was enough to allow the agencies that marketed effectively and
operated efficiently to provide both. "advice only" and debt management plan
administration without charging the consumer a direct out-of-pocket fee.
The agencies claimed to provide education and budgeting help to consumers as well. It
turned out that 15% was a bit rich. The fat in Fair Share could have inspired the agencies
to provide enhanced and improved services, but instead it led to a host of problems
including bloated executive salaries, perverse incentives for new entrants and growing
skepticism from creditors and consumers.
As consumer credit, especially credit card debt, expanded exponentially and defaults
skyrocketed, Fair Share payments skyrocketed as well. Attracted by this pot of gold,
entrepreneurial types who cared little about consumers or creditors flocked into the credit
counseling business and found ways to take money from both-by advertising expansively
and deceptively and selling everyone who walked in the door their most profitable item, a
DMP. These new agencies often masqueraded as § 50l(c)(3) tax exempt nonprofits in
order to comply with state Jaws but found creative ways of using excess revenue to line
their own pockets. After several years of abuses, the IRS and states' attorneys general,
led by Consumer -Federation of America and National Consumer Law Center, ran many,
but not all of the "bad guys" out of the credit counseling business.
As the clean up progressed, old-line agencies switched from face-to-face interviewing to
phone banks and internet contacts, and the largest of them swallowed up many of the
others. The result was an industry with a small number of very large providers using
phone banks that hardly resembled the "counseling" and education they previously
purported to offer. Creditors did not stand still through all these changes in the
counseling industry. In response to too many sales of DMPs to consumers who did not
need them, creditors developed criteria that qualified consumers for D.MP concessions.
As the credit card industry consolidated, the larger lenders developed in-house
concession pro- grams which bypassed the counseling agencies and avoided DMP Fair
Share. These lenders reduced their Fair Share payments (which for some had become
their second largest expense item) in several steps from 150;(, to about 5% of collections
and reconceived this reduced Fair Share as grants tied to complex formulas.' The IRS
crackdown on the phony nonprofits led the IRS to scrutinize all of the providers. The
IRS rejected the characterization that a DMP was charitable or educational and it probed
the complex relationship between the counseling agencies and creditors. At the height of
these investigations and the resulting outrage, Congress chimed in-prohibiting the IRS
from granting§ 50l(c)(3) status to agencies that relied too heavily on DMP Fair Share
revenue. Although the relationship between counseling agencies and creditors has
hardened considerably, it remains robust. Even today, some large creditors continue to
refer selected customers to a few of the largest phone bank agencies, at least one of which
was severely and justifiably embarrassed at a congressional hearing by the astounding
salaries paid to multiple family members whose job responsibilities were obscure.
Perhaps the starkest implication of all this change was the devastating reduction in the
revenue of the surviving agencies. Fair Share had been cut by two thirds, there were
fewer opportunities for a DMP and there was no money to provide financial counseling
without a revenue source. Because their educational and counseling missions had always
been suspect, the agencies had few friends in the consumer movement
These factors dominated the period from the late 1990s to 2005 when two important
developments occurred. The first was passage of amendments to the Bankruptcy Code
which became effective in October 2005. Credit card lenders convinced Congress that
many "unnecessary" bankruptcies could be prevented if consumers were required to
obtain a "briefing" before they were eligible for bankruptcy and that repeat bankruptcy
filings could be reduced if the discharge was conditioned on debtors completing "an
instructional course concerning personal financial management"
When the Executive Office of the United States Trustee advertised for honest providers
of these briefing and instructional services, the folks first to come forward and to be
accepted were cred- it counseling agencies that were nonprofit and seemed legitimate.
There is considerable debate whether the statutory services are useful to debtors or
creditors, but there is no doubt that these requirements have provided a new and badly
needed source of revenue for the traditional agencies. Indeed, in 2008, nearly 25% of the
"counseling" sessions provided by agencies affiliated with the National Foundation for
Consumer Counseling (NFCC) related to the compulsory requirements of the
Bankruptcy. Abuse Prevention and Cm1sun1er Protection Act of 2005. As competition
among the providers for bankruptcy debtors has somewhat reduced the fees for these
services, bankruptcy briefings and instructional courses have become a less robust source
of replacement revenue for the agencies.
The second recent revenue enhancing opportunity was precipitated by the devastating
explosion of home foreclosures. Some credit counseling agencies had historically
provided !-IUD first-time home buyer counseling as well as FHA counseling for
homeowners who were behind on their mortgages. One major difference between
housing counseling and credit card counseling is the source of funding. Much of the
housing counseling is paid for by the federal government through a contract with an
entity known as Neighborworks.
When foreclosures exploded, Neighborworks needed more counseling capacity
throughout the country. The credit counseling agencies had counselors, needed more
customers and very much needed the revenue that these customers would provide. By
2008, foreclosure counseling constituted 50% of the counseling sessions pro- vided by
NFCC member agencies. These sessions are primarily diagnostic to determine whether a
consumer fits an available foreclosure forbearance program. Interestingly, there has been
very limited independent evaluation of the "value" to consumers•of this type of
counseling.
So, where does this leave consumers worried about their debts, but for whom foreclosure
forbearance is not relevant or realistic and who do not wish to file bankruptcy? Consider
their plight and thought process as they watch late-night television; unable to sleep. First,
they see the ad for a consumer bankruptcy attorney; then they see the ad for a credit
counseling agency; finally, they are captivated by a new entrant to the mix-the loud, slick
promo full of largely false promises by a Debt Settlement Provider (DSP). Indeed, as
advertising by bankruptcy attorneys and credit counseling agencies has diminished, debt
settlement industry ads have exploded. DSPs promise the magic that every consumer
wants and which the credit counseling industry cannot honestly offer: the elimination of
most credit card debt. After watching the three ads, it is no wonder that droves of
consumers are succumbing to the false promises of debt settlement.
The community of DSPs asserts it provides a valuable service to over-indebted
consumers. Not surp1isingly, the community of credit counseling agencies thinks that
DSPs do not provide valuable services and charge too much for whatever they do. The
consumer advocacy community is appalled by the viral growth of DSPs. The March
20 I 0 issue of Consumer Reports warns consumers away from DSPs. The Consumer
Federation of America, the National Consumer Law Center and Consumers Union have
joined efforts to inform consumers precisely how little the industry offers, how much it
charges and to seek regulatory prohibition of some dangerous practices. The Federal
Trade Commission is involved in rule making that would require changes in the way
DSPs charge and provide services. Attorneys General of several states have closed down
large providers and others are engaged in enforcement activities. Ironically, at the same
time the debt settlement industry is experiencing severe criticism, it is having marked
success convincing state legislatures to provide a debt settlement industry friendly
environment.
Granted, there are renegade outliers in the debt settlement industry that even the
mainstream of the industry opposes. Still, the almost universal use of high-volume
advertising, the get-rid-of- debt-quick promises, the large, up-front fees and the high
failure rates make it hard to believe that there is any magic for consumers in the rising
DSP tide.
So, for those for whom foreclosure forbearance is not relevant, the choice is between
bankruptcy, debt settlement or credit counseling. For those about to lose their house or
car or whose debt is clearly beyond their ability to pay, bankruptcy along with a good
bankruptcy lawyer is the only viable alternative. At the margins; folks who won't
consider bankruptcy and those less in need of bankruptcy who might benefit from lender
concessions should undertake direct negotiations with card issuers or engage a reputable
credit counseling agency to develop a DMP. It is possible to conceive of an industry,
expert at extracting debt reduction concessions that most consumers could not realize
alone, that advertises honestly and charges fairly. Unfortunately, that is not the debt
settlement industry that exists today or that is likely to exist in the near future.
Over indebted consumers who want help understanding bow to live within their means or
who want to change their behaviors need advice from professionals in an industry that
also does not presently exist. The credit counseling industry might have shifted to fill
this gap in the late 1990s when they were awash with cash, but they were never
sufficiently consumer-client-centered, they had insufficiently trained staff, paid salaries
that were too low, and did too little quality training or evaluation. Certainly there are
individual counselors who combine commitment with quality skills and a consumerclient-centered approach, but the current configuration of phone banks and limited time
and skills make this the exception.
The consumer debt crash has created an environment in which social work schools or
business schools might develop curriculums and a career path for students who would
work in this "future" and badly needed profession. High quality client- based nonprofit
human service providers such as the Financial Clinic in New York and the Centers for
Working Families program funded by the Annie Casey Foundation offer a model for this
profession and perhaps could hire the first generation of "to be trained professionals." A
few of the best and most ambitious of the existing credit counseling and housing
counseling agencies might also rise to the occasion. All of this will require a level of
rigorous evaluation that is currently absent across the board in housing and credit card
counseling. The past couple of years has seen an explosion of prestigious business and
other professional schools launching efforts to bring scholarly research and publication to
consumer indebtedness. They are a discipline looking for a purpose and perhaps they
will help fill this gap.
Social Workers and Financial Capability in the Profession's First Half-Century
PAUL H. STUART
During the post-World War II suburbanization of the United States, as families moved
from the working class into the middle class, from cities to the suburbs, and from renting
to owning homes, they incurred debt in a variety of new ways. These debts-incurred
through home mortgages and time purchases of house- hold appliances, furniture, and
recreational goods and services-meant that the new middle-class lifestyle was "sustained
by a heavy bet on the future-long-term mortgages for the home, the installment plan for
the future" (Wilensky & Lebeaux,
1965, p. 113). For millions of families, middle-class incomes depended on two jobs and,
often, overtime pay. In addition, the prosperity of the post-World War II era was
unevenly distributed, and there were barriers to the social mobility that had at first
appeared to be within the grasp of all.
As borrowers were encouraged to take on more debt than they could sustain, new
problems and "new opportunities for service" arose, as detailed in Industrial Society and
Social Welfare by Wilensky and Lebeaux (1965, p. 174). They cite an examination of
the finances of 83 middle-income young suburban couples, who "prefer the high-interest
installment plan to the free charge account[s]" often pro- vided by stores. The couples
"show colossal indifference to and ignorance of 12 and 18% interest rates of revolving
credit plans' at the department store" (p. 175). In response to these trends, Wilensky and
Lebeaux (1965) advocate that family service agencies should undertake "skilled, hardheaded advisement of clients in the purchase of homes and expensive commodities" for
the "increasing numbers of people" experiencing "real problems."
Prescient as this observation seems today, the half-century following the pub- lication of
Industrial Society and Social Welfare saw only isolated attempts to incorporate building
clients' financial capability into social work practice. In part, social work practice
followed social policy. The New Frontier and Great Society programs of the 1960s
focused on social services to prepare clients for the work force and political mobilization.
After Richard Nixon's victory in the presidential election of 1968, job training programs
and income supports became ascendant. Although social work practice theorists
considered environmental modification a promising intervention, this has usually meant
the social worker acting to modify the environment on behalf of the client rather than the
social worker acting to help clients increase their financial capability.
In 1973, Richard M. Grinnell Jr., called for a renewal of environmental modi- fication by
social caseworkers. His definition of environmental modification included "enriching the
environment through provision of new stimuli, outlets, resources, and services" and
"helping the individual make profitable use of these opportunities and inputs" (p. 219).
While this definition would have been quite compatible with interventions designed to
create institutions to promote increased financial capability, Grinnell did not include such
interventions. Similarly, Kemp, Whittaker, and Tracy (1997) did not explicitly discuss
building clients' financial capability in their otherwise excellent exposition of personenvironment practice, an approach to social work practice.
Wilensky and Lebeaux (1965) presented the idea of social workers doing finan- cial
counseling as something new, a response to the unprecedented growth of the suburban
middle class, fueled by industrial expansion. However, a glance at the history of social
work practice suggests that social workers and their predecessors in state charities,
private charity organizations, and settlement houses were heavily invested in building the
financial capability of their clients in the Gilded Age and Progressive Era, through
advice-giving, financial education, and the creation of new institutions for saving and
borrowing. As Charlotte Towel observed in 1930, "In the long life of social work, one is
aware of fluctuating emphases ... Back and forth the pendulum swings [but] change does
not necessarily imply growth; it may imply regression" (p. 341). This chapter will
review social workers' concern with clients' financial capability in the profession's early
history, explore the decline of professional concern for financial capability, and conclude
with the importance of building client financial capability today.
The interest of early social workers in financial capability originated from the mission of
the emerging social work profession-the alleviation and prevention of poverty (Popple &
Reid, 1999). Often expressing their goals in moralistic terms, early social workers
attempted to build up the financial capability of families and neighborhoods in a society
that was experiencing increasing disparities in wealth and income, even as the average
wages of industrial workers were rising. Building financial capability, social workers
believed, would secure the financial position of poor people, smoothing out the swings of
good times and bad that seemed to characterize their clients' lives.
Social work as an occupation originated during a period of crisis in American society.
Urbanization, immigration, and industrialization resulted in increasing and seemingly
unbridgeable chasms between urban and rural people, between rich and poor, native-born
and immigrants, and Protestants, Catholics, Christians, and Jews (Addams, 1893b). In a
period of increasing crisis, social workers, like other progressives, attempted to heal the
rifts in the society by providing practical advice (in Charity Organization Societies), by
being good neighbors (in settlement houses), or by saving children (in nascent public and
private child welfare agencies) (Stuart, 1999a). Unlike child welfare workers, charity
organization and settlement workers regarded themselves as generalist practitioners-they
engaged with clients or neighbors about a range of problems that the clients or neighbors
were experiencing and attempted to resolve those problems. As was the case with child
welfare workers, many of the problems encountered by charity organization and
settlement workers resulted from poverty, so service to the poor, specifically finding
ways to prevent poverty and bring the poor out of poverty, dominated professional
discussions at the turn of the twentieth century.
Charity organization societies (COS) and settlement houses were established in most
American cities between 1880 and 1910. Charity organization societies attempted to
organize charitable giving, directing assistance to those found to be "truly needy" and
studying the causes of poverty. Settlement house residents moved into immigrant
neighborhoods, becoming neighbors of the poor; neigh- borliness would result, it was
hoped, in bridging the gaps between social classes. As Jane Addams (1893a), put it, Hull
House was started in the belief that the mere foothold of a house, easily accessible, ample
in space, hospitable and tolerant in spirit, situated in the midst of the large foreign
colonies which so easily isolate themselves in American cities, would be in itself a
serviceable thing for Chicago. Hull House endeavors to make social intercourse express
the growing sense of the economic unity of society (p. 27).
Both charity workers and settlement residents emphasized the development of financial
capability. Settlement house residents helped organize the Women's Trade Union League
in 1903 as a means to improve the working conditions and pay of women workers (Davis,
1964). Josephine Shaw Lowell, the secretary of the Charity Organization Society of the
City of New York (NYCOS), argued that all workers needed a living wage, one that
made it possible "to secure what they have learned to consider the necessaries of life"
(Lowell, 191lb, p. 412). She enjoined friendly visitors to make special efforts to
persuade the family to prepare for the future and to lay by for the idle time of the next
year; [they] can then inculcate lessons in economy and in saving which may be the means
of lifting the family permanently on to a higher level than they would ever have attained
without [the visitors'] friendly encouragement (Lowell, 19lla, pp. 147-148).
Emphasizing thrift and savings, then, seemed a key to solving the problem of poverty.
Poor people needed access to financial institutions.
Charity organizations promoted what we would call today the empowerment of the poor,
as well as providing good advice and persuasion; Lowell argued that workers needed to
organize labor unions to secure decent compensation. In 1890, she founded the New
York Consumers' League, an organization that pressured employers to improve the wages
and working conditions of women workers in New York City. Nine years later, Lowell
and other members of the New York Consumers' League helped establish the National
Consumers' League.
THRIFT AND SAVINGS
Thrift was a catchword of charity organizations; visitors were instructed to use their
influence to guide families, and especially husbands, in the direction of savings and
careful budgeting. Lowell (1884) outlined a variety of provident schemes that would
"help people to help themselves" (p. 109). She pointed out that savings banks, by the
1880s "immense business enterprises;' had been initiated in Europe during the eighteenth
century as charitable enterprises, a way to help poor people manage their financial
resources. In the United States, savings banks were established early in the nineteenth
century, many of them by reformers. By the 1870s, savings banks held "between a
quarter and a third of all the wealth in all the financial institutions in the country"
(Wadhwani, 2006, pp. 126-127).
Mary Richmond, secretary of the Baltimore Charity Organization Society (COS), advised
friendly visitors to develop habits of thrift among the poor. Thrift was not a "merely
economic" virtue, but an indication of a person's optimism and self-commitment.
Visitors could advocate thrift "for both economic and moral reasons" (Richmond, 1899,
pp. 108, 110). In the 1880s and 1890s, charity organization societies created savings
banks, small loan programs, and pawnshops for the poor as alternatives to commercial
enterprises that often exploited or ignored the poor. Savings was a necessary aspect of
thrift, according to Mary Willcox Brown (1899), who was to succeed Mary Richmond as
secretary of the Baltimore COS. Savings institutions were essential; the savings bank
was "educational because it shows an improvident class the need of foresight; a thriftless
body the utility of being frugal. It is educational because it teaches men to be
independent and trains children to recognize the power they have of accumulating a small
capital" (p. 71).
Based on a successful experiment initiated by the Charity Organization Society of
Newport, Rhode Island, in 1879, the Castleton Charity Organization Society, on New
York's Staten Island, created a savings society for its clients in 1883. According to Anne
Townsend Scribner (1887), of the Castleton COS, "The main objects gained... by the
introduction of the Savings Society are two: first, the inculcation of thrift; and, second,
the aid to friendly visitors which the society offers. To raise the needy above the need of
relief is one of the first principles of the Charity Organization Societies. That the Savings
Society is a wonderful aid in this work of helping the poor to help themselves has been
proved beyond question by the society's work on Staten Island" (p. 144).
The savings plan was simple; volunteer collectors visited families weekly to collect a prearranged amount to be saved, providing a receipt for the deposit. Once
deposited, the funds could be withdrawn at any time, as needed for emergencies or when
the amount saved was enough for a major purchase. Like industrial life insurance
policies that were marketed to the poor beginning in the 1870s, the savings plan provided
a form of budgeting that enabled poor people to plan for the future (Stalson, 1942). The
plan proved to be popular, even providing an entree for friendly visitors to the homes of
families "where entrance would be impossible on other than a business footing"
(Scribner, 1887, p. 146). Soon other charity organizations on Staten Island joined in the
project. The NYCOS established a "Penny Provident Fund;' aimed largely at
schoolchildren, in 1899. The fund provided savings stamps for persons who saved from
one to fifty cents, and encouraged them to establish regular savings accounts when the
savings amounted to $10 or more. Within a year, the fund had ten thousand depositors
and deposits of over $3,600 (Cruce, 2001; "How to Save Pennies;' 1890).
Reformers and self-help organizations continued to establish savings banks and other
financial resources for the poor during the Progressive Era. The Independent Order of St.
Luke, an African American self-help organization, established the Provident Savings
Bank of Richmond, Virginia, in 1903. As a result, Maggie Lena Walker, the grand
secretary-treasurer of the order, was the first woman to head a bank in the United States
(Brown, 1989; Simmons, 1975).
Although they were criticized for their often amateurish approach to problems of urban
poverty (Cummings, 1892), settlement houses, like charity organization societies,
engaged in efforts to improve the financial capability of their neigh- bors. Settlement
residents espoused a goal of the protection and enhancement of working-class standards
of living" (Woods & Kennedy, 1922, p. 200). In addition to their support for labor
unions, settlement houses studied small loans taken by their neighbors and introduced
savings plans and small loan enterprises (Report of the Social Settlement Committee,
1896). Some settlements also introduced cooperative ventures such as buying clubs to
provide groceries, coal, and other necessities to neighbors at a reasonable cost. Residents
of New York's Greenwich House were informed about the neighborhood's savings banks,
postal savings offices, penny provident stamp stations, sources of loans, and laws
regulating loans in New York State. "Trustworthy loan associations," residents were
informed, were "unfortunately few in number" (Dinwiddie & Ferguson, !913, p. 39).
Many charged "all that the traffic will bear:• in the words of Robert Treat Paine, a Boston
philanthropist and treasurer of the Workingman's Loan Association (Paine, 1895, p. 15),
even adding fees to excessive interest rates.
LOANS
Both COS workers and settlement house residents viewed themselves as gen- eralists in
social work; they encountered a variety of problems and developed solutions for them
(Stuart, 1999a). The savings plans developed in the late nineteenth century were
examples of responses to a perceived problem. When periods of unemployment
increased the demand for credit, charity organization societies established remedial or
provident loan associations, organizations that made "small loans at reasonable rates"
(National Federation of Remedial Loan Associations, 1919, p. 33; for an example of a
charity organization society that organized a remedial loan association, see Johnson,
1916). However, the extent of the financial problems encountered by clients suggested
that more specialized action was necessary.
Most troubling was the increasing use of credit-both for immediate needs and for major
purchases. In 1895, Joseph Lee reported that loan sharks, installment buying, and pawn
shops were charging "from 36% to 100% per annum" interest on loans to poor people (p.
506). Chattel mortgages, loans on movable personal property such as household
furniture, carried reported interest rates as high as 120% in Cambridge, Massachusetts
(Birtwell, 1899). Improved regulation of small loans, particularly reducing interest rates
and fees, seemed to be the solution, but most state laws delegated regulation of small
loans to municipalities, complicating reform efforts. A survey of pawnshops in ten cities
revealed effective annual inter- est rates of between 30% and 300% (Patterson, 1899).
In 1894, the NYCOS organized the Provident Loan Society of New York as a separate
organization, with offices in the United Charities Building, headquar- ters for a number
of charitable and philanthropic organizations, including the NYCOS. The purpose of the
society was to "help people help themselves without loss of self-respect" by providing
loans at reasonable interest rates to the neediest (Provident Loan Society, 1919, p. 21).
The success of the Provident Loan Society resulted in the organization of similar
"remedial loan" organizations in cities across the country and the organization of a
national organization, the National Federation of Remedial Loan Associations (Ham,
1910).
Although the founding of the Provident Loan Society had "partially solved" the small
loan problem in New York "for those who can borrow on the pledge of per- sonal
property;' difficulties remained for people in need of small loans (Wassam,
1908, p. iv). The New York School of Philanthropy's Bureau of Social Research, which
had been created as a result of a grant from the Russell Sage Foundation (RSF),
conducted studies of salary lenders and the chattel loan business in 1908 and 1909.
Clarence W. Wassam's The Salary Loan Business in New York City (1908) found that
salary lending-loans secured by the borrower's future paycheck-was widespread, and
lenders charged very high interest rates. Arthur H. Ham's 1he Chattel Loan Business
(1909) described businesses in New York that loaned small amounts of money using
personal property, such as household furniture, as col- lateral. Although a small number
of loan associations started by philanthropic organizations were doing good work, Ham
concluded that they did not provide effective competition; many chattel lenders continued
to charge very high rates of interest, tacking on fees that made the effective interest rate
even higher.
In 1909, RSF, the "center of intelligence of the charity organization movement"
(Hammack, 1994), created a Remedial Loan Division to encourage the formation of
remedial loan associations and to advocate for legislation to regulate small loan
programs, with Ham as the director (Anderson, 2008). In addition to serving as the
director of the RSF Remedial Loan Division, Ham served as a vice president of the New
York Provident Loan Society. Ham and other reformers lobbied for
legislation regulating small loan businesses that catered to the poor, and encouraged the
formation of remedial loan associations in other cities. The foundation also supported the
organization of a National Federation of Remedial Loan Associations, and Ham and
representatives of local societies discussed the remedial loan movement at several
National Conferences of Charities and Correction and at the New York Academy of
Political Science in the 'teens. Ham was a member of a standing committee on remedial
loans which planned several sessions at the 1910 National Conference (Organization of
the Conference for 1910, 1909). By the 1920s, lobbying for regulatory legislation and
monitoring the implementation of regulations were seen as professional responsibilities,
in part because of the example of the remedial loan campaign (Bruno, 1923).
Over the next three decades, the Russell Sage Foundation was successful in setting up
numerous remedial loan associations and credit unions and in secur- ing regulatory
legislation in 34 states, based on a model law, the Uniform Small Loan Law, drafted by
Ham and his associates. Although the impetus for remedial loan associations and small
loan regulation originated with the charity organization societies, social workers were not
for the most part involved in the operation of the loan associations. The New York
Provident Loan Society hired "a practical pawnbroker;' a person with experience in the
business, not a social worker, to manage its credit business when it was established in
1894 (Provident Loan Society, 1919). Although remedial loan societies were encouraged
to cooperate with charity organization societies, specialization resulted in the separation
of social workers from the activity.
The federal government reformed the national banking system with the enact- ment of the
Federal Reserve Act of 1913 (38 Stat. 251), which established the Federal Reserve
System. However, the Act regulated national banks and not small lenders, who usually
operated on a local level (Mehrling, 2002). The Glass-Steagall Act of 1933 ( 48 Stat.
162) separated commercial banking and investment banking and created the Federal
Deposit Insurance Corporation (FDIC), which insured bank deposits. As was the case
with the Federal Reserve System, the FDIC did not regulate small lenders, Thus, reform
efforts directed at small lenders focused on the state rather than the federal level (Kelso,
1948b).
THE FAMILY BUDGET
Much early research in social work focused on the cost of living and the budget necessary
for a family to maintain an adequate standard of living. English studies, notably Charles
Booth's Life and Labour of the People of London (1889-1903) and Seebohm Roundree's
Poverty: A Study of Town Life (1901), inspired much of this work (Appelbaum, 1977;
O'Connor, 2001). Hull-House Maps and Papers (Residents of Hull- House, 1895), which
included data on the incomes and expen- ditures of people in Chicago's near West Side,
provides an early example, as does W. E. B. DuBois's The Philadelphia Negro (1899).
Margaret F. Byington's Homestead: The Households of a Mill Town (1910), a volume of
the Pittsburgh Survey funded by the NYCOS, included data on workers' incomes and the
cost of living. The first article published in the new social work research journal, the
Social Service Review, was Leila Houghteling's "The Budget of the Unskilled Laborer"
(1927a), a summary of her book-length study of Chicago workers, The Income and
Standard of Living of Unskilled Laborers in Chicago (1927b). Houghteling, a former
super- intendent of the United Charities of Chicago's Haymarket district, earned one of
the first doctorates awarded by the University of Chicago School of Social Service
Administration and was a member of its faculty at the time of her death in 1927 ("Leila
Houghteling:' 1927).
In his review of estimates of the poverty line between 1904 and 1965, Gordon M. Fisher
(1997) found that "much of the work on poverty lines and standard budgets during the
first two decades of the twentieth century was done by social workers." As a result,
studies of the poverty line were not mere "sociological investigation" but "constructive
work" as Jane Addams put it: "using investigation as the basis of wide-ranging programs
of community mobilization and action [and] using investigation as the basis of publicity"
(O'Connor, 2001, p. 31).
Diana Karter Appelbaum (1977) analyzed studies of the poverty line completed from
1906 to the 1970s. She concluded that the theoretical family budgets on which the
poverty line was based reflected arbitrary judgments as well as prevailing social values.
Estimates of the poverty line "served the dual purposes of providing a definition of
poverty ... and of furnishing guidelines to social workers to help them decide how much
aid a family needed to reach an adequate level" (p. 516).
Initially, social workers used family budgets to provide a guide to calculating the
appropriate amount of assistance to be provided to a relief recipient (Goodyear,
1906). In time, budget studies came to have other uses as well. Data on the cost of living
could provide guidance for reform efforts, as sociologist Robert C. Chapin (1910) told
the National Conference of Charities and Correction. After comparing workers' wages in
several industries to the cost of living, Chapin concluded that "it is difficult to believe
that [these workers earn] a living wage, save for a single man" (p. 456).
In 1912, the National Conference's Committee on Standards of Living and Labor called
for minimum wage commissions to be established in each large city to estimate the cost
of living as the basis for a minimum wage. The committee's report would be endorsed by
Progressive Party presidential candidate Theodore Roosevelt and would provide the
domestic plank of the 1912 Progressive Party Platform (Stuart, 1999b). Committee
member Florence Kelley (1912), general secretary of the National Consumers' League,
which had been campaigning for minimum wage legislation since 1908, told the
conference that insufficient wages underlie a vast proportion of the need for correctional
and reformatory work. They entail upon the community child labor, tuberculosis,
underfeeding, lack of refreshing sleep, and the consequent nervous break- down. They
underlie industrial employment of mothers, whose neglected children consequently fail in
health and morals. The children in turn crowd the hospitals, dispensaries, juvenile courts,
and custodial institutions
(p. 396). A minimum wage commission would study the cost of living in a city and
recommend minimum wage rates based on their investigations (Lovejoy, 1912).
The Committee on Standards of Living and Labor had recommended minimum wage
legislation affecting all workers, but the earliest minimum wage legislation in the United
States provided for women workers only. In 1912, Massachusetts enacted the first
minimum wage legislation, a weak bill that provided for a Commission that could make
recommendations for minimum wages for women in particular industries (Berkowitz &
McQuaid, 1988). However, Oregon first amended its constitution to permit minimum
wage legislation for men and women, and then enacted minimum wage legislation that
provided minimum wages for women. By 1913, seven states had enacted minimum wage
laws and five additional states were studying the issue (Kelley, 1913).
The provision of mothers' pensions by both private and public agencies provided another use for the family budget. Caroline Goodyear (1906), a District Agent for
the NYCOS, calculated a minimum budget for an "adequate standard of living" in New
York City to guide decisions about the amount of pensions, ongoing as opposed to
emergency relief, granted to families. This was to be the first of numerous studies of
adequate family budgets. The New York Association for Improving the Condition of the
Poor (AICP) calculated family budgets for recipients of its widow's pension program,
usually in consultation with a dietitian and the mother (Matthews, 1914). A NYCOS
report found that a family budget "helps family and social worker to plan ahead with
reference to necessary expenditures rather than adjusting present expenditures simply to
meet present needs" (Committee on Home Economics, 1919, p. 1).
As public mothers' pension programs were established, beginning in Illinois and Missouri
in 1911, social workers in the new public entities administering the new public programs
became engaged in estimating budget needs (Goodwin, 1997). Gertrude Vaile (1914), a
graduate of the Chicago School of Civics and Philanthropy (now the University of
Chicago School of Social Service Administration) and executive director of the Denver
Board of Charities and Corrections, told the National Conference that
the size of pension is another point needing careful consideration. We feel strongly that
if a pension is to be granted at all it should be sufficient to exempt the family from the
need of any other charitable relief and maintain a wholesome and dignified standard of
living. Only on that basis can a family be expected to live as they should ... The amount
of the pension is deter- mined by making a careful estimate of the necessary budget and
subtracting from it what the family can provide from their own resources (p. 675).
As educational programs for the new profession of social work were established,
budgeting and the social worker's role in using budgets with clients were topics for
course work and for publications. For example, the Chicago School of
Civics and Philanthropy published The Charity Visitor (Sears, 1918). This "hand- book
for beginners" included advice for new social workers and a chapter on "Estimating a
Family Budget" by Florence Nesbitt, a pioneer dietician and social worker. Nesbitt's
chapter was also published separately by the Chicago Council of Social Agencies as The
Chicago Standard Budget (Nesbitt, 1918a).
SOCIAL WORK AND HOME ECONOMICS
The association of social work with another nascent profession-home economicssupported the interest in family budgets. Although "the widest pos- sible variation ...
will be found among the families that come under the social worker's care:' Florence
Nesbitt (1918b) observed,
the need for certain educational work is practically universal. None of the mothers are
familiar with the simple principles of nutrition which must be known by one who would
make intelligent choice of foods. None possess such a knowledge of the comparative
values of different foods, kinds of clothing, household materials and supplies, as will
enable them to lay out their money to the best advantage. All need more or less
instruction in dietetic standards and help in planning the family budget. (p. 26).
In a Children's Bureau study of mothers' pension administration in nine loca- tions
nationwide, Nesbitt (1923) found that the social workers "gave a great deal of instruction
in diet, management of income, and care of health ... they taught the mothers to keep
expense accounts and to budget their incomes" (p. 34).
Nesbitt was "one of the best-known home economists in social service" ("Our
Contributors:' 1935, p. 690), and had a long career bridging the two professions.
Beginning as a dietitian in the Cook County Mothers' Pension program, she spent most of
her career in social work, becoming assistant general superintendent of the United
Charities of Chicago by the 1930s. By the mid-1930s, the Chicago Standard Budget,
revised several times since its appearance in 1918, was regarded as an authoritative
source for estimating family needs (Douglas, 1935).
The American Home Economics Association had a Social Work Committee in the 1910s
and early 1920s. The committee encouraged home economists to attend the National
Conference of Social Work. At the 1917 National Conference, the committee sponsored
a luncheon discussion of the relationship between home economics and social work
(Winslow, 1917). The committee's chair, Emma Winslow, was on the faculty of
Columbia University's Teachers College and a member of the NYCOS Committee on
Home Economics. In 1919, the committee published Winslow's pamphlet, Budget
Planning in Social Case Work.
In addition to Nesbitt and Winslow, Sophonisba Breckinridge, an instruc-
tor and head of the Research Department at the Chicago School of Civics and
Philanthropy, taught in the Department of Household Administration at the University of
Chicago and served as assistant dean of women from !904 until
!920, when the Chicago School became the university's School of Social Service
Administration (SSA) and Breckinridge a full-time SSA faculty member. Marion Talbot,
a pioneer in home economics, a mentor to Breckinridge, headed the Department of
Household Administration and served as Dean of Women at the University of Chicago
during those years.
Much of home economics was practiced in the public schools, through classes in
cooking, textiles, and child care; however, many home economists realized "the large
scope of the field and the fact that it could not all be reached through the school" (Midwinter meeting, 1921, p. 10). Although Nesbitt and Winslow remained active in social
work circles during the 1920s, and Breckinridge was an important figure in the social
work profession during the 1920s and 1930s, interest in interprofessional collaboration
faded during the decade. Social work entered a period of expansion, with the
establishment of new professional schools, the expansion of state-supported social and
health services for children, and an increasing professional self-consciousness.
Homemaker services were provided by some private social agencies in the
1920s and in state public assistance programs established by the Social Security Act of
1935, sometimes under the supervision of home economists. As in the Mothers' Pension
and private family welfare programs of the 1920s, social workers provided social services
to beneficiaries of the public assistance programs established by the Social Security Act.
Although caseloads were often very large, many social workers in public assistance
provided financial advice to their clients. In addition, the Works Progress Administration
provided a Housekeeping Aides Program for unemployed women in the 1930s and early
1940s. Nonprofessionals who had been trained by home economists and social workers
provided house- keeping services on a temporary basis to families in need of them,
usually because of the mother's illness (Morlock, 1942). However, although the
homemakers provided some instruction in household management, including budgeting,
the focus of most homemaker programs was on providing substitute services when the
mother was away from home (Brewster, 1965).
PROFESSION-BUILDING AND SOCIAL MOVEMENTS
In part, the decline of interest in home economics-and in building clients' financial
capability generally-may have been an unintended consequence of increased
specialization in social work, and the directions that specialization took (Stuart,
1999a). Even by 1910, it seemed that there were too many social movements, each
focused exclusively on a particular goal. In that year, Mary E. Richmond, the chairperson of the National Conference's Committee on Families and Neighborhoods,
convened a conference session on "The Inter-Relation of Social Movements:' Richmond
observed that "more social movements, national in scope, have been organized during the
last ten years than the sum of all the movements organized before that date and still
surviving" (Richmond, 1910, p. 212). The result of this proliferation had been
confusion-although many of the national movements had been initiated by settlement
houses or charity organization societies, the average worker felt estranged from the
movement and had difficulty relating to it.
At the session, Howard S. Braucher, of the Playground Association of America; Owen
R. Lovejoy, of the national anti-child-labor movement; Lawrence Veiller, of the National
Housing Association; and Alexander M. Wilson, of the National Association for the
Prevention of Tuberculosis outlined their organizations' campaigns and solicited social
worker participation. Richmond (1910) addressed three pleas to the national
organizations: (1) to relate the national movements to the work of the charity
organization societies and the settlements, (2) to recognize the rehabilitation of families
and neighborhoods as necessary and important, and (3) to link the specialized goals
together, not only with neighborhood and family workers but also with each other.
Richmond recommended that the specialized social movements recognize the work of
charity organization societies and settlement houses-family and neighborhood
rehabilitation-as important in itself and as a potential ally in their more specialized
campaigns. To do so, the specialists would need to make their campaigns intelligible to
generalists, in particular charity and settlement workers.
However, fragmentation characterized reform campaigns in the 1920s. As had
happened with the provident loan movement, reform campaigns focused on achieving
limited goals in a difficult policy environment. Both charity work and• settlement work
became more specialized during the decade. Settlement houses focused increasingly on
recreation and adult education (Stuart, 1990). Charity work became family case work,
ironically as a result of Richmond's prodding. She led an RSF effort to create a national
organization of charity organization societies, which became the American Association
for Organizing Family Social Work in 1919 and the Family Welfare Association of
America in 1930. Family social workers became increasingly interested in psychological
aspects of casework and in 1930, two years after Richmond's death, labor activist A. J.
Muste complained that family agencies, the successors to the COS, "have gone
psychiatric in a world which has gone industrial" (Stuart, 1999a, p. 51).
Some social workers continued to be concerned with financial capability. Robert W.
Kelso, a leading social work administrator in the 1920s and 1930s, who became the first
director of the University of Michigan's social work program in
1935, published a monograph on the small loan business in the United States in
1948. After tracing the history of remedial loans and efforts to regulate the small loan
business, Kelso offered an optimistic assessment of the social responsibility of small loan
businesses:
Today, under the protection of [regulatory] statutes, a legitimate business can set itself up
as a genuine banker for the low-income family, making a decent profit, sufficient to
encourage capital to remain in the business of sell- ing credit. At the same time the
necessitous borrower can seek a loan, how- ever small, with full knowledge of what he
has to pay back, and certainty that sharp practice will not force him to pay more for credit
than a legally defined and predetermined amount (Kelso, l948a, pp. 42-43).
Another social worker, Helen Hall, the headworker of Henry Street Settlement in
New York, was engaged throughout her career in consumer affairs. She chaired the
National Federation of Settlements committee that commissioned a study of unemployment in 1928, on the eve of the Great Depression (Andrews, 1997). During the
1930s, she served as consumer representative on the New York State Milk Advisory
Committee and was a founder of the Consumers' National Federation. She was a board
member of Consumer's Union in the 1950s. With two other settlement houses, Henry
Street Settlement sponsored a study of consumer and credit practices of low-income
people, which became sociologist David Caplovitz's The Poor Pay More (1963). In
contrast to Kelso's optimistic conclusions fifteen years earlier, Caplovitz found that the
cost of credit for poor people was far higher than for the middle class. In an address to
the National Conference of Social Work in 1966, Assistant Secretary of Labor Esther
Peterson cited Caplovitz and called for new regulatory legislation "on this whole complex
of consumer credit and contracts;' echoing presentations at the conference a half-century
earlier (Peterson, 1966, p.50). However, when Caplovitz left academic research in the
1980s, he became a bankruptcy lawyer rather than a social worker (Reifner, 1992),
Gordon Fisher (1997) has observed that, while social work was the primary profession
involved in the construction of family budgets during the Progressive Era and the 1920s,
economists became dominant after World War II. In 1948, the Bureau of Labor Statistics
(BLS) unveiled "the city worker's family budget;' developed by economist Dorothy S.
Brady of the BLS and an advisory committee chaired by economist Hazel Kyrk of the
University of Chicago, The committee included "experts in the fields of consumption
economics, standards of living, and labor economics" but not social work (Brady, 1948,
p. 312). The city worker's family budget, which would be revised periodically by the
BLS and which would inform estimates of the poverty line in the 1960s, would provide
"a modest but adequate standard of living" (Kellogg & Brady, 1948, p. 133).
CONCLUSION
Social workers withdrew from improving the financial capability of clients as other, more
expert, professions took up the task. Now, more than half a century after other
professions and groups took responsibility, there is little or no professional assistance
available to clients, providing an opportunity and a challenge to the profession. Interest
in building clients' financial capability may be growing as larger numbers of people are
affected by problems resulting from financial illiteracy and excessive interest rates. The
winner of the 2009 Influencing State Policy contest for BSW students and her faculty
mentor, for example, worked on a successful statewide campaign to regulate the interest
rates charged by payday lenders in Ohio (Influencing State Policy, 2010).
The times seem right for a revival of interest in increasing the financial capa- bility of
social workers' clients. The "mortgage meltdown" of 2008 illustrated the problem of
overextended borrowing. But this is only a part of the problem. Wilensky and Lebeaux's
warning in 1958 that middle- and lower middle-class people were in danger of
overborrowing seems prescient. Today, payday loans, credit card debt, and other forms
of installment debt endanger consumers
(Longman & Boshara, 2009; Stegman, 2007). In the past, social work's genius was its
willingness to confront the real problems encountered by people, their clients and
neighbors. Today, social workers must again develop interventions that will increase the
financial capability of the many people who are trapped by the ongoing economic crisis.
REFERENCES
Addams, ). (1893a). The objective value of a social settlement. In H. C. Adams (Ed.),
Philanthropy and social progress (pp. 27-56). New York: Thomas Y. Cromwell.
Addams,). (1893b). The subjective necessity for social settlements. In H. C. Adams
(Ed.),
Philanthropy and social progress (pp. 1-26).. New York: Thomas Y. Cromwell.
Anderson, E. (2008). Experts, ideas, and policy change: The Russell Sage Foundation
and small loan reform, 1909-1941. Theory and Society, 37,271-310.
Andrews, ). (1997). Helen Hall and the Settlement House Movement's response to
unemployment. Journal of Community Practice, 4(2), 65-75.
Appelbaum, D. K. (1977). The level of the poverty line: A historical survey. Social
Service
Review, 51, 514-523.
Berkowitz, E., & McQuaid, K. (1988). Creating the welfare state: The political economy
of twentieth-century reform (2nd ed.). New York: Praeger.
Birtwell, M. L. (1899). Chattel mortgages. Proceedings of the National Conference of
Charities and Correction, 26, 296-305.
Brady, D. S. (1948). The city worker's family budget. Proceedings of the National
Conference of Social Work, 75, 310-316.
Braucher, H. S. (1910). The social worker and the Playground Association of America.
Proceedings of the National Conference of Charities and Correction, 37, 219-222.
Brewster, B. M. (1965). Extending the range of child welfare services. Children, 12(4),
145-150.
Brown, E. B. (1989). Womanist consciousness: Maggie Lena Walker and the
Independent
Order of St. Luke. Signs, 14,610-633.
Brown, M. W. (1899). The development of thrift. New York: Macmillan.
Bruno, F. ). (1923). The co-operation of social workers with public officials in the
enforcement of law-from the point of view of social workers with private agencies.
Proceedings of the National Conference of Charities and Correction, 50, 327-333.
Byington, M. (1910). Homestead: The households of a mill town. New York: Charities
Publication Committee.
Caplovitz, D. (1963). The poor pay more: Consumer practices of /ow-income families.
New York: Free Press.
Chapin, R. C. (1910). Present wages and the cost of living. Proceedings of the National
Conference of Charities and Correction, 37, 449-457.
Committee on Home Economics, Charity Organization Society of the City of New York.
(1919). Budget planning in social case work (COS Bulletin No. 3). New York: Charity
Organization Society of the City of New York.
Cummings, E. (1892). University settlements. Quarterly Journal of Economics, 6(3),
257-279.
Cruce, A. (200I). Ahistoryofprogressive-era school savings banking1870 to1930
(CSDWorking
Paper 01-3). St. Louis, MO: Washington University, Center for Social Development.
j
02_Birkenmaier_Ch02.indd 57
!0/24/2012 !:37:04 AM I
Chapter 14. Price Controls
January 23, 2014
a. Study Questions on Price Controls
What are the benefits of controlling the price of borrowing?
What are the detriments of controlling the price of borrowing?
What are some of the challenges to controlling the price of borrowing?
b. The History of Usury Law in the United States
Please read the following article.
http://www.fdic.gov/bank/analytical/bank/bt_9805.html
c. The Economic Effects of Usury Rates:
The Economic Effects of Usury Rates: What does the following chart teach us about the
micro effects of usury rate?
Y = Bank’s minimum acceptable interest rate for this borrower
Z = Maximum interest rate this borrower can afford
W
X
Y
Z
1
Tom
4
44
2
Dick
8
40
3
Harry
12
36
4
Jack
16
32
5
Jill
20
28
6
Peter
24
24
7
Paul
28
20
8
Mary
32
16
9
Matthew
36
12
10
Mark
40
8
11
Luke
44
4
12
John
48
0
Person
Bank’s minimum acceptable interest rate for this borrower
Maximum interest rate this borrower can afford
16% usury ceiling
Market-clearing interest rate
0
0
48
1
Tom 4
44
2
Dick 8
40
3
Harry 12
36
4
Jack 16
32
5
Jill
20
28
6
Peter 24
24
7
Paul 28
20
8
Mary 32
16
9
Matthew
36
12
10
Mark 40
8
11
Luke 44
4
12
John 48
0
The typical economists view of the economic harm done to one and all by usury rates:
Please read the article that follows
An Economic Perspective on Interest Rate Limitations by Thomas Durkin
9 Georgia State Law Review 821 ( 1993)
GEORGIA STATE UNIVERSITY LAW REV1EW
[Vol. 9:821
1993] PERSPECTIVE ON INTEREST RATE LIMITATIONS
823
My purpose today, however, is not to review or summarize the views of interest rate
observers (economists or otherwise), but rather to focus on the reasons for the
profession's unanimous or near-unanimous conclusion. This discussion forms the first
part of my remarks. Following this I will briefly review two additional arguments about
interest-rate ceilings which are more philosophical than economic in nature. Although
there is more divergence in the economics profession on the philosophical arguments
than on the economic ones, many economists find the philosophical arguments against
ceilings compelling as well. Next, I will quickly look at and criticize some arguments
occasionally advanced as favoring price ceilings•, Finally, I will briefly examine some
principles to follow if there is a decision to establish ceilings anyway, despite the strength
of the contrary arguments. As part of this last discussion, I will only mention some red
herrings and economically tangential issues, such as the question of state versus federal
authority, which economists usually regard as sideshows.
ECONOMIC ARGUMENTS AGAINST PRICE CONTROLS
Economists list four major objections to price ceilings or controls, each sufficient by
itself, it seems, to recommend elimination of binding controls: A) controls create
shortages; B) controls reduce competition; C) controls• waste resources; and D) controls
have adverse impacts on the macroeconomy including negative impacts on employment,
output, and income.3
A.
Controls Produce Shortages
In the nineteenth century Thomas Carlyle called economics the "dismal science" when he
wrote about Thomas Malthus's theories of population growth and inadequate food
supplies (still a concern today). It seems possible in the late twentieth century, however,
that the phrase sticks in many minds because of the tendency of economists to derive
things that sometimes seem intuitively obvious using assumptions, axioms, theorems,
rules of deductive logic, and even equations and esoteric branches of
mathematics in the process. One of these derivations is the so called "Law of Demand"'
which (without worrying here about the assumptions or the deductive processes) suggests
simply that quantity demanded of anything varies inversely with price, other things equal.
Thinking of credit, this means that at a lower price. borrowers will demand more (other
things equal) and at a higher price, less. 1v1aybe the amount demanded will be a little
more at a lower price and maybe a lot more, but it will certainly be as much or more at a
lower price and not less.
Conversely, we might contemplate a corresponding "law" of supply. Again without
worrying about the behavioral assumptions, the mathematics, or the details of the
derivations, this component of theory derives the intuitively obvious conclusion that
producers offer more of a product at higher prices, other things equal. Again thinking of
credit, this suggests that amounts offered will be greater at higher interest rates, other
things equal, a contention that seems reasonable on its face. Taking both "laws" together,
supply and demand suggest the likelihood that there must be some price (high, low, or in
between) at which demand just equals supply. This is the equilibrium or market price
(interest rate for credit markets) at which trading (lending and borrowing) take place. It
may vary over time depending on demand and supply conditions.
Obviously, of course, things are not this simple in the real world. Users show by their
actions that they demand lots of different financial and credit products and suppliers
provide lots of varieties. There are size, production cost, security, and risk differences,
and many other complications as well. Still, the simple conception remains useful for
each credit product or variety in the marketplace there is a demand, a supply, and an
equilibrium price at which' trading (borrowing and lending) takes place. There may be
higher or lower interest rates depending on production cost, risk, and degree of
interaction with other credit submarkets, but the basic supply demand framework remains
useful regardless. In each credit submarket supply and demand conditions, which may
vary sharply between submarkets, determine an equilibrium or trading price.
One of the complications that •arises is the possibility of legislatively mandated rate
ceilings or controls. Interest rate ceilings are as old as recorded history; historians have
found them in the ancient Laws of Manu in India, the Code of Hammurabie in Babylon,
the Old Testament, and the statutes of
AN ECONOMIC PERSPECTIVE ON
INTEREST RATE LIMITATIONS
Thomas A. Durkin†
INTRODUCTION
It is my pleasure today to have this opportunity to speak to such an august gathering of
attorneys about a 4500 year old economic question, the efficacy and usefulness of price
controls in financial markets. Most of the historical as well as present, concern in this
area involves interest rate ceilings on credit, which will be the focus of most of my
remarks. Much of what I say, though, pertains equally well to other financial controls
such as deposit rate ceilings. Consequently, I am discussing those other controls at the
same time, even if I do not seem to address them as specifically or extensively.
There is an old joke about economists, most often repeated by economists themselves,
that if you laid all members of the profession end to end, they would reach halfway to the
moon but they still would not reach a conclusion. Please let me assure you that this old
saying does not reflect economists' views about interest rate ceilings; they long ago
reached a conclusion on that question. I suspect Nobel Laureate Milton Friedman spoke
well for the entire profession in 1970 when he reported, "I know of no economist of any
standing ... who has favored a legal limit on the rate of interest that borrowers could pay
or lenders receive-though there 'must have been some." In a pithy 1982 comment on
controls, former Chairman of the President's Council of Economic Advisors Paul
McCracken suggested a reason why: "The list of people who made the sun stand still
does not contain many names after Joshua, and the list of those who successfully
commanded interest rates to stand still is even shorter."
My purpose today, however, is not to review or summarize the views of interest rate
observers (economists or otherwise), but rather to focus on the reasons for the
profession's unanimous or near-unanimous conclusion. This discussion forms the first
part of my remarks. Following this I will briefly review two additional arguments about
interest-rate ceilings which are more philosophical than economic in nature. Although
there is more divergence in the economics profession on the philosophical arguments
than on the economic ones, many economists find the philosophical arguments against
ceilings compelling as well. Next, I will quickly look at and criticize some arguments
occasionally advanced as favoring price ceilings. Finally, I will briefly examine some
principles to follow if there is a decision to establish ceilings anyway, despite the strength
of the contrary arguments. As part of this last discussion, I will only mention some red
herrings and economically tangential issues, such as the question of state versus federal
authority, which economists usually regard as sideshows.
I. ECONOMIC ARGUMENTS AGAINST PRICE CONTROLS
Economists list four major objections to price ceilings or controls, each sufficient by
itself, it seems, to recommend elimination of binding controls: A) controls create
shortages; B) controls reduce competition; C) controls waste resources; and D) controls
have adverse impacts on the macro economy including negative impacts on employment,
output, and income.
A. Controls Produce Shortages
In the nineteenth century Thomas Carlyle called economics the "dismal science" when he
wrote about Thomas Malthus's theories of population growth and inadequate food
supplies (still a concern today). It seems possible in the late twentieth century, however,
that the phrase sticks in many minds because of the tendency of economists to derive
things that sometimes seem intuitively obvious using assumptions, axioms, theorems,
rules of deductive logic, and even equations and esoteric branches of mathematics in the
process. One of these derivations is the so-called "Law of Demand" which (without
worrying here about the assumptions or the deductive processes) suggests simply that
quantity demanded of anything varies inversely with price, other things equal. Thinking
of credit, this means that at a lower price borrowers will demand more (other things
equal) and at a higher price, less. Maybe the amount demanded will be a little more at a
lower price and maybe a lot more, but it will certainly be as much or more at a lower
price and not less.
Conversely, we might contemplate a corresponding "law" of supply. Again without
worrying about the behavioral assumptions, the mathematics, or the details of the
derivations, this component of theory derives the intuitively obvious conclusion that
producers offer more of a product at higher prices, other things equal. Again thinking of
credit, this suggests that amounts offered will be greater at higher interest rates, other
things equal, and a contention that seems reasonable on its face. Taking both "laws"
together, supply and demand suggest the likelihood that there must be some price (high,
low, or in between) at which demand Just equals supply. This is the equilibrium or
market price (interest rate for credit markets) at which trading (lending and borrowing)
take place. It may vary over time depending on demand and supply conditions.
Obviously, of course, things are not this simple in the real world. Users show by their
actions that they demand lots of different financial and credit products and suppliers
provide lots of varieties. There are size, production cost, security, and risk differences,
and many other complications as well. Still, the simple conception remains useful: for
each credit product or variety in the marketplace, there is a demand, a supply, and an
equilibrium price at which trading (borrowing and lending) takes place. There may be
higher or lower interest rates depending on production cost, risk, and degree of
interaction with other credit submarkets, but the basic supply-demand framework remains
useful regardless. In each credit submarket supply and demand conditions, which may
vary sharply between submarkets, determine an equilibrium or trading price.
One of the complications that arises is the possibility of legislatively mandated rate
ceilings or controls. Interest rate ceilings are as old as recorded history; historians have
found them in the ancient Laws of Manu in India, the Code of Hammurabie in Babylon,
the Old Testament, and the statutes of ancient Greece and Rome. The ancient laws and
writings contain two main threads: A) somehow, lending is not productive and therefore
there should be controls on its price; and B) borrowing occurs because the borrower has
great need and so charging a price for it is uncharitable. Ancient scholars and medieval
schoolmen developed both ideas more fully and their influence survives today, albeit
with diminished influence in this commercial age.
Rather than origin, however, the pertinent question about rate ceilings and controls is
their impact. The "laws" of supply and demand give the answer. If officials establish an
interest rate ceiling that is below the rate (price) at which demand equals supply for a
particular credit type, then there is a shortage of that type of credit. At a price below the
equilibrium price the amount demanded (which increases at lower price) then exceeds the
supply (which decreases at lower- price). By definition if demand exceeds supply at a
given price there is a shortage. The market response would be a price rise to equate
demand and supply, but the rate ceiling precludes an increase and the shortage persists.
The situation is analogous to the gasoline lines of a few years ago. Mandatory price
controls on gasoline created a situation where price could not equate demand and supply.
At the artificially low price demand exceeded supply resulting, by definition, in a
shortage and leading to the gasoline lines. Eventual removal of the price controls
allowed higher prices to decrease the amount demanded, increase the amount supplied,
and quickly eliminate the shortage and the lines.
There is, however, one big difference between credit and gasoline lines: the nature of the
rationing device. In the gasoline case the available supply goes to those first in line,
those lucky enough to arrive at the right time, those willing to tolerate waits, or even to
the relatives and friends of gasoline station owners or those willing to pay bribes. In the
credit case rationing would more likely be governed by adjusting risk acceptance rather
than by choosing those chronologically first in line. In particular, creditors would reject
outright those borrowers they believed to be risky, eliminating them from the applicant
line. Second, creditors undoubtedly would also adjust nonprice aspects of the credit
offer, such as by requiring larger down payments or equity, shorter maturities, and more
collateral. Both kinds of action would generate selective impacts on the population of
borrowers. Likely losers would be newer, younger, or otherwise less well known
borrowers: small businesses and farms, less financially stable firms and consumers, and
those demanding small amounts of credit where the production cost is high per dollar of
loan. Creditors might also impose fees and raise uncontrolled aspects of the price and
eliminate or reduce grace periods and collect more quickly and more vigorously.
On occasion interested observers dispute the argument that interest rate ceilings cause
credit shortages, contending instead that there is plenty of credit around despite the
ceilings. What, of course, they are really saying is not that economic theory is wrong, but
rather that the ceilings are not binding they are set above the supply-demand equilibrium
rate and so are not constraining the market at that time. Saying, for example, that there is
plenty of credit card credit available despite rate ceilings says nothing when the ceilings
are far above market rates (as they should be to prevent shortages). The question is what
happens when ceilings are below the supply-demand equilibrium rate. Those are the
ceilings that cause shortages.
Thus, shortages and rationing that selectively affect certain population segments and
classes of borrowers are the economic result of interest rate controls that impede the
convergence of supply of and demand for credit. Is this a problem? Certainly, some
people hold the view that consumers and maybe businesses as well would be better off
without credit. If credit were not so readily available, according to this view, credit users
would be better able to practice self-denial, to avoid overburdening themselves with debt,
and even- possibly to save a little more. This view completely overlooks economic
experience, which shows that most borrowers use credit responsibly and, more
importantly, for productive purposes.
Neither consumers nor businesses borrow, after all, for the purpose of wasting the
resources, and unlike the debtors contemplated in Leviticus and Deuteronomy they do
not, by and large, borrow because of distress. Rather, most borrowing in a modem
economy occurs for investment purposes. Consumers invest in homes, durable goods
like automobiles and appliances, and durable services like education and medical care.
Each of these forms of capital provides a flow of returns over time in the form of
valuable consumer services. Consumer capital is analogous to business capital like
factories, machines, and equipment, which provides investment returns over time to
business. By investing in capital goods and services both consumers and, businesses can
raise total returns available from their resources and increase the level of their real
wealth. Interest rate ceilings interfere with this process by restricting credit availability
and potentially lowering the real wealth of those rationed from the market. By itself, this
a strong indictment of controls.
Controls and shortages also ruin the usefulness of markets in indicating that changing
conditions warrant changes in' quantities demanded and supplied-in the jargon of the
profession, controls destroy market signals. If rate ceilings hold interest rates below the
free market level, there is no signal to savers that more funds are needed or to borrowers
that less credit demand is appropriate. High interest rates signal the need for smaller
amounts of credit demand and larger amounts of supply, but nonprice rationing hides this
information and continues the shortage. Markets can transmit information about the need
for change, but only if controls do not interfere with the effectiveness of the dynamic
signals.
B. Controls Reduce Competition
Cloudy signals discourage potential suppliers from entering the market. In effect, price
controls become a barrier to entry. With controls in place, potential entrants have little
enthusiasm for the market or for increasing supply. But, free entry is a prerequisite for
competitive conditions in markets.
The benefits of competition in markets are well understood, but they bear repeating
because they are often overlooked. First, competition assures that products or services,
including credit, are available to those who demand them at minimum production cost for
the quantity and quality of service. Thus, competition produces efficiency. Second, free
competition reduces potential conflicts of interest and concentrations of power that, along
with higher prices, are the hallmarks of uncompetitive markets. As soon as substantial
barriers to entry are put in place, the competitiveness of markets begins to deteriorate and
the benefits of competitive markets to decline. As competitiveness ebbs, prices rise, the
quality of service declines, or both. Interest rate ceilings and controls produce a barrier to
entry and reduce the likelihood of competitive conditions.
C. Controls Waste Resources
If the bad news is that controls cause shortages and impede competition, the good news is
that they are not always fully effective because imaginative people find ways around
them. But that is bad news too, because both they and the government waste resources in
finding ways around them and in enforcing them. The evasion issue merits a closer look.
Not surprisingly, economists have thought about and studied reactions to regulation. In
recent years the field has been very active, and economists have developed interesting
economic theories about the origins of, motivation for, and reactions to regulatory
change. One theory suggests that regulation itself is important in generating regulatory
change. This theory suggests that, in effect, regulation functions as a tax, raising costs. It
has the result of making production of regulated services more costly or it raises the cost
of entering regulated markets. As a result, in a competitive market suppliers of products
are constantly looking for ways around the regulations or are constantly shifting
resources from regulated to unregulated ways of doing things. In other words, they are
looking for ways to reduce costs.
There is no intent here to imply that the attempt to avoid regulation is a cynical reaction.
Very simply, the attempt to avoid regulation is merely a rational economic reaction to
business cost pressures in a competitive market. But it does produce constant testing of
the frontiers of the regulations themselves. Often these tests and the shifts of resources
into unregulated related activities result in new regulations. These, in turn, are tested
anew and the process cycles on, giving rise to the descriptive term "regulatory dialectic.
Ongoing regulatory change is costly, however, because of the constant need for operating
and procedural upheavals as well as the necessity of devoting considerable resources to
the dreaded "L words" of business: lawyers, legislation, and litigation.
Interest rate ceilings and controls seem to be a good illustration of the dialectical process
of regulatory change. In fact, to a great degree, most of the legislative and regulatory
changes of the past seventy-five years in the consumer credit field, particularly at the
state level, have involved price control efforts and reactions to attempted escapes.
Clearly, disputes over add-on rates, discount rates, simple interest, and even credit card
billing methods involve pricing and reactions to price controls. Likewise, small loan
legislation, the time-price doctrine, the Marquette doctrine, dual business restrictions, and
even convenience and advantage licensing concern pricing and its control. Controversies
over credit insurance, leasing, and rental purchase, by and large, involve credit pricing
and control. Furthermore, issues involving real estate points and fees, rule of seventyeight's refunds, and even disclosure matters such as components and itemization of
finance charges are, at least in part, manifestations of reaction to price control. As each
of these issues cycles on, the economy continues to pay for our legacy of price controls
with each hearing, legislative change, mandatory operational variation, and lawsuit these
issues generate.
It is not possible, of course, to say how consumer credit markets might have developed in
this country without the legacy of ceilings and controls, but it seems certain some things
would have been different. Probably most of these issues would never have developed.
At the least, it seems that much of the cost associated with the regulatory dialectic would
have been less, and the economy could have devoted fewer resources to regulatory
changes and enforcement efforts.
D. Controls Have Negative Macroeconomic Impacts
Although analysts have not devoted as much time or attention to the effects of financial
controls on the macro economy, it seems again that the likely impact is dismal. First, by
keeping interest rates below their free market equilibrium rate, interest rate ceilings
reduce savings. Second, by reducing savings the ceilings also keep borrowing and
investment below their free market levels. Third, savings and investment below choice,
which implies that resources are engaged in second-best uses, together promise negative
impact on output, employment, and income. Inefficiencies associated with regulatory
avoidance and enforcement also involve shifts of resources to less effective uses,
reinforcing the negative effect. Although no one has measured the actual impact and,
indeed, it may not be measurable, there is no reason to suspect anything other than these
negative outcomes.
II. PHILOSOPHICAL ARGUMENTS AGAINST PRICE CEILINGS
The economic arguments against price ceilings are not the only telling criticisms. Rather,
further arguments, broader in generality, and maybe in appeal to some noneconomists,
equally suggest the folly of financial price ceilings or controls.
A. Controls are an Improper Role for Government
A first criticism is that placing controls on the private contracting of lenders and
borrowers is not an appropriate role of government in a free society, except perhaps in
cases of unquestionably unconscionable behavior by one of the parties. In effect, the
issue is whether, apart from clearly unconscionable conduct, it is the proper role of
government to tell individuals they cannot engage in certain activities or transactions
when they fully understand what they are doing, they freely choose to do so, when they
regard these transactions as beneficial to themselves, and when the activities are harmful
to no one. Many people, including many economists, argue this is not a proper role of
government, but others disagree. The others apparently take a more paternalistic view,
contending, in effect, that the law should not permit borrowers to pay rates above some
ceiling, presumably to protect them from themselves. It is possible to apply economic
analysis here, too.
There is a widespread myth, perpetuated perhaps by those whose personal resources
enable them to provide for their own needs and wants easily, that individual consumers
become worse off when they enter into credit agreements. This, of course, is not the case
when consumers enter into credit agreements by free choice and there is no deception or
unconscionable behavior by the creditor. Consumers choose to enter such contracts
because they perceive the benefits to themselves in the form of returns on the uses of the
funds, typically assets such as houses, automobiles, education, durable goods, and
medical care, but also preferred consumption time patterns, to be worth the cost they
must pay savers (usually through financial institutions) to borrow the savers resources. In
the jargon of economics, the net present value is positive. If lives were infinite in length
or if needs to purchase houses, durables, and other assets were uniformly distributed over
consumers lives and did not tend to come in bunches, consumers might demand less
credit. Lives are not infinitely long, however, and asset needs do come in bunches,
typically in the twenty-five to forty-five age brackets. Many people believe that limiting
consumers' opportunities to make their own choices does them a disservice.
Beyond this, there is the question whether a few government officials are better prepared
to make choices for millions of citizens anyway. Legislators and officials have their own
experiences and biases which do not necessarily match the views of all their constituents
all of the time. Unsuitability of government's choices together with imagination of
entrepreneurs and the fungibility and substitutability of money have produced the
regulatory dialectic noted earlier. That path leads to bureaucracy, enforcement, reporting
burden, new managerial efforts to evade, and distortions in resource allocation. These
produce a dead-weight loss to society.
B. Controls do not Solve the Identified Problem Anyway
Most significantly, another criticism of interest rate ceilings is that they do nothing to
address the problem that inspires them, namely, high interest rates. The level and
variation of interest rates depends on broader factors than just conditions in the controlled
markets or submarkets. Rather, particular interest rates are under the influence of capital
market conditions generally, and these reflect many wider influences ranging from wage
rates and inflation rates to resource allocation choices of society and even to world
economic conditions. Looking at consumer credit markets alone is not sufficient to
understand capital markets or trends in interest rates, including consumer credit interest
rates. And controlling consumer credit rates will not favorably affect capital markets.
Market interest rates consist of a list of components, all of which may fluctuate: a realreturn component, an inflation adjustment, a risk adjustment (including a liquidity
premium), and an adjustment for fixed costs (if any). The real return is the return that the
ultimate lender requires in units of constant purchasing power-a real return of three
percent per year, for example. The inflation adjustment, in turn, compensates for
money's changing value. If inflation of four percent per year over the life of the credit is
expected (in other words money is expected to decline in. value four percent per year),
then the lender would reasonably require seven percent (three percent real return plus
four percent for inflation). Likewise, if the lender expects some losses, then there must
be compensation for the losses. If losses of three percent per year are expected, then the
lender would require another three percent per year or ten percent in all, considering all
three components. Finally, the market interest rate must cover all fixed costs. If the
fixed costs are small relative to the loan size (say, on a ten million dollar commercial
paper note of a low-risk issuer), the impact on the market rate is almost negligible. In
contrast, if fixed costs for credit analysis, payment processing, and regulatory compliance
loom large relative to the credit amount, then their impact on the required market rate will
be substantial.
The point of all this is that high or fluctuating rates result from a variety of factors, not all
of which are specific or limited to the type of credit under consideration. In recent
history enthusiasm for rate ceilings has most often involved consumer and mortgage
credit, of course. But high rates in the former largely arise because of high fixed costs on
small credit amounts. Credit costs depend on such things as wage rates, postage rates,
and trends in automation and technology. It is not clear that interest rate ceilings
favorably - affect any of these
factors. High rates in the mortgage credit case most often result from higher inflationary
expectations and higher market interest rates generally. These may change with the
business cycle or even with international developments. It is not obvious what price
ceilings could do in these cases, except create shortages.
In sum, rate ceilings and controls are not effective solutions to high interest rates. High
interest rates are caused by factors such as operating costs and inflation expectations that
are outside the purview of interest rate ceilings. In a large sense interest rates are like a
thermometer that measures the economy's temperature. High or rising rates measure
economic symptoms and may well indicate economic problems or ills. But controls do
not even treat symptoms; they merely do violence to the thermometer.
III. CRITICISM OF ARGUMENTS THAT PURPORT TO SUPPORT CONTROLS
Despite 4500 years of sorry experience with price ceilings on credit, controls still have
their supporters. Let us now look at some of their arguments.
A High Rates Disadvantage the Needy
All of the reasons advanced from time to time which purport to support the need for
interest rate ceilings and controls all illustrate the above criticism of controls: they are not
effective solutions to the problems they are supposed to address. For example, even
today some observers argue the ancient and medieval contention that taking interest is
wrong because it involves uncharitableness toward the needy. These people may apply
this contention only to interest rates above some low level or only to some kinds of credit
or borrowers (low-income consumers, for example). Nonetheless, despite any
limitations, the contention is the same: high rates charged at least to some consumers for
some kinds of credit are uncharitable or unfair.
Unfortunately, rate ceilings and controls are not an effective remedy to the problems of
necessitous borrowers, and controls will adversely affect many others too. As already
discussed, most borrowing is not done out of necessity by the needy and desperate, but
rather by those who have resources and incomes and who desire to change the time path
of their income and consumption flows. These include businesses that borrow current
resources for investing in facilities and equipment that provide a greater flow of
investment returns, consumers who borrow to invest in assets such as houses, autos,
durable goods, education, and health care that provide a greater real wealth. Necessitous
or desperate people normally are unable to borrow anyway, and so interest rate ceilings to
protect them is the wrong remedy to apply to their needs.
This is not the place to discuss proper private or government programs to help the needy,
except to say that interest rate ceilings and controls are not among the useful suggestions.
Rather, control efforts disrupt commercial activities among the nonneedy without doing
anything for those who are desperate.
B. Controls Address the Problem of Unequal Bargaining Power
A second argument is, that ceilings are needed to redress unequal bargaining power and
keep rates from rising to astronomical levels. But this ignores the forces of competition.
An individual creditor is not free to charge an arbitrary price as long as other creditors are
charging lower prices for similar services and the public is even partially aware of the
existence of alternatives. Today it is hard to argue otherwise. Many credit markets are
free of ceilings and prices still fall within relatively narrow ranges across creditors.
Residential first mortgage credit, for example, has been free of rate ceilings since passage
of the Depository Institutions Deregulation Act of 1980, but the uncontrolled rates are not
astronomical. In fact, rates have fallen sharply since 1980, and they tend to fluctuate very
sensitively with changes in the economy. Rates in local markets, as revealed in many
newspaper surveys, tend to be quite similar across creditors, even if not exactly the same.
While individual consumers may not have great strength of bargaining power
individually, they do have immediate and obvious alternatives. The breadth of potential
buyers taken together, each of whom individually has alternatives, gives consumers
market power of their own, and those who shop for credit can police the market for those
who do not. Certainly, it is difficult to argue that monopoly conditions are prevalent in
many credit markets today. Rate ceilings or controls could only make the situation worse
by establishing barriers to entry.
C. Credit is a Utility that Government Should Regulate
A third argument is that credit, and, indeed, financial services generally, are so important
today that they should be considered public utilities subject to public direction and price
control. But, financial firms are much different from typical public utilities. For one
thing, financial firms do not produce outputs like electric power where scale economies
and advantages of large size are alleged to be sufficient to drive out competitors and
produce a monopoly. Evidence of economies of scale for financial firms is very slight
and only then for movement out of the very small firm size classes. Furthermore,
financial firms do not require the large, fixed capital investments of electric, water, and
other public utilities that suggest a public interest in protecting them from competition so
they are profitable and the investment is forthcoming. For financial firms monopoly is
unlikely and so public action to protect against monopolistic pricing is not needed.
Even if monopoly were likely, however, it is not at all clear that public utility-type
regulation would solve problems in the financial area. Public utility regulation typically
sets prices in such a way as to provide a reasonable return on invested assets. In the
credit area a single price would result in preferred risk classes or loan sizes, most likely
large loans to low risk borrowers. If there were to be multiple prices for different risk
classes and loan size with each price supposed to bring a guaranteed return on assets
invested in that type of credit, there would be immense difficulties with allocation of joint
costs. It seems highly improbable that the bureaucratic mill could provide better answers
than free market credit production. In addition, investments in loans and other financial
assets are much more mobile than investments in power plants and gas pipelines. If
public pricing decisions were inadequate, assets would migrate to other credit markets,
other kinds of activities, or even to other countries.
D. Controls Help Avoid Overburdening Consumer with Debt
A fourth argument supposedly supporting the usefulness of price controls on credit is that
controls help avoid overburdening consumers with excessive debts. But excessive is, at
least to a degree, in the eyes of the beholder. If the objective is to set rate ceilings so that
no or few consumers can borrow, this objective will not be consistent with the, views,
wants, or needs of the affected individuals. If, in contrast, the goal is to reduce credit
availability only to those unable to pay, controls seem to be the wrong response. Inability
to repay typically arises after the fact due to loss of job, sickness, marital problems, or
other personal difficulties. Prior interest rate controls are unlikely to help solve these
problems. If in the remaining cases consumer insolvency arises from creditors' lack of
information about the financial condition of new applicants, the solution is improvement
in information systems and not in interest rate controls that disrupt commercial relations
for many others as well.
E. Controls Assure that Consumers Pay "Fair" Rates for Credit
Finally, on occasion rate ceilings are suggested as means of assuring that consumers pay
"fair" rates for credit. But, fair for whom? In a competitive market credit transactions can
occur only if lenders and borrowers agree that the price is "fair." A regulatory agency can
never achieve this match for each of the millions of credit transactions that take place
annually. If ceilings make creditors unwilling to generate small amounts of credit or
credit to riskier borrowers, for example, then those excluded from the market may not
agree that ceilings have made prices "fair" for them. Of course, sales credit might -still
be available because merchants could raise prices and use the difference to subsidize the
credit losses. Cash buyers might not feel the prices are fair, however, and would shop
elsewhere.
The likely result of the rate ceiling would be development of a class of stores, which sell
credit goods largely to poor risks but at higher prices. The stores would use the excess
income on the goods to subsidize the risky credit operation and not earn as high a profit
as the high goods prices might otherwise suggest. This would frustrate the goal of
achieving a "fair" price (if that means a lower price) for credit and might actually make
matters worse because market segmentation would tend to increase and competitive
forces to decline. In sum, legislation restraining gross income from finance changes
necessitates adjustments in credit availability, fees, goods prices, or some combination.
There is no magic way to reduce prices.
IV. DESIGNING CEILINGS
The foregoing should, I hope, be convincing arguments that credit rate ceilings and
controls are not good public policy. If ceilings are necessary, nonetheless, perhaps for
political reasons, let me suggest a few developmental principles that can help minimize
difficulties.
The first principle is, of course, if at all possible, to set ceilings high enough that their
sole effect is to eliminate truly unconscionable behavior but not otherwise to interfere
with the smooth functioning of the credit markets. Ceilings can serve a useful function if
government officials are able to use them as a standard of unconscionability but they do
not otherwise impede legitimate commerce. Ceilings might have to be very high for
small amounts of credit for short periods. Moreover, the existence of ceilings should not
serve as an invitation for establishment of bureaucratic monitoring, reporting,
interpreting, and enforcing regimes that submerge the usefulness of an objective
unconscionability standard under a mountain of red tape.
Second, ceilings should not vary by type of creditor. Ceilings specific to certain creditors
merely make those creditors favor or not favor certain types of credit producing market
segments and barriers to entry. The objective should be to encourage easy access for
creditors to all submarkets to discourage market segmentation and tendencies toward
monopoly.
Third, for the same reason, ceilings should not depend on the type of goods financed.
Some goods may have better collateral value than others, but the main differences in
consumer credit interest rates arise from variations in credit size and type of customer
rather than collateral differences. Thus, ceilings dependent on collateral type may well
induce preferences by credit size and type of customer, again tending to produce
segmented markets and greater likelihood of monopoly power.
Fourth, ceilings should employ the same components and definitions as other regulationsincluding disclosure regulations. It makes no sense, for example, that a percentage rate
calculated under the ceiling requirements be some different percentage under disclosure
regulations because the components or compounding methods required are different. If
they are different, at a minimum the ceiling regulations should be regarded as applying
only to ceilings and not to disclosures and vice versa. Neither area should serve as a
cause of litigation in the other.
Finally, ceilings should not vary by geographic area or state. A hodgepodge of unrelated
ceilings merely serves to complicate the operations of creditors, to make creditors prefer
one area over another (tending to segment markets), and to impede the development of
efficient credit flows to credit-needy areas. Variations among states, eventually causes
real resources, including employees, to change locations for artificial, inefficient reasons.
Such differences can be, and in fact have been, sources of long and drawn out legal
maneuvering and litigation, which economists regard as sideshows to the underlying
economic issue of the inappropriateness of controls. Recent acts in the sideshow include
questions surrounding the legality of exporting and importing interest rates, concerns
over the rights of states versus the Federal government in regulating interest rates, and all
the controversial aspects of the so-called "Marquette doctrine." Rate ceilings that did not
vary by geography would make all of these costly problems disappear.
CONCLUSION
In sum, this economist agrees with the unanimous or near unanimous view of the
profession: ceilings or controls on interest rates have been a bad idea for a long time and
will continue to be a bad idea in the future. Controls create credit shortages, they impede
competition, they waste resources, they harm the macro economy, they interfere with free
choice, and probably most tellingly, they do not work anyway. At the next American Bar
Association Consumer Financial Services Ten-Year Outlook Conference we will
celebrate the millennium, the coming of the year 2000 and, we hope, a new era. After
4500 years of experience-with credit controls, I hope that conference win not have to
address this issue when discussing the outlook.
d. The arguments in favor of Price Controls.
Earlier in these materials we read selections (Pages ___ to ___ infra) from the seminal
article by Professor Wallace that lays out the rationale for imposing price effective
controls on the cost of borrowing. You will recall that Wallace recognizes the
various negative effects of price controls and acknowledges the impact on those
consumers who will be excluded from borrowing. Please refresh your recollection of
that argument and then compare the Durkin analysis with the analysis of Professor
Wallace at page ___
e.
With that background in mind let's look at the idea of price controls in regard to
various specific lending products from the clearest and simplest to the most complicated
Auto finance:
New Car sale and financing Issue on sale price separate from financing; big trap for the
unwary; New car: Saturn example
Used Care: How to regulate if the sale and financing are from the same dealer on a used
car?
Furniture
What is the time price differential?
What role did it play in the history of the regulation of the price of borrowing?
Credit Cards Home Mortgage
What is the role of Federal Preemption in credit cards and home mortgages and payday
lending?
Chapter 15. Prohibited Transactions
Several years ago Senator, then Professor Elizabeth Warren and Professor Oren Bar Gill
proposed a variation of the Consumer Products Safety Commission as the right type of
regulatory agency for consumer financial products. The result is the Consumer Financial
Protection Bureau. Here is some information about that Bureau.
Prepared Remarks by Richard Cordray
Director of the Consumer Financial Protection Bureau
Press Conference with Mayor Rahm Emanuel
Chicago, Illinois
December 5, 2012
Thank you for having me here today. It is great to be back in Chicago, this fascinating
city of so many unexpected dimensions, where I spent my law school days. During my
first year, I lived on the South Side across the park from where Mayor Washington lived.
Outside his building, a large family of green-and-gold “wrong way” parrots, who perhaps
had confused their migration patterns from South America, had built an enormous nest.
Little did they know they had stumbled upon the safest home in the Northern
Hemisphere, since the Mayor’s police security detail was parked underneath their tree 24
hours a day, seven days a week! I also understand that the Mayor was a fierce and valiant
defender of those parrots.
This is just one instance of the intricate tapestry of our communities and the interesting
connections they represent. My own public service roots were planted firmly in local and
state government in Ohio. But your former county executive, the late John Stroger, was
the person who introduced me as the nation’s County Leader of the Year for 2005 – an
award won this year by your own Toni Preckwinkle. Your very fine City Comptroller,
Amer Ahmad, worked alongside me when I served as the Treasurer of Ohio, and he did a
fantastic job there as I am sure he is also doing here. And, of course, your Mayor –
everyone knows your Mayor, and can see his relentless tenacity to find every single way
he can, whether big or small, to make life better for all those who live or work in the City
of Chicago.
From my experience in state and local government, I have found that strong partnerships
are sometimes difficult to build, but always the best way to get things done. So I
especially appreciate the announcement we are making here today.
Chicago is the first city in the country to agree to share information directly with us, the
new Consumer Financial Protection Bureau, about enforcing the laws that ensure people
are treated fairly in the confusing and complex consumer financial markets. We want to
learn from and expand on the ways you protect consumers, and to share these approaches
nationwide. We also want you to be able to take advantage of the new resources we bring
to the arena, including strong analytical tools and a broad mandate to protect consumers
against illegal practices.
Every day, millions of Chicagoans use financial products with the goal of achieving
prosperity through hard work and sound decisions. Mortgages allow families to invest in
a home and pay for it over time. Credit cards give us convenient access to our money
when we need it. Student loans make it possible for people with ambition and drive to
finance an education and brighten their future. But, as the past few years have revealed
all too clearly, if these products are misused, then they also have the potential to wreak
havoc on consumers and the wider economy.
Debt can devastate people’s lives. Individual financial problems then become community
problems. We saw that quite clearly with the mortgage crisis. The foreclosure epidemic
sucked the vitality out of once-vibrant neighborhoods. Vacant properties are not only
eyesores, but can become magnets for drugs and crime, and they also lower property tax
revenues as they decline in value.
If these properties turn into a dead loss and have to be leveled, you know who pays for
that? Of course, the city has to do that. When neighbors see their own property values
decline, entire neighborhoods suffer, and cities are forced to bear the bottom-line cost of
problems created by others. In this manner, predatory lending exhibits what my
economics training at the University of Chicago would denote as “externalities.” That is a
sterile academic term, but the upshot is that predatory lending hurts more than its
immediate targets; it assaults the very foundations of stable communities. The damage
can take years and years to repair.
The Consumer Bureau was created to ensure that such irresponsible and illegal practices
do not continue to plague our lives and our communities. Partnerships like this one are at
the heart of our efforts to improve how consumer financial markets work for people. You
are on the frontlines, and we are glad to join you there and partner with you as a new
federal agency focused exclusively on in consumer financial protection.
We want to know what you are seeing and how that informs what we should be doing –
where our supervision and enforcement teams should focus their attention, and what
problems our policymakers should undertake to fix. We need to do this work together,
and to promote responsible business practices. When honest businesses prosper,
communities can flourish and so will America’s economy.
We have already begun our work to enforce the law against unfair, deceptive, and
abusive acts or practices. We are launching brand-new federal supervision of payday
lenders and debt collectors and credit reporting companies. Because of your close
relationship with your constituents, you have a unique ability to help us spread our reach
more broadly. By working in partnership, we can succeed in educating, empowering, and
protecting our citizens. They deserve to have someone standing on their side. At the
Consumer Financial Protection Bureau, we look forward to teaming up with you to do
just that.
Thank you and next up, I would like to introduce a man who is never afraid to be on the
frontlines for the people he represents: your Mayor, Rahm Emanuel.
The CFPB blog aims to facilitate conversations about our work. We want your
comments to drive this conversation. Please be courteous, constructive, and on-topic. To
help make the conversation productive, we encourage you to read our comment policy
before posting. Comments on any post remain open for seven days from the date it was
posted.
CONSUMER FINANCIAL DODD-FRANK AND CONSUMER
PROTECTION ACT’S “ABUSIVE” STANDARD
By Tiffany S. Lee*
“‘[T]he addition of ‘abusive’ to the standard in the Consumer Financial
Protection Bureau provisions is ‘the most egregious’ part of Dodd-Frank.”
— Richard Hunt, President of the Consumer Bankers Association.1
I. Introduction
The Dodd-Frank Wall Street Reform and Consumer Financial Protection Act (“DoddFrank Act”) ushers in a new era of consumer protection and financial regulation. The
Act spans 2,300-pages and regulates a panoply of consumer and commercial financial
products.2 Considering the wide range of business practices effected, what about the
inclusion of a single word— abusive—has the Consumer Bankers Association so upset?
Title X of the Dodd-Frank Act, the Consumer Financial Protection Act (“CFPA”),3
creates a new federal agency dedicated solely to consumer protection: the Bureau of
Consumer Financial Protection (“the Bureau”).4 This agency is expected to be
juggernaut.5 Its purpose is to act as a consumer watchdog and ensure “markets in
consumer [financial products] are fair, transparent, and competitive.”6 When the Bureau
assumes its responsibilities on July 21, 2011, it will regulate virtually all consumer
financial products, from loan products like mortgages to transactional products such as
checking accounts,7 affecting over $14 trillion in consumer debt and services.8
The scope of the Bureau’s expansive power turns in part on the definition and
application of a single word: abusive. Specifically, the Bureau is empowered to take any
authorized action, including rulemaking, to prevent a credit or service provider “from
committing or engaging in unfair, deceptive, or abusive acts or practices” in connection
with a consumer financial product.9 Prior to the Dodd-Frank Act, federal regulators (such
as the FederalTrade Commission (“FTC”)) already had the authority to ban actions that
were defined as unfair or deceptive under the Federal Trade Commission Act. But the
CFPA adds the legal standard abusive, which expands the standard of misconduct.10
For two reasons, the term abusive will play a critical role in determining the scope of the
Bureau’s power. First, though the CFPA provides several definitions, abusive has been
used only in limited contexts, so its use as a legal standard has limited jurisprudential
history.11 Second, the abusive standard itself may be subject to abuse if the Bureau
uses it to ban products or practices that would have been helpful to consumers.12 As a
result, the interpretative deficiency surrounding the term is fueling allegations that the
CFPA drafters overstepped their powers by drafting such a broad standard.13 Such
suspicions have provided the Bureau’s influential critics with ammunition in their efforts
to undercut the agency’s power.14
This article, however, contends Congress chose the word abusive consciously as a way
to create additional powers that go beyond the previous powers of the FTC to control
unfair and deceptive practices.15 Although there has been criticism that the word abusive
is unacceptably vague, the term actually has a history in other statutes that shows how the
Bureau should begin applying the CFPA’s definition of the standard. Analogy to past
application of the same term in other statutes and recent federal provisions against
unethical consumer financial practices reveal that the standard applies to at least three
practices: (1) extending high-risk credit without adequately assessing each consumer’s
ability to repay; (2) using aggressive sales and marketing tactics to harass, oppress, or
abuse consumers; and (3) steering consumers who qualify for low-cost credit to highercost products. The development of regulations for these three practices will allow the
term to be better understood and manageable.
Part II presents the purpose and policies behind the creation of the Bureau and the
inclusion of abusive in the Act. It also contends that though the standard is broader than
the unfair and deceptive standards, its inclusion in the CFPA is necessary to restore
consumer confidence in our financial markets. Part III examines how the three abovementioned practices fall under the abusive standard. It then fleshes out specific consumer
financial contexts where the Bureau should take action, such as home mortgages, payday
lending, and private student loans. II. The Rationale For the Inclusion of Abusive
Congress included the term abusive in the CFPA to resolve consumer protection failures
leading up to the subprime mortgage crisis.16 Indeed, inadequacies of previous consumer
protection statutes contributed to the severity of the crisis. As a legal standard, abusive is
not as new or unfamiliar as some believe. While the addition of the abusive standard
raises several policy considerations, the turmoil of the last few years indicates that a
broader standard is necessary to restore financial stability and confidence in our financial
markets.
A. The Mortgage Crisis & Failed Consumer Protection
The subprime mortgage crisis was caused in part or at least exacerbated by a flawed
system of consumer protection.17 Essentially, bank and non-bank lenders extended
exploitative loans, which should have never been approved and which borrowers simply
could not afford.18 Companies became increasingly deft at bypassing regulation using
controversial (and ultimately unethical) practices such as loan flipping, prepayment
penalties, complex product offerings to unsophisticated consumers, and so on.19 This led
to an economic meltdown, as millions of borrowers—unable to repay their mortgages—
defaulted and walked away from their homes.20 Put simply, the pre-crisis consumer
protection system had too many gaps, allowing unscrupulous credit practices.
Prior to the enactment of the CFPA, consumer financial protection was fractured across
seven federal agencies, such as the Office of the Comptroller of Currency and Office of
Thrift Supervision.21 In the wake of the crisis, Congress centralized consumerprotection authority with the Bureau. The new agency will operate as a fully independent
agency, have access to a wealth of industry data, be well-funded, and have a powerful
director.22
In addition to the structural problems, the CFPA also addressed statutory inadequacies of
the consumer protection system. Statutorily, the federal agencies—particularly the
FTC— did not have sufficient rulemaking authority to attack unethical practices that
preceded the crisis.23 Pre-crisis, the FTC was the primary consumer financial regulator,
but its powers were limited in several ways. Under section 5 of the Federal Trade
Commission Act (“FTCA”), the FTC may only prohibit acts that fall within the FTCA’s
definitions of unfair and deceptive.24 “Unfair” and “deceptive” acts and practices must
each meet different three-part tests, which have high thresholds and are difficult to
satisfy, thus advances in consumer financial protection, through the FTC, have been
limited.25
A practice is unfair where it “(1) causes or is likely to cause substantial injury to
consumers, (2) cannot be reasonably avoided by consumers, and (3) is not outweighed by
countervailing benefits to consumers or to competition.”26 Under the second element of
the unfairness test “some courts have held that consumers can avoid injury by choosing
another product or service. This makes the second element hard to prove.”27
Regarding the third unfairness element—essentially a cost-benefit analysis—lenders have
successfully argued that “pro- viding credit is a benefit even if questions can be raised
about a borrower’s long term ability to repay it.”28 For example, consider Borrower A
who has a 30-year fixed home mortgage at a 15% interest rate.29 A different lender
convinces Borrower A to refinance their home with an adjustable-rate mortgage that has
an initial two-year fixed interest rate at 7%, but after year two will jump to a fully
indexed rate, mostly likely several percentage points above Borrower A’s original 15%
interest rate. Further, the lender incorporated a $7,000 penalty if Borrowers prepays the
loans early, making the huge interest rate jump almost unavoidable.30 Even though this
new mortgage has a “built-in potential for payment shock”31 at year two, some courts
would hold that Borrower A has received a significant benefit because refinancing
reduces the loan’s original interest in the consumer financial industry.38 It enables the
Bureau to prevent any covered person or service provider from engaging in “unfair,
deceptive, or abusive acts or practices” in connection with any transaction for a
consumer financial product or service.39 The definition of “covered person” includes
bank and non-bank entities and is broadly defined as “any person that engages in offering
or providing a consumer financial product or service.”40
There exists considerable interpretative history for what is “unfair” or “deceptive”, as
such practices have been prohibited for some time.41 By comparison, abusive is a newer
term to the regulatory landscape,42 thus the CFPA provides several definitions for the
term:
(d) Abusive—The Bureau shall have no authority under this section to declare an act or
practice abusive in connection with the provision of a consumer financial product or
service, unless the act or practice—(1) materially interferes with the ability of a consumer
to understand a term or condition of a consumer financial product or service; or (2) takes
unreasonable advantage of—
(A) a lack of understanding on the part of the consumer of the material risks, costs, or
conditions of the product or service;
(B) the inability of the consumer to protect the interests of the consumer in selecting or
using a consumer financial product or service; or (
C) the bureau will define, interpret, and limit the abusive standard will continue to be
an issue of frenzied debate for years to come.
rate by more than half. Some courts decline to deem such practices as “unfair,” even
though borrowers often fail to understand the risks associated with these types of
loans, leading to an inevitable default.32 Sheila Bair, Chairwoman of the Federal Deposit
Insurance Corporation, testified that reasonable reliance by the consumer on a
covered person to act in the interests of the consumer.43
The standard is considerably more expansive than prior consumer protection standards,
because it places greater weight on subjective analysis when determining what practices
should be considered illegal.44 Its inclusion in the CFPA acknowledges the cost-benefit
prong of the unfairness analysis, a factor that has been used in last thirty years, is not
suitable to provide adequate consumer protection in all contexts.45 Moving forward,
under the abusive standard, even if a provider discloses all risks or provides a beneficial
product—passing the unfair or deceptive tests—these circumstances would not absolve
the providers from responsibility. The Bureau could still prohibit such conduct as
abusive.46
Regulators and financial companies can look to the these elements taken together
mean that situations that cannot withstand the FTCA’s statutory requirements are rare,
and there- fore, enforcement actions are equally rare despite the existence of many
unethical practices.33
An act or practice is deemed “deceptive” when “a representation, omission,
or practice misleads or is likely to mislead the consumer; a consumer’s interpretation of
the representation, omission, or practice is considered reasonable under the
circumstances; and the misleading representation, omission, or practice is material.”34
The deceptive test is also generally difficult to meet because consumers must have
evidence that a consumer financial company made a false or unsupported statement.35
This is a great challenge for consumers because almost all industry data is held by the
offending companies themselves, making it very difficult to build a case.36
Because of the various factors discussed above, the FTC and other federal agencies
became either unwilling or unable to implement necessary prohibitions to prevent
unethical practices, despite their prevalence.37
B. The Solution to Statutory Failures: Adding the “Abusive” Standard
Congress recognized the statutory failings of the pre- crisis consumer-protection system.
To resolve this, it intentionally included the abusive standard in section 1031 of the
CFPA. The standard provides the flexibility to address the rapid changes
legislative origins of abusive for guidance on how the Bureau may apply it. Chairwoman
Sheila Bair made one of the first suggestions for Congress to use the abusive standard
and supported expansion of the unfair and deceptive standards.47 In a 2007 congressional
hearing on how to improve federal consumer protection, Chairman Bair proposed that
Congress consider:
adding the term “abusive.” “Abusive” is a standard contained in HOEPA [Home
Ownership and Equity Protection Act] that the Fed [Reserve] is looking at using in the
context of mortgage lending . . . “[A]busive” is a more flexible standard [than unfair or
deceptive standards] to address some of the practices that make us all uncomfortable.48
A survey of federal legislation shows that the term abusive is not as new as some critics
assert.49 Some commentators suggest that the abusive standard is merely a repurposing
of doctrine of unconscionability—a doctrine first introduced in the English courts of
equity and later codified in the Uniform Commercial Code.50 More frequently,
commentators point to existing federal legislation that already use an abusive standard—
some of which have been in place for more than thirty years—as evidence that the
standard is not so unique.51 At least three federal consumer-protection provisions give
various federal agencies the power to prohibit certain acts or practices as abusive. These
are the (1) Home Ownership and Equity Protection Act;52 (2) Fair Debt Collection
Practices Act;53 and (3) Federal Telemarketing
Sales Rule. Regulators and financial institutions can also look to other federal provisions
(such as Final Rules to Truth-in-Lending Act) that may not use the abusive standard,
however, subsequent to the crisis, have banned practices that had evaded regulation under
the unfair and deceptive tests. The Bureau can look to both types of provisions to
interpret and apply the abusive standard.54
Despite a lengthy statutory definition and analogous provisions, great tension still exists
regarding the scope of the abusive standard.55 Is abusive a purely subjective standard
examined only from the consumer’s perspective, or does it reflect the idea that both the
provider and consumer must take a certain level of responsibility in financial
transactions? Unlike unfairness, abusive does not include a cost-benefit analysis.56
Therefore, would the Bureau be able to ban non-traditional products that may be abusive,
but which consumers would otherwise find very beneficial? Consider auto-title loans—
short-term loans secured by the title of a consumer’s car.57 Could the Bureau limit the
number of auto-title loans extended to a given consumer within a one-month period,
even though many consumers find having multiple auto-title loans particularly
attractive?58
Critics assail the standard as vague59 and overly broad, because it is based in part on
consumer perception.60 Regulators and courts will be required to engage in subjective
analysis of the consumer’s mindset in a transaction, yet “it is unclear how a lender could
guarantee a customer’s understanding . . . .”61 Consider payday loans or cash advance
loans, a product that has historically passed the unfair or deceptive tests62 but may no
longer be immune to regulation because of the greater emphasis on consumer
understanding in the abusive standard.63 The loan rollover—the ability for one to roll
their loan balance from one term to the next for increasing fees—is an attractive feature
of payday loans, but it can create a cycle of debt.64 Many consumers systematically
“overestimate their belief that they will pay off the loan at the end of the period and thus
underestimate the likelihood that they might end up rolling over the loan.”65 By offering
the rollover option with the knowledge that consumers are unlikely to repay, could the
payday lender be abusive under section 1031(d)(2)(A), taking “unreasonable advantage
of a lack of understanding on the part of the consumer?” These types of questions are
propelling the consumer financial industry and legislators to demand more clarity around
the standard or to strip the Bureau of such broad authority as this standard provides.
C. Responding to Criticism: the “Abusive” Standard Is Work- able and Necessary
Standard to Restore Consumer Confidence The uncertainty around the abusive standard
has caused resistance from politicians and the consumer financial industry.66 Critics
argue the standard’s vagueness and subjective nature will result in adverse policy
consequences. Many predict the legal uncertainty, increased risk of litigation, and
compliance costs will lead to a chilling effect on innovation and availability of credit.67
This could have a significant impact on economic recovery in this country.68 A reduced
availability of credit products may harm the economically disadvantaged
disproportionately, as they already have limited access to credit and further regulatory
efforts could even further constrain available credit to the group.69 While there may be
some adverse consequences to the abusive standard, the high degree of concern is
unwarranted because the standard is not unduly vague and it is necessary to ensure a
similar financial crisis is not repeated.
From an administration standpoint, new legal standards are frequently drafted and
enacted into law.70 By analogy when Congress initially enacted the unfair or deceptive
standards in the FTCA, they intentionally drafted the language broadly to allow
regulators and courts to continue to refine its definition and provide the flexibility to
close regulatory gaps.71 One can also compare the abusive standard to broad language in
federal antitrust legislation. In the Sherman Act, Congress gave the FTC authority to
deal with “unfair methods of competition,”72 and declared illegal any “restraint of trade
or commerce.”73 The language in the Sherman Act is “intentionally vague” to “allow
each administration to interpret and enforce laws.”74 The broader language allowed
flexibility for courts and regulators to adapt to changing conditions in the marketplace
and to balance competing interests of private business and consumers.75 Analogies to
these acts demonstrate that the abusive standard as drafted is not unduly vague.
Millions have suffered as a result of the crisis, thus extensive change is needed to restore
consumer confidence.76 The crisis demonstrated the need to shift to a more paternalistic,
government-led approach to consumer financial protection; otherwise, some companies
will continue to evade regulations as they historically have done.77 Pre-crisis consumer
protection focused on disclosures and making consumer understand what they were
getting into.78 The CFPA shifts the emphasis from disclosure to one of fairness;
companies must now ask themselves: “Are we being fair?”79 John C. Dugan, the former
Comptroller of the Currency during the crisis observed, “[T]here will be
significantly more consumer protection regulation and enforcement over time, because
that’s clearly what Congress wanted.”80 As Senator Christopher Dodd, one of the coauthors of the Act said: “Financial reform [is] not about punishing the financial services
industry. Rather it [is] about restoring order, stability, and, most of all, confidence to our
financial system.”81 These comments demonstrate the need for greater statutory reform,
which the abusive standard satisfies.
In summary, having a consumer watchdog with broad enough statutory reach to go after
unethical practices is one of the first steps to restoring consumer confidence and
economic stability. The abusive standard plays an integral part in achieving this goal. The
standard is not as new or unduly vague as critics allege, and it is necessary to address
the problems of failed consumer protection that played such a large part in the recent
financial crisis.
I.
Defining and applying the abusive standard
Some fear when the Bureau assumes its responsibilities in July 2011, it will overwhelm
the financial industry with new regulations.82 To the contrary, any rulemaking or
enforcement actions will likely not happen so quickly, because they take time to
develop.83 Also, the Obama Administration has yet to appoint or confirm a director for
the Bureau.84 Without a director, the Bureau cannot establish any new rules to protect
consumers.85 Nor can the Bureau exercise any authority over non-bank businesses that
currently evade regulation.86 Even once a director is nominated, the confirmation
process will likely drag on for months.87
In light of this inevitable delay, exactly how the Bureau will define, interpret, and limit
the abusive standard will continue to be an issue of frenzied debate for years to come.88
To contribute to these discussions, this section suggests how the Bureau may apply the
abusive standard by identifying several classes of practices the Bureau should prohibit.
These practices should be foremost in the Bureau’s mind as it utilizes its rulemaking and
enforcement authority.
In first applying the abusive standard, the Bureau must address the concerns of
consumers and legislators, yet not alienate the financial industry—or otherwise risk the
wrath from these groups.89 It is a very fine line. Many of the most blatantly abusive
practices, such as hidden balloon payments, bait and switch tactics, etc., have already
been prohibited through the CFPA or recent regulatory action.90 In order to build
credibility and cooperation with consumers and financial companies, initially, the Bureau
should use the abusive standard to prohibit unethical practices that have been banned in
other consumer contexts by existing federal legislation. Using other federal legislation as
support for its actions, the Bureau can establish credibility and avoid the perception of
being arbitrary. If a practice is banned in one consumer financial context, it should not be
tolerated in another. The three classes of practices that the Bureau should deem abusive
are: (1) extending credit without regard to borrower’s ability to repay; (2) using overly
aggressive sales and marketing tactics in consumer transactions; and (3) steering
borrowers to certain products for the purpose of increasing lender compensation without
meaningful benefit to the borrower.
This Part analyzes each practice with a focus on three key factors: (1) what conduct
constitutes the abusive practice, (2) why the practice falls under the CFPA’s definition of
abusive and what existing legislation the Bureau can leverage to justify this prohibition,
and (3) how the Bureau may apply this prohibition in different consumer financial
contexts. By using this analytical framework, the contours of abusive can be more firmly
established.
A. Extending Credit Without Regard for the Ability to Repay
Under its authority to prohibit abusive practices, the Bureau should prohibit the extension
of credit to a borrower without adequate regard to a borrower’s reasonable ability to
repay.
1. Conduct Constituting the Extension of Credit Without
Regard to a Borrower’s Reasonable Ability Repay
Extending credit without regard to a borrower’s ability to repay occurs when a lender:
(1) fails to adequately verify a borrower’s credit, income, and financial obligations to
determine a borrower’s reasonable ability to repay the loan or (2) inflates a borrower’s
income in order to obtain a loan larger than the borrower can reasonably repay.91
For a secured loan, rather than relying on a borrower’s ability to make scheduled
payments, lenders extend credit based on the liquidation value of the borrower’s
collateral, such as a home or car. Put simply, lenders rely on the ability to seize a
borrower’s equity in the asset to satisfy any outstanding obligation.92 This is commonly
referred to as asset-based lending.93 For an unsecured loan, lenders rely on the recovery
of high fees in the event of missed payments, rather than on the borrower’s ability to
repay.94
These practices are particularly prevalent in the area of subprime or high-risk lending.95
Subprime and high-risk loans are “loan[s] with more burdensome terms than those of a
‘prime loan’ and is designed for a borrower who lacks the income or credit score to
qualify for a prime loan.”96 High-risk products include payday loans, auto-title loans,
and student credit products.97
2. Why is Failing to Perform an Adequate Assessment on a
Borrower’s Repayment Ability “Abusive?”
a. Falling Under the Statutory Definition of Abusive
The Office of the Comptroller observed that extending credit absent a determination of a
borrower’s reasonable repayment ability is “not consistent with established lending
standards”98 and “generally forms the basis of abusive lending.”99 In light of these
comments and as discussed below, the Bureau should find extending credit without
adequate regard to a borrower’s ability to repay an abusive practice under section
1031(d)(2)(A) of the CFPA.100
First, extending credit without regard to a borrower’s
ability to repay should be defined as abusive because under section
1031(d)(2)(A) of the CFPA, such practice takes “unreasonable
advantage of . . . a lack of understanding on the part of the consumer of the material
risks, costs, or conditions of the product or service . . . .”101 Consumers often fail to
fully understand common financial products because of their complexity and prolix
agreements.102 In the prime market, lenders are less able to exploit consumers’ lack of
understanding because competition drives out bad products.103 Borrower exploitation is
much more common in subprime markets where consumers are financially
unsophisticated and more vulnerable to opportunistic lenders.104 Because of limited
financial literacy, consumers do not comprehend key terms of a financial product, such as
variable interest rates, annual percentage rates, and prepayment fees.105 Therefore,
consumers fail to grasp the total cost of a loan, which leads to a poor understanding of
their ability to make timely payments to lenders.106 Consequently, many consumers
simply do not comprehend the material risks and costs associated with financial products
such as mortgages, payday loans, and overdraft fees.
Many subprime lenders, knowing or likely knowing of the consumers’ lack of
understanding,107 nevertheless fail to adequately verify each borrower’s repayment
ability, opting instead to extend loans relying on borrowers’ collateral or high fees. As
the FTC has observed, such loans are intentionally structured to fail.108
Though the Bureau has yet to define what constitutes “unreasonable advantage,” the
language could be construed to establish a quasi-duty of care owed by lenders to
borrowers, limiting the amount that a lender could profit when one of the three prohibited
conditions109 described in section 1031 exist.110 Also, if an “unreasonable advantage”
is likely to be reviewed from the perspective of a reasonable consumer in the specific
circumstance, the analysis could account for individual characters and attributes, such as
financial literary.111 Against this backdrop, it is highly plausible that the Bureau would
consider a lender to have taken “unreasonable advantage” of a borrower by extending a
loan that the lender knows or should know is likely to fail. For example, in payday
lending, it is estimated that over 90 percent of lender profitability is generated from high
fees and penalties collected from borrowers who decline to pay or default on the initial
loans and rollover their loans back-to-back over five or more successive payment
periods.112 By offering such products, which lenders know or likely know the borrower
is unlikely to repay, the lenders are taking unreasonable advantage of the borrower.113
Although one or two rollovers may actually assist the borrower, repeated rollovers with
high fees serves only to place the consumer in a far worse financial position.114
The risk inequity between payday borrowers and lenders demonstrates why such loans
are unreasonable. When lenders provide loans that borrowers are unlikely to repay, the
consequences are significantly worse for borrowers than lenders. Consumer advocates
claim that by failing to adequately verify a borrower’s repayment ability, lenders “trap
borrowers into collateral-based loans they clearly cannot repay.”115 Borrowers may lose
important assets, such as their home or cars; be forced to perpetual, high- cost
refinancing; or be forced to declare bankruptcy.116 On the other hand, lenders profit
handsomely, whether or not scheduled payments are made. This is done through their
ability to seize the borrower’s collateral to satisfy the outstanding loan, profit from
forced refinancing, or collect high fees associated with default.117
Lending without an adequate assessment of a borrower’s repayment ability is even more
unreasonable, because it departs from customary underwriting principles.118 The Office
of the Comptroller observed that a basic principle of loan underwriting requires a proper
assessment of the “borrower’s capacity to make scheduled payments.”119 Ignoring basic
loan underwriting lies at the heart of abusive, or as they are also commonly called,
predatory practices.120 Given this outcome, lenders take unreasonable advantage of
the borrower’s lack of understanding. When lenders knowingly lead borrowers into
loans that will fail, borrowers are subject to significant harm from defaulting
on failed loans, and despite the harm to borrowers, lenders receive a windfall.
Therefore, the Bureau should prohibit as abusive the extension of loans absent
an adequate assessment of a borrower’s ability to repay.
b. Analogous Federal Legislation
This section outlines the Federal Reserve and Congress’ decisions to ban the extension
of credit without the regard for a borrower’s ability to repay for home mortgages and
student credit-cards.121 Congress and the Federal Reserve took action because such
practices took advantage of a borrower’s lack of understanding or misplaced reliance on
lenders.122 Due to the similarities between these and other consumer financial sectors,
the Bureau should prohibit such lending in other contexts.123
i. Home Ownership and Equity Protection Act
In 1994, Congress gave the Federal Reserve authority, through HOEPA, to prohibit acts
or practices related to any mortgages that the Federal Reserve determined were “unfair,
deceptive . . . or associated with abusive lending.”124 Congress focused on preventing
practices designed to “take advantage of unsophisticated borrowers.”125 In 2008, the
Federal Reserve Board finalized rules prohibiting asset-based lending for high- priced
mortgage loans,126 as part of its mandate under HOEPA to prevent those activities
“associated with abusive lending.”127 In mortgage lending, brokers receive a
commission on each loan closed. They are incentivized to close as many and as large
loans as possible, rather than looking out for the long-term interests of the borrowers.128
As a result of these misaligned incentives, lenders inflated borrowers’ stated incomes to
gain approval for larger- than-needed loans, understated borrower obligations, or failed to
verify borrowers’ ability to repay.129
Inevitably, borrowers mistakenly relied on lenders to determine their ability to repay,
unaware of high risks and unable to comprehend the complexities of a high-priced
mortgage loan lenders sold to them.130 Accordingly, they became exposed to
tremendous foreclosure risk.131 Such circumstances created a windfall for lenders. They
profited regardless of whether or not borrowers met their loan payments.132 If borrowers
met payments, lenders would profit from high-interest charged.133 If borrowers did not
meet their payments but were able to refinance, lenders profited from the high fees and
pre-payment penalties associated with refinancing. In the event of a borrower default,
lenders usually recovered money owed in part from the foreclosure of the borrower’s
homes.134 Each result heavily favored lenders to the severe detriment of borrowers.
Several states, including New York, followed the Federal Reserve and enacted
requirements for lenders to assess consumers’ ability to repay.135 Congress later
expanded the prohibitions against asset-based lending across all consumer mortgages, in
Title XIV of the CFPA.136 Given the strong measures taken against this practice in home
mortgages, the Bureau should follow suit for similar practices in other contexts.
ii. Credit Card Reform Act
As part of the Credit Card Reform Act, enacted in
2009, Congress required credit card companies to first assess students’ reasonable
ability to repay before approving them for a credit card.137 The Act specifically
prohibited the issuance of credit cards to students, unless they were employed
or had a reliable cosigner. The rationale for this requirement focused on how most
students—by virtue of their youth and inexperience—do not understand consumer credit
and the consequences of creating long- term credit card debt.138 Consequently, creditcard companies capitalized on this lack of understanding by
offering easy credit and encouraging students to use credit cards without first verifying
students’ repayment ability.139 This is in stark contrast to an adult’s application for a
credit card, which generally requires verification of a consumer’s ability to repay based a
consumer’s income, household income, work and credit history, and so forth.140
Although, the average student credit card limit is only
$500, these products are highly profitable for the companies issuing them.141 Credit card
companies profit when students use and pay the credit debt on time, but also profit if the
students default, thanks to the ability to charge the highest interest rate on unpaid
balances and students’ reliance on their families to cover the outstanding debt.142
Disturbed by the vulnerability of unsophisticated students—and windfalls received by
credit card companies—Congress prohibited the extension of credit cards to students
without regard to their ability to repay.143
3. How the Bureau May Implement This Prohibition
Congress’ decision to require lenders to perform an adequate assessment of a student
borrower’s repayment ability indicates a failure to do so is unreasonable not only for
secured, larger-sized loans (like mortgages) but also for unsecured, small- sized loans.144
The Bureau may use this reasoning to prohibit the extension of payday loans without a
determination that the borrower has a reasonable ability to repay.
Payday loans are a type of subprime loan that have come under considerable public
pressure and media scrutiny.145 Payday loans are intended as short-term cash advances
provided for a fee, secured by a borrower’s post-dated check. Ideally, these loans are only
intended to cover short-term emergencies.146 Most typically, a lender extends a $300
loan with a $50 fee to be repaid in two weeks.147 This loan equates to a high annualpercentage rate of 435 percent.148 Payday lending is a $35 billion industry and
growing; loans are provided online and at over 22,000 locations nationwide.149 Despite
state efforts to regulate the industry, lenders have frequently found creative ways to
avoid state-level regulation and judicial action, necessitating the creation of a federal
regulatory approach.150
Payday lenders do not provide an adequate assessment of a borrower’s ability to repay,
thus the Bureau should deem the failure to do so as abusive given the disproportionate
impact this practice has on borrowers compared to the lenders. Similar to consumers
who receive high-priced mortgages or student credit cards, consumers who take out
payday loans are usually financially unsophisticated.151 Though borrowers may be
aware of the finance charges associated with the loan, they still lack an
understanding of other material risks, costs, and conditions. These aspects include a high
annual percentage rate, which limits a borrower’s ability to effectively compare
alternative products;152 a systematic overestimation by borrowers of their ability to
repay the loan; and a lack of understanding of the actual cost of the loan upon multiple
renewals.153 Moreover, many borrowers do not realize that lenders have no obligation to
conduct accurate assessments of borrowers’ abilities to repay.154
Payday lenders capitalize this lack of understanding. They typically perform limited
verification on borrowers. Lenders require only proof the borrower receives a regular
paycheck, has a bank account, or receives public benefits.155 Lenders do not possess an
adequate view of the borrower’s true financial position.156 As such, lenders provide
loans designed to fail.157
What makes the failure to properly verify borrower re- payment ability so unreasonable is
outlined by analyzing loan rollovers. Only 25 percent of payday loans are paid off on
time.158 An estimated 76 percent of payday loans are made to repay a pre- vious payday
loan.159 As discussed in Part III.A.2.a., borrowers are consequently
consumers, and at least perform selective assessments.169 To fail to conduct a more
reasonable verification would be to perpetuate predatory loans.170 As Professor
Elizabeth Warren commented about payday loans, “it is important from a regulatory
standpoint that people are not at the mercy of lenders who build business models around
fooling people. There’s a real problem . . . [and] I anticipate a lot of change in this
[payday loan] area.”171 Accordingly, as illustrated by the analogies to high- priced
mortgage loans and students credit cards, the Bureau can justify prohibiting as abusive
any extension of credit without adequate regard to a borrowers’ abilities to repay—
especially given the windfall to lenders at the expense of naïve borrowers.
B. Overly Aggressive Sales and Marketing Tactics
Another practice the Bureau should prohibit is overly aggressive sales and marketing
tactics that are used to coerce or intimidate borrowers into entering a credit
transaction.172
1. What Constitutes Overly Aggressive Sales & Marketing
Tactics?
Another practice the Bureau should prohibit is overly aggressive sales and marketing
tactics that are used to coerce or intimidate borrowers into entering a credit transaction.
forced to rollover the first loan into a new loan in order to pay off the first at high
additional costs, leading to a perpetual cycle of debt.160 Professor Elizabeth Warren—
the Special Advisor to the Obama Administration responsible for laying the
groundwork for the Bureau—
To determine what conduct constitutes abusive sales and marketing tactics, the Bureau
can find authority in the Fair Debt Collection Practices Act and Federal Telemarketing
Sales Rule.173 Obviously, some “hard-sell” sales tactics will exist in the marketplace.
Overly aggressive sales and marketing tactics, however, should be viewed as any conduct
a lender may engage in, “the natural consequence of which is to harass, oppress, or abuse
any person” in connection with the sale or marketing of a consumer financial product.174
Government reports and academic studies outline some of these practices. These include
engaging in incessant sales calls, either made through the telephone or door-to-door
visits; discouraging borrowers from investigating lower cost alternatives; pressuring
borrowers to sign documents immediately or without reading them; and so forth.175 One
tactic that has been observed that rollovers are the most dangerous feature of payday
lending.161 On average, borrowers will rollover the same loan nine times before
repayment, usually in back-to-back succession. 162 This doubles the ultimate repayment
amount.163 For example, if a borrower rolls over their $300 loan, eight times, borrower
will pay $705 in principal, interests, and fees.164
What is even more concerning is that 90 percent of the payday lenders’ profitability
derives from borrowers who are unable to repay and must rollover their loans. Thus,
payday lenders are not incentivized to perform in-depth checks of a borrower’s ability to
repay. The more people use the loans as they are intended and repay on-time, the less
profitable payday lenders will be. This strengthens the assertion that payday lenders, who
fail to adequately verify a borrower’s repayment ability, are taking unreasonable
advantage of borrowers’ lack of understanding of risks by purposefully ignoring the
fact that they are leading borrowers into loans they cannot repay.165A Department of
Defense report—which led to heavy federal regulation of payday loans for the military—
explains the exploitative nature of this industry: “It is clear that the payday lending
business model is based on the repeat high loan fees from one borrower in successive
transactions, without the extension of new principle.”166
Small-dollar loans, like payday loans, are useful to American families as they provide a
source for fast, short-term cash, thus the Bureau’s intent is not to eliminate them.167 Nor
is the Bureau able to impose usury caps.168 To facilitate the speed of the transaction,
requiring an extensive verification of ability to repay is somewhat problematic. Yet, with
its existing data, payday lenders could analyze and generate profiles of those borrowers
who are most likely to default, use the profile to screen new and existing
particularly effective occurs when lenders “send out solicitations that are designed to
resemble collection notices, so that frightened homeowners will reply, only to be cajoled
into taking out high cost loans.”176 These acts are done with the purpose of selling a loan
by subjecting the borrower to undue psychological or emotional pressure.177
2. Overly Aggressive Sales and Marketing Tactics Fall Within
CFPA’s Standard
a. Falling Under the Statutory Definition of Abusive
Section 1031(d)(1) of the CFPA states that any practice is abusive if it “materially
interferes with the ability of a consumer to understand a term or condition of a consumer
financial product or service.”178 Aggressive sales and marketing tactics materially
interfere with a consumer’s ability to understand the terms of the product because they
are intended to be or have the effect of overwhelming, confusing, or causing anxiety in
the consumer.179 Lenders rely on threats, emotional and psychological pressure, and
borrower ignorance to push prospective borrowers through an application process in
pursuit of credit beyond what the borrowers want, need, or can afford.180 All of this
severely limits a consumer’s ability to make sound judgments on the product being
offered.181
A joint federal taskforce characterized the effect of aggressive sales tactics like the
CFPA’s §1031(d)(1) definition of an abusive practice. The report stated: “These
practices interfere with, and in some cases, deprive borrowers of the opportunity to
understand the terms of a proposed loan.”182
Some lenders even use federally required disclosures to confuse consumers.183 Loan
officers “typically schedule a home loan closing every thirty minutes, an unrealistic
amount of time for even a highly literate borrower to read through all the [approximately
50 pages] fine print.”184 Buried in the documents will be the three to five pages of
disclosures.185 Lenders move through the documents rapidly; by doing so, it
communicates to the borrower that they are expected to not ask questions or are expected
to understand the documents easily.186 This is designed to “‘overload, overwhelm,
distract, and . . . fatigue borrowers.”187 This rushed feeling creates a sense of stress,
“leading to truncated reasoning” rather than a careful understanding of aspects of the
loan.188 This articulates the negative impact overly aggressive sales and marketing
tactics have on a consumer’s ability to understand the important terms of a loan.
Therefore, overly aggressive sales and marketing tactics fall within the CFPA’s
definition of abusive.
b. Analogous Federal Legislation
The Bureau’s decision to prohibit overly aggressively sales and marketing tactics as
abusive can leverage similar reasoning and definitions used by Congress and the Federal
Reserve used to curb such practices under the Fair Debt Collection Practices Act189 and
the Federal Telemarketing Sales Rule.190 Like the CFPA, the purpose of these
provisions is to prevent and eliminate abusive practices that became serious national
problems.
i. The Fair Debt Collection Practices Act
In 1977, Congress established abusive as a legal standard in the Fair Debt Collection
Practices Act (“FDCPA”). The standard, enforced by the FTC, was intended to protect a
major part of consumer finance: debt collection. The FDCPA uses the abusive standard
broadly to encompass abusive, deceptive, and unfair practices.191 Specifically section
1692(d) states: “A debt collector may not engage in any conduct the natural consequence
of which is to harass, oppress, or abuse any person in connection with the collection of a
debt.”192 This section also enumerates specific conduct as a violation of this prohibition,
including the use of repeated calling to annoy or harass the listener; use of obscene
language or “language the natural consequence of which is to abuse the hearer or reader”;
and threats of violence.193 These behaviors are akin to overly aggressive sales and
marketing practices discussed above. The statute gives the FTC added flexibility by
enabling “the courts, when appropriate, to proscribe other improper conduct, which is not
specifically addressed” in the statutory language.194
Since 1978, the FTC has brought over sixty enforcement actions against parties who
violated this Act;195 many involved lenders engaging in abusive debt collection in
violation of
1692(d).196 This gives the Bureau a considerable body of case law to consider in
forming policy and regulations to further define abusive under section 1031 of the
CFPA.197
ii. The Federal Telemarketing Sales Rule
The Bureau can also look to the Federal Telemarketing Sales Rule (“FSTR”), a part of
the Telemarketing and Consumer Fraud and Abuse Prevention Act,198 for more recent
guidance.199 Congress designed the FSTR to prohibit deceptive and abusive
telemarketing activities.200 It is estimated that unscrupulous businesses utilize
advances in telemarketing as a way to victimize consumers, costing consumers $40
billion a year.201
To implement the Act, the FTC promulgated the FTSR based in large part on the
FDCPA definition of prohibited practices—conducts that “harass, oppress, or abuse” a
borrower.202 The FTSR enumerates certain acts as abusive, including: all types of
threats, intimidation, or obscene language;203 patterns of unsolicited calls intended to
annoy, abuse, or harass any person;
and refusal to identify the calling party.204
Commentary by the FTC also provides an even more expansive definition of abusive
acts of intimidation including “acts that would place undue pressures on the consumer, or
which call into question a person’s intelligence, honesty, reliability, or concern for
family . . .[or] [r]epeated calls to a consumer who has declined a telemarketing offer.”205
Lenders engaging in any of these acts render consumers unreasonably more susceptible to
telemarketing schemes. Such practices are, therefore, considered abusive. The Bureau
should look to the FSTR and the FDCPA for considerable guidance when justifying the
prohibition of overly aggressive sales and marketing practices in other consumer
financial contexts.
3. How will the Bureau Implement this Prohibition?
Consulting applicable federal legislation, the Bureau will establish regulations to
eliminate the most abusive practices. While reports indicate overly aggressive marketing
and sales tactics are common in several areas, the industry requiring immediate
regulation is home mortgages, given its gross impact on the financial crisis.206
There are two reasons the Bureau should deem overly aggressive sales and marketing
tactics to be abusive in home mortgages. First, prohibiting these practices will reduce
the kinds of predatory subprime loans that resulted in millions of foreclosures. The
severity of the financial crisis resulted in part from the proliferation of such unaffordable
loans.207 Once borrowers realized they could not afford these subprime loans that were
inherently designed to fail, foreclosures ensued.208 There is a broad consensus amongst
commentators that aggressive marketing and solicitation tactics are central aspects of
predatory subprime lending.209 Practices, such as incessant calling and excessive
disclosures, negatively impacted borrowers’ abilities to make informed decision and
allowed lenders to take advantage of them.210
Most subprime borrowers have lower income, often have less education, and frequently
lack the financial sophistication to adequately scrutinize a loan.211 Unscrupulous
subprime lenders preyed on unsophisticated borrowers by using fear and psychological
pressure to interfere with consumers’ understanding of the terms and conditions of a
given transaction. Certain groups, such as the elderly, who have significant equity in their
homes but limited financial education, were the most susceptible to lenders engaging in
these tactics.212 Ultimately, lenders engaged in overly aggressive sales and marketing
tactics coerced borrowers “to continue through the loan application process in cases in
which the customer would prefer to discontinue the process.”213 Consequently, lenders
“direct[ed] them to products that may not be the best for their needs – or affordable in the
long run.”214 Under the abusive standard, the Bureau has the flexibility to ban overly
aggressive sales and marketing tactics, reducing the numbers of consumers who are
pressured into unfair loans.
Second, the nation’s current financial straits demand regulation of overly aggressive
sales and marketing tactics far more than aggressive debt collection or telemarketing.
Congress justified the FDCPA prohibitions by pointing to the size and growth of the $5
billion debt-collection industry in 1976.215 By the same reasoning, restricting overly
aggressive sales and marketing tactics is even more necessary. The total losses resulting
from the subprime mortgage crisis are estimated to hit $636 billion;216 eight million
borrowers will lose their homes to foreclosures “because of an inability to repay unsound
loans.”217
Given the magnitude of the subprime mortgage crisis, and the common association
between consumer foreclosures and aggressive sales tactics—the Bureau should
prohibit overly aggressive sales and marketing tactics as
abusive.
C. Steering Practices
The fallout of the subprime-mortgage crisis not only revealed the need to regulate
aggressive marketing and sales tactics and asset-based lending but also loan steering.
1. Conduct Constituting Abusive Steering Practice
Steering occurs when a lender or loan originator directs a consumer away from a certain
type of product towards a less beneficial alternative.218 Most often the lender has
access to alternative products or terms for which the consumer is eligible, yet lenders will
steer consumers away from better suited products, toward a detrimental alternative.219
Steering is done to increase the lender’s revenue through additional kickbacks or profits
generated for the lender by selling a different product.220 These acts occur despite an
expectation or reliance by the consumer that lenders will act in the consumer’s best
interests.221
The practice of loan steering is commonly reported in mortgage lending, overdraft
fees,222 student loans, and other consumer products.223 Consider overdraft payment
programs.224 Cases have been reported where banks steered consumers who frequently
overdraw on their accounts into fee-based overdraft programs in order to maximize bank
revenue, rather than less expensive overdraft options or other credit alternatives.225 The
most frequent users of overdraft programs are lower-income individuals with less
financial sophistication. Critics allege banks use these programs to exploit these
consumers’ lack of knowledge and naivety to generate an estimated $38 billion
annually.226 In November 2010, the FDIC issued guidance, strongly discouraging
steering in overdraft programs, but only after the CFPA was proposed.227
2. How Does Steering Fall Within the Definition of Abusive
a. Falling Under the Statutory Definition of Abusive
Steering should be defined abusive under section
1031(d)(2)(C) of the CFPA. Section 1031(d)(2)(C) states an act or practice is abusive if it
“takes unreasonable advantage of the reasonable reliance by the consumer on a covered
person to act in the interests of the consumer.”228 For many consumer finance
transactions, there is evidence that consumers rely heavily on a lender’s advice when
selecting a product or loan.229 In the mortgage context, this reliance is developed as
lenders may cultivate themselves as a “trusted advisor”230 or through an established
relationship between the borrower, lender, and an affiliated institution.231 Because of
this reliance, consumers inaccurately (though commonly) believe lenders are obligated to
obtain the best interest rates and terms for them.232 For example, in a national Fannie
Mae Survey, over half of all Hispanic and African-American borrowers surveyed
believed that “lenders are required by law to provide the best possible loan rates.”233
Despite recognizing that many consumers rely on their lenders, lenders still steer
consumers towards products or loans with disadvantageous terms compared to other
available products. In a speech to the Consumers Union, Professor Warren observed
“[t]oo many profit models have been built around steering customers into products they
can’t understand or may not be able to afford.”234 Accordingly, lenders profit from and
take unreasonable advantage of this reliance by placing consumers in loans which did
not meet their financial and personal needs.235 In many cases, this practice forces
borrowers into unmanageable or crippling debt.236
b. Analogous Federal Legislation in the CFPA
Prohibitions against steering already exist in the home- mortgage context and thus
steering should no longer be tolerated in other consumer credit contexts as well.237 The
CFPA amended TILA to impose restrictions on steering by loan originators and on yield
spread premiums for mortgages. In home mortgages executed prior to April 1, 2011,
lenders typically paid loan originators—mortgage brokers and their employees—higher
compensation if the borrower agreed to an interest rate that is higher than the rate
required by the lender. This is commonly referred to as a yield spread premium.238
Because of this compensation structure, brokers were highly incentivized to steer and
influence borrowers towards loans with higher interest rates in order to gain the
additional compensation, often at the expense of the borrower.239 The practice became
so prevalent that Fannie Mae estimated that as many as 50 percent of subprime borrowers
could have qualified for lower prime rate interest loans.240 While disclosure
requirements existed, they had little impact.241
Section 1403 of the CFPA prohibits a “mortgage originator from receiving, directly or
indirectly, compensation that varies based on the terms of the loan, other than the amount
of the principal.”242 It also prohibits originators from steering borrowers from a
qualified mortgage (one with generally less risky terms) to a non-qualified mortgage (one
with generally riskier terms); to a loan that the consumer lacks a reasonable ability to
repay; or to a loan that has “predatory characteristics (such as equity stripping, excessive
fees, or abusive terms).”243
Even though changes in the CFPA were not to go into effect until April 2011, on August
16, 2010, the Federal Reserve Board took several actions to immediately protect
consumers from steering in advance of the CFPA provisions.244 From testimony and
consumer testing supporting its decision, the Board concluded (1) consumers are simply
not aware or lack an understanding of yield spread premiums and the large incentive that
brokers have to steer borrowers; (2) consumers who understand that creditors pay loan
originators “may not fully understand the implications of this practice”; and (3)
consumers place significant reliance on their trust and relationship with the broker to
provide terms that are in the consumers’ interest.245 In announcing the new rules, just a
month following the enactment of the Dodd-Frank Act, the Board actions may reflect
what actions the Bureau may take once it takes authority over consumer financial
protection.
3. How the Bureau Should Implement Anti-Steering Prohibitions
The CFPA and Final Rules to TILA adopted by the Board signaled a
willingness to embrace some quasi-form of fi- duciary duty owed to borrowers by lenders
to act in borrowers’ best interests in home mortgages.246 The spirit of these protections
should apply broadly to consumer finance, as the circumstances that led the Board to
label steering as an abusive practice in home- mortgage industry are present in other
credit markets. One such example is private student loans.
Private student loans are loans extended by private institutions to students and
families in order to pay for higher- education costs.247 These loans are outside of
government-sponsored student loan programs and are not subsidized by the federal
government.248 Private loans are significantly more risky and ex- pensive than their
federal counterparts.249 Unlike federal student loans that are offered at fixed rates,
private student loans have variable interest rates. On average, the base interest rate is
twice that of federal loans.250 Reported interest rates for private loans in
2010 averaged from 11 to 12 percent251 and went as high as 18 percent.252 In contrast,
rates at about the same time for government-supported student loans were 5.6 to 6.8
percent.253
The private student loan industry bears many alarming similarities to the precrisis subprime mortgage industry.254 It possesses limited regulatory activity, features
high-risk borrowers, and appears to inflict disproportionate harm on lower-income borrowers.255 Other statistics call attention to tremendous growth of the industry. In August
2010, the Federal Reserve reported that national student loan debt surpassed credit card
debt; approximately 20 percent of the loans are private student loans.256 In the
2005–06 year, private student lenders originated $17.3 billion in loans, tripling in size
from the five years prior.257 These conditions demonstrate a need for active regulation of
private student
of obtaining private loans without first exhausting one’s federal loan options could lead
to “a lifetime of excessive and unnecessary debt.”276 This is particularly alarming
because student loans can- not be discharged through personal bankruptcy
proceedings.277 Overall, private student loans enjoy fewer consumer protections, have
less flexible repayment options, and generally expose borrowers to greater financial risk
than federal student loans.278
Despite these consequences, many preferred lenders may nevertheless steer students
away from federal loans by electing to not confirm whether the student has exhausted his
or her federal loans. As a result, Congress explicitly included this industry within the
Bureau’s jurisdiction. Additionally, the CFPA creates a private education loan
ombudsman, demonstrating Congress’ intent to reign in abuses.259
Under its authority to prohibit abusive practices, the Bureau may elect to
prohibit private student lenders, who have a preferred lender status with educational
institutions, from steer- ing students (1) to enter higher than necessary private student
loans when they qualify for low cost federal loans and (2) steering students to larger
loans than students need.260 Such acts have the practical effect of increasing lender
compensation, since lenders generate greater interest payments from a larger loan.
When entering into private student loans, students rarely shop around.263
They instead rely heavily on the preferred vendors recommended by their schools’
financial aid office. Over
90 percent of students seeking loans will go with the school’s “preferred lenders.”264
Therefore, placement on a preferred list is highly competitive.265
A student’s reliance on a preferred lender is generally based on the student’s
lack of understanding of the difference be- tween federal and private loans.266 Students
simply do not possess the financial sophistication to make informed decisions.267 Also,
the reliance on the lender is based on a misguided, but not unreasonable, expectation that
as preferred lenders to their school these lenders are required to act in the best interests of
the school and, by extension, the student.268
Preferred private student lenders are aware of the stu- dent’s reliance and lack of
understanding.269 In fact, that is likely why they compete so fiercely to get on a school’s
list of recom- mended lenders.270 The incentive structure for these lenders deters them
from verifying with the school whether the borrower has exhausted their federal loans
and offering a lesser loan amount. Of private student loans extended in 2009, 64 percent
of students had not exhausted their federal loans.271 More concerning is that
26 percent of private loan borrowers, who qualified for federal
loans, failed to even use federal loans at all.272
By steering a student to a larger loan without regard to federal loan access,
lenders take unreasonable advantage of the students’ reliance and thus engage in an
abusive practice. This is the type of practice that the Bureau and section 1031 seeks to
prevent.273 The larger loan automatically exposes students to more risk than a federal
loan.274 As Senator Jared Polis, a member of the House Education and Labor
Committee, observed “[p]rivate student loans are one of the riskiest and most expensive
ways to pay for college . . . [it] can be riskier than using a credit card.”275 The result
ment.279 Such practices are abusive and the Bureau should take action to prohibit
preferred private student lenders extend student loans without verifying whether the
student has exhausted their federal loan options.
The problems of private student loans became so severe that the House passed
an amendment to the Dodd-Frank Act, requiring lenders to obtain certification from the
borrower’s schools confirming students had exhausted federal loans.280 Congress had
recently approved a student self-certification requirement, so the Senate declined to
approve the amendment until results on self- certification were more extensive.281 Initial
field studies indicate that self-certification has not been effective in curbing student
awareness.282 In light of the proven ineffectiveness of similar dis- closures283 selfcertification is unlikely to provide the necessary protections to stem loan steering.284
Therefore, the Bureau should prohibit steering as an abusive practice in the context of
private student loans.
Iv. Conclusion
The Bureau of Consumer Financial Protection will play an integral role in redeveloping
stability in the consumer financial industry. Practices that once fell outside the FTCA’s
unfair and deceptive standards will no longer evade regulation under the Consumer
Financial Protection Act’s abusive standard. Despite some criticism to the contrary, the
term abusive is neither new nor unduly vague. Further, the abusive standard is necessary
to provide adequate protections against future financial crisis related to consumer credit
products. By analogy to past application of abusive as a legal standard in other statutes,
one can confidently say that the CFPA’s abusive standard applies at least three classes of
practices. Developing the regulation of such practices will allow the abusive standard to
be better understood.
*J.D., May 2012, Loyola Law School Los Angeles. My deepest gratitude to Professor
Lauren Willis for her guidance. Thank you to Professor Richard Alderman of the
University of Houston Law Center, Gail Hillebrand of the Consumers Union, Kathleen
Keest of the Center for Responsible Lending, Professor John Pottow of the University of
Michigan Law School, and John Wright of Wells Fargo Bank for their valuable insight. I
would like to acknowledge Professors Aaron Caplan, Bryan Hull, Laurie Levenson, and
John Nockleby for their mentorship. Special thanks to Ali Mojibi, John
McClintock, Jeffrey Payne, Andrew Lichtenstein, Kathy Huang, and many others for
their support. This Article is dedicated to my family.
Discussion Questions
How do you decide whether to prohibit a product or practice?
How many people like it?
How dangerous is it?
Is the analogy to the faulty toaster a good one?
Is the analogy to the FTC rules regarding misleading ads or the FDA letting a drug onto
the market. How should they balance benefits vs. dangers?
Should they ban or heavily regulate Payday loans in general or only those to special
targets such as the mentally challenged or those in the military? Is limiting interest on
payday loans a price control or a prohibition?
What is the relationship between their mandate and the concept of unconscionability or
the concepts of deception?
One of their earliest proposals was to deny enforcement on credit obligations where the
credit granter did not follow basic underwriting standards?
Was this a good choice?
Why do you think they started there?
They limited their scrutiny to subprime mortgages.
Why do you think they made that decision?
Isn’t taking advantage of the consumer’s lack of knowledge a basic tenet of capitalism?
Where does it cross a line and become wrongful?
What duty does the lender owe to the borrower?
What about steering a consumer to a less advantageous product?
Who kind of duty does the credit granter have to the customer?
What may the parties reasonably expect from one another?
What about marketing to groups with known limitations:
People with under a certain i.q?
High school students?
College Students?
Consider each of the following>
Please reread the Ronald Mann article at page _________
How Risky Is It to Make a Non-QM Mortgage? And Is QM Going to Hold Back Access
to Credit?
posted by Adam Levitin
One of the huge questions hanging over the mortgage market today is what will
happen to access to credit for credit impaired or non-traditional borrowers. There is a real
concern that the Dodd-Frank Act’s mortgage reforms will reduce the availability of
mortgage credit because lenders’ fear liability for making mortgage loans that fail to
qualify as “Qualified Mortgages” (QM) and are thus potentially subject to an Ability-toRepay (ATR) defense. I've blogged on aspect of QM before (here, here, here, here, here,
here, here, and here). Based on a preliminary analysis, I think this concern is overblown,
and in this very long post I attempt to work through the potential liability for lenders that
make non-Qualified Mortgages. (I note that all of this is my tentative readings of the
statute; we really don’t know how courts will interpret it, and others may see better
readings than I do now.)
Still, my back-of-the-envelope calculation suggests that it is quite low in terms of
loss given default and could probably be priced in at around 18 basis points in additional
cost for a portfolio with weighted average maturities (actual) of five years. Even with
rounding up, that's 25 basis points to recover additional credit losses, which is not a big
impact on credit availability. I invite those who would calculate this differently to weigh
in in the comments—it’s quite possible that there are factors I have overlooked here, as
this is a really preliminary analysis.
Ultimately, I don't think ATR liability really matters in terms of availability of
credit. What matters is the lack of liquidity--meaning a secondary market--in non-QM
loans, as lenders aren't going to want a lot of illiquid loans on their books, and that is a
function of the GSEs' credit box, not CFPB regulation.
Because this post is REALLY long (the Mother of All QM Posts), here’s where it
goes (yes, I feel like I'm doing one of those unwieldy 100+ page UFTA decisions, so I'm
going to have a table of contents!):
First, it gives the legal background on the Dodd-Frank Act ATR requirement;
Second, it covers the Qualified Mortgage safe harbor to the ATR requirement;
Third, it covers the civil liability to the CFPB and Attorneys General for failing to verify
ATR;
Fourth, it covers private civil liability for ATR violations;
Fifth, it covers the private civil damages for ATR violations;
Sixth, it addresses the likelihood of liability of ATR liability;
Seventh, it attempts to calculate a reasonable loss given default rate for ATR and the
affect on mortgage pricing (please note that I am not attempting to work in compounding
anywhere here; this is a ballpark analysis, not a precise figure);
Eighth, it considers whether the real issue is ATR so much as the costs imposed by
contested foreclosures (which ATR might make more common); and
Ninth, it suggests that ATR may not really matter in terms of access to credit, as the real
limitation will be the lack of liquidity for loans that do not meet the GSEs’ underwriting
guidelines independent of QM.
Phew.
1. The Ability-to-Repay Requirement
The single-most substantive regulation for consumer banking included in the DoddFrank Act is the Ability to Repay (ATR) requirement for mortgages (sorry Durbin
Amendment, I love you, but mortgages are just bigger than debit). Title XIV of the
Dodd-Frank Act amends the Truth in Lending Act (TILA) to provide that “no creditor
may make a residential mortgage loan unless the creditor makes a reasonable and good
faith determination based on verified and documented information that, at the time the
loan is consummated, the consumer has a reasonable ability to repay the loan, according
to its terms, and all applicable taxes, insurance (including mortgage guarantee insurance),
and assessments.”
2. The Qualified Mortgage Safe Harbor
The Dodd-Frank Act directs the CFPB to create a safe harbor for “Qualified
Mortgages” or QMs. The CFPB has defined a QM (with some minor exceptions) as a
mortgage meeting six criteria
1.regular payments that are substantially equal (ARMs and step-rate mortgages
excepted) and always positively amortizing
2.term of no more than 30 years
3.limited fees/points (caps vary with mortgage size)
4.underwritten using the maximum interest rate in the first five years to ensure
repayment
5.income verified
6.backend debt-to-income ration of no more than 43% (including simultaneous loans)
The last three requirements are satisfied prior if the loan is eligible for GSE purchase
or guarantee. If the loan is a QM it qualifies for a safe harbor from the ATR requirement.
If the loan is a regular QM, this is an absolute, irrebuttable safe harbor, while if the loan
is a high-cost QM (defined as pricing at 150 basis points over prime for first liens, and
350 basis points over prime for junior liens), then the safeharbor is a rebuttable one.
To understand the importance of the safe harbors, it is necessary to understand what
happens if a lender doesn’t comply with this ability to repay (ATR) requirement. This
has been a source of a lot of confusion. There is definitely some risk for lenders, but I
think it is much less than generally perceived by the lending industry. What is critical to
understand is that a loan can be non-QM, but still satisfy the statutory ATR requirement.
The statute only prohibits loans that are made without verified ATR.
3. Civil Liability to CFPB and Attorneys General for ATR Violations
If a loan is made without verified ATR, there is the possibility of a CFPB
enforcement action within three years of the violation. TILA is a “Federal consumer
financial law,” by virtue of being an “enumerated consumer law” and the Dodd-Frank
Act provides that “It shall be unlawful for…any covered person…to offer or provide to a
consumer any financial product or service not in conformity with Federal consumer
financial law, or otherwise commit any act or omission in violation of a Federal
consumer financial law”. The CFPB can seek a civil monetary penalty and/or an
injunction for violations of Federal consumer financial laws. The CFPB, of course, has
limited enforcement resources; as long as a lender is making a good faith effort to verify
ATR, CFPB enforcement seems unlikely. The mere fact that loans have high default
rates should not by itself be a problem for ATR liability, although it does suggest a
possible problem with the lender’s ATR analysis and might raise some eyebrows.
Note that the CFPB's statute of limitations on an ATR violation is shorter than the
generic CFPB statute of limitations. Generally, the CFPB has three years from the
discovery of a violation in which to bring an action. But that does not apply to actions
"arising solely under enumerated consumer laws." Instead, the enumerated consumer
law's statute of limitations applies, and for TILA it is three years from the violation, not
three years from discovery of the violation. (There might be caselaw interpreting this
differently, of course.)
ATR violations can also brought by state attorneys general within three years of the
date of the violations (not from the date of the discovery of the violation). It isn't clear,
however, how the remedy would work. The state AGs are authorized to bring an action to
"enforce" the ATR rule, but the only remedy prescribed by the statute for an ATR
violation is one of setoff or recoupment. Neither remedy is of any use to a state AG
because the state AG is not a debtor and therefore wouldn't have any right of setoff.
(Remember, setoff requires mutually owing debts.) I think the intention is civil liability to
the attorney general for the amount allowed for the TILA setoff (below), but the statute
isn't clear. Given that the state attorney general has no right of setoff or recoupment, it
isn't clear what it would mean for a state attorney general to bring an ATR violation.
Perhaps injunctive relief is possible, but I don't see a TILA provision authorizing state
AGs to bring an action for injunctive relief. State AGs have authorization to bring actions
under Title X of the Dodd-Frank Act (other than against national banks and federal
thrifts). It's not clear if that only allows for actions enforcing the organic provisions of
Title X, such as UDAAP, or whether it also extends to enforcing the provision that “It
shall be unlawful for…any covered person…to offer or provide to a consumer any
financial product or service not in conformity with Federal consumer financial law, or
otherwise commit any act or omission in violation of a Federal consumer financial law”.
(If so, then state AGs can enforce all of the enumerated consumer laws.)
4. Private Civil Liability for ATR Violations
The real risk, it would seem, for failing to verify ATR is that that it creates TILA
liability. It is not clear, however, just what this TILA liability is. There are two
possibilities. The first is that there is both liability for an affirmative cause of action
under TILA and as TILA setoff defense, while the second is that there is only liability for
a TILA setoff defense.
TILA’s generic remedy provision, 15 USC 1640(a), provides for damages in a
private right of action, but this remedy is limited to original creditors; assignees are liable
only to the extent that a violation is apparent on “the face of the disclosure statement”.
That’s language that has no applicability to an ATR violation, which isn’t a disclosure
violation. Therefore, there is no assignee liability for a direct TILA right of action on
ATR. But isn’t even clear that there is originating creditor liability for a direct
affirmative cause of action. Section 1640(a) provides for affirmative damages, "[e]xcept
as otherwise provided in this section," and elsewhere in section 1640 there is the
specification of a remedy for an ATR violation of a "defense by recoupment or set off".
15 USC 1640(k). I think it would be fair to read this as saying that a defense by
recoupment or set off is the exclusive remedy for an ATR violation. But this is far from
clear at least on the face of the statute.
If there is an affirmative cause of action available, it is subject to a three-year statute
of limitations from the date of the ATR violation and can be brought only against the
originator. A TILA defense, in contrast, can be brought at any time during the life of the
loan, and can be raised against anyone attempting to collect on the loan, be in the
originator or any assignee.
If a defense is the exclusive remedy, there are two important implications. First, the
TILA remedy is triggered only when the creditor tries to collect on the loan by
"intiat[ing] a judicial or nonjudicial foreclosure of the residential mortgage loan, or any
other action to collect the debt in connection with such loan". I read "intiat[ing]...any
other action" to mean bringing a judicial action, not just any attempt to collect such as
sending out a billing statement. If so, the consumer really does not control the timing of
the TILA ATR defense.
Second, because the TILA remedy is a setoff, it only reduces the collection on the
loan. (Setoff is a broader concept than recoupment--setoff involves offsetting any mutual
debts, whereas recoupment involves offsetting debts from the same transaction. For this
reason I will only refer to setoff.) The TILA ATR remedy does not prevent the
foreclosure (unless, presumably, the TILA setoff is greater than the unpaid balance on the
loan). Although, there is no statute of limitations for the TILA defense, it can only be
raised as a setoff defense to a collection action, which means that there have to be
mutually owing debts. If the money has been collected from the debtor, there are no
longer mutually owing debts, and the funds the debtor has paid cannot be clawed back.
Thus, if a foreclosure sale's proceeds have been distributed, it is too late to raise the
defense, other than against the collection of a deficiency judgment.
Third, how a TILA setoff defense this applies in a nonjudicial foreclosure is not
clear. A defense or counterclaim simply has no application to a nonjudicial foreclosure.
Perhaps this means that any borrower that can raise an ATR claim can convert a
nonjudicial foreclosure into a judicial one, but there’s nothing making clear how this
works.
In any case, I’m going to focus here on the TILA defense, because that’s where I
think the real issue lies, not in an affirmative cause of action. I think this is the case
because an affirmative cause of action:
1.is questionable, at least from the face of the statute, whether there is such a right of
action;
2.the affirmative cause of action has a shorter statute of limitations than the defense;
3.the affirmative cause of action has limited defendants;
4.plaintiffs would lack the facts to be able to sufficiently plead a case to get past Iqbal
and Twombly and would therefore likely lose on motions to dismiss (this problem doesn't
exist for a defense); and
5.the affirmative cause of action has small enough damages that it isn’t an attractive sort
of suit to bring for most attorneys, even with the attorneys’ fee provision; pro se actions
are more likely in the foreclosure context where the homeowner is motivated to try to
reduce losses or fight the foreclosure rather than opportunistically seek a gain.
The possibility of a class action isn't much of a concern because TILA caps class action
damages at the lesser of $1 million or 1% of the defendant's net worth. There's the
possibility of TILA violations being predicates for state law UDAP class actions, where
no damages cap exists, but I don't see this as a real risk for lenders that actual make some
attempt to underwrite loans.
5. Calculation of ATR Private Civil Liability
Irrespective of how the TILA defense works procedurally, it does not prevent a
foreclosure. (The same is true if an affirmative cause of action exists.) Instead, if
successful, it simply reduces the foreclosing lender’s claim on the foreclosure sale
proceeds. The reduction is by the sum of:
1.actual damages resulting from the failure to verify ATR.
2.statutory damages of between $400 and $4000.
3.the consumers’ costs of the litigation plus “reasonable” attorneys’ fees
4.the sum of all finance charges and fees paid by the consumer on the loan within three
years of the ATR violation, unless the failure to verify ATR “is not material.”
It’s worth unpacking all of these. (Again, these are the same damages as in a direct
affirmative cause of action, if one exists.)
What are “actual damages” from failure to verify ATR? From other similar “actual
damages” provisions, such as those in the FDCPA, we know that “actual damages” can
include emotional harm to the borrower. It might also include consequential damages,
such as harm to the consumer’s credit score, which can have effects on employment,
insurance, and other loan pricing. It might also include the relocation costs from a
foreclosure (although generally those costs would not have been incurred at the time the
defense is raised).
But what about the loan itself? Is that actual damages? Actual damages requires a
loss causation requirement, meaning that it must be shown that but for the failure to
verify ATR, the borrower would not have incurred the damages. But I could see a
reading in which there is an assumption of loss causation, in that the loan was made only
because the lender failed to verify ATR. If so, then actual damages would be all amounts
paid on the loan plus the outstanding balance (principal, interest, fees, etc.). That said, I
don’t think the loan itself would likely be included in actual damages as it is too
speculative to say that the borrower wouldn’t have gotten a loan at all based on after-thefact underwriting. Perhaps the borrower could have gotten a loan, just at a higher rate.
Still, there is some question as to what, if anything, “actual damages” are.
The statutory damages are the easy part and are capped at $4,000, with judicial
discretion within the allowed range. Costs and attorneys’ fees can be quite expensive. If
a case gets litigated all the way, it could easily be $50,000 (remember, consumer
attorneys are generally not billing $1,000/hr) and possibly much more, especially if the
consumer retains expert witnesses.
The finance charges and fees could add up to quite a lot, if the default is late in the
life of the loan. Figure that on a $200,000 loan at 6%, this is $12,000 per year (I’m doing
simple annual interest). If it’s a $1.2 million loan, that’s $72,000/year. That turns into
real money fast. Of course, all of this is subject to the TILA materiality requirement. It’s
not quite clear what the materiality requirement means in this context—the TILA
provision regarding materiality was drafted for other types of TILA violations, and the
set-off defense is written to piggyback on the pre-existing TILA provision. The
materiality requirement means that the failure to verify ATR was material…but to what?
Here are three possible readings:
1.Material to the harm to the borrower?
2.Material to the default on the loan?
3.Material to the foreclosure?
I think it should be #2 the default on the loan, but the statute isn’t explicit about this, and
it strikes me as a potential problem for a borrower trying to raise an ATR defense. Let’s
assume that reading #2 is correct. I think the burden of proof on materiality is on the
defendant creditor, but there are two important limitations on this strand of liability.
First, liability for finance charges and fees is limited to those paid (not billed) in the
first three years since the ATR violation. And second, this is a cap, not a floor. I'm
skeptical that finance charges in year three or even perhaps year two can be shown to
have a material connection to failure to verify ATR. (The QM safeharbor in contrast
looks out to five years for underwriting.) If a borrower defaults at month 30, the fact that
the loan wasn’t really underwritten in month 0 doesn’t seem particularly relevant.
Underwriting is, at best, a prediction of future risks. But it is really hard for even the best
underwriting to predict a borrower’s financial condition out beyond the immediate future.
Measures like credit scores and income and DTI are inherently retrospective. They
cannot capture the prospective changes in employment, family status, health, or property
values that drive many defaults. Thus, I would think that the risk of losing finance
charges is really only an issue for a fairly short window post-origination. Again,
however, the burden of proof here is on the creditor, which means that the creditor will
have to litigate this point, which might cost more than the liability avoided.
So what does all this liability mean in the worst case scenario? Let’s assume a
$200,000 loan at 6% annual interest, which defaults at the end of year 2, and that all
finance charges paid (24 months worth) are assumed material. Let’s assume that the
LTV on the house is 95%, so the house is worth $210,500. Let’s also assume $50,000 in
costs and attorneys’ fees. If there are no actual damages, then the lender is looking at
$78,000 in set-off liability:
•Zero actual damages;
•$4,000 in statutory damages;
•$50,000 in costs and attorneys’ fees;
•$24,000 in finance charges and fees paid.
With a $78,000 setoff applied to a $200,000 loan, the lender's claim is reduced to
$122,000. If the property sells for market value or even substantially less, the lender
recovers that $122,000 in full. That’s a 39% (0.39) loss severity on the loan, which is
quite serious (and doesn't account for future lost interest). And if the LTV is higher, the
loss severity might be worse because there might not be enough equity in the property to
pay off the loan, although in such a case the setoff will not be paid in real dollars, as
discussed below, but in tiny deficiency judgment dollars or uncollectible nonrecourse
dollars.
ATR liability, however, does not stop with TILA itself. A TILA violation could be
a predicate for a state law UDAP claim (or potentially also an FDCPA violation). That
might itself carry further statutory damages, although it is unlikely in most cases to
increase the lender’s total liability significantly. (This is more of a concern for an
affirmative cause of action, which might produce a class, rather than a defense, which
will surely be one-offs.) But this adds some uncertainty to the question of loss severities.
In any case, we need to apply the loss severity to the likelihood of loss.
6. Likelihood of Liability for ATR Violation
In order for there to be ATR liability, several things need to happen. First, there has
to be a default on the loan. Second, that default needs to result in a foreclosure. Third,
that foreclosure has to be contested. Fourth, the borrower needs to show that the lender
did not consider his/her ability to repay when making the loan. That’s a lot of different
gates to run through.
If a loan is in fact well-underwritten, but simply doesn’t qualify for QM, the default
rate should be fairly low. Let’s assume 10%, which I think is really quite high. Of
course, if the loan is well-underwritten, then an ATR defense should not be successful at
all. If a lender is simply making loans based on collateral values, there is an ATR
problem, but even then, let’s say 25% of loans default.
Even then, not all defaults result in foreclosures. A lot depends on servicing. Let’s
assume that the foreclosure rate on defaulted loans is 90%. Most foreclosures are not
contested. I don’t know any hard statistics on this, but I’d guess than no more than 5%
are contested. Let’s double that to 10% for our purposes here. This means that we’re
talking about .25 * .9 * .1 =2.25% (0.0225) of all non-QM loans resulting in contested
foreclosures. Not all of these ATR defenses would be successful, of course, but for our
purposes here, let's assume that they all are.
7. Loss Given Default for ATR Violations
If we apply this 2.25% loss probability figure to the 39% loss severity estimate,
we’re talking about 87.75 basis point increase (0.008775) in loss given default. So on a
portfolio with an average original loan balance of $200,000, that translates to an average
loss of $1,755 per loan. This risk is covered by increasing the interest rate by 18 basis
points for five years. That’s not a huge affect from QM itself. Even if the 18 bps were
rounded up to 25 bps (as mortgages come in 12.5 or 25 bp intervals), this is hardly a
prohibitive change in the cost of credit. Indeed, the lender quite likely just increases the
cost by 12.5 bps and charges $100 in fees.
Moreover, to the extent that a property is underwater, the setoff isn’t being paid in
real dollars, but either in uncollectible deficiencies, or in deficiency judgment dollars. If
the loan is non-recourse, the lender hasn’t lost anything to the extent that the setoff is
applied to the underwater part of the balance. (The setoff reduces the amount owed and
hence the amount underwater.) If the loan is recourse, the lender’s loss is of the
deficiency judgment, but given that these tend to sell for 3-4 pennies on the dollar, we’re
talking about a loss of 1 basis point. If the property is not underwater, the lender is
paying in real dollars, but this means that ATR is really a concern for lenders only when
there is a collection possible.
On top of this, I think I’m likely overestimating both probability of loss and loss
severities due to the ATR defense. Even if my numbers are off by 40%, the impact is still
only 25 bps. If I'm right, that means that all of the hand-wringing about QM is simply not
justified. Still, I recognize that there’s some uncertainty here, which makes pricing more
difficult.
8. The Cost of Delay: Direct ATR Liability May Not Be the Real Issue
Perhaps the biggest risk for lenders created by ATR is the issue of delay. If a
borrower raises an ATR defense against a non-QM loan, the borrower should be able to
get past a motion to dismiss, as there is a question of fact outstanding. It’s not clear to
me that a lender, much less a lender’s assignee, can prove ATR verification based simply
on affidavits and pleadings. (How to prove ATR easily seems to me to be a major issue
lenders’ counsel should think about.) It strikes me as requiring a more detailed
investigation that might preclude an early summary judgment motion. This delay gives
the consumer significant leverage for extracting a settlement, even if ATR was in fact
verified.
Indeed, ATR gives a borrower one more ground on which to contest a foreclosure.
The mere fact that a foreclosure is contested will impose costs on the lender. A contested
foreclosure will be a slower foreclosure, which means lost time value. The ATR defense
also likely means that any non-judicial foreclosure will effectively become a judicial
foreclosure. Beyond this, litigating a foreclosure is expensive, even if successful. The
lender may be able to recover its costs from the foreclosure sale proceeds, if there is
sufficient equity in the property, or from a deficiency judgment, possibly with interest,
but those are delayed recoveries that impose an up-front liquidity burden on lenders who
have to fund the foreclosure litigation. And if the loan is accruing interest at a belowmarket rate, delay is also imposing an opportunity cost. To be sure, none of these costs
are specific to ATR. They are generic to contested foreclosures, but the possibility of an
ATR defense (and particularly the recovery of attorneys’ fees, which enables the possible
funding of foreclosure litigation) might increase the frequency of contested foreclosures.
9. Does ATR Matter for Non-QM Loans? Or Is the Real Problem the Lack of a
Secondary Market?
Even putting aside the TILA defense risk on non-QM mortgages, there is still the
chicken-and-egg problem of liquidity in non-QM mortgages, and I think that's where the
real risk of constriction of access to credit lies. Depositories aren’t going to want to make
non-QM mortgages in any volume if there isn’t a secondary market for the loans that
provides them with potential liquidity. A secondary market in non-QM loans is going to
depend on the GSE credit box and/or the revival of the private label securitization
market. There's little reason to be optimistic about either.
Last May the FHFA directed the GSEs to purchase only QM loans or loans exempt
from the ATR requirement. This means that after Jan. 10, 2014, the GSEs, will only
purchase loans subject to the ATR requirement if they are fully amortizing, with terms no
longer than 30 years, and points and fees of no more than 3% of the total loan amount (or
other applicable limits).
These aren't huge limitations on the mortgage market. Eliminating IOs and Payment
Option loans, 30/40s and plain 40s, and high point/fee mortgages isn't where the real
credit constriction will come. There weren't a lot of these loans happening post-bubble in
the first place. Instead, the real issue is DTI requirements. But the GSEs are exempt
from the QM requirements of a maximum DTI, income verification, and underwriting to
the maximum interest rate in the first five years. Instead, their own underwriting
standards (e.g., Desktop Underwriter) suffice. That's where the real action is. The
contraction of credit is really going to be a function of how tight the GSE credit box is,
not QM. It's possible that FHFA will allow the GSEs to buy non-QM loans, but I don't
see that happening any time soon, and even if it does, again the real issue is the GSE
credit box, not the CFPB's definition of QM.
It's possible for there to a private-label secondary market in non-QM loans, but for
the foreseeable future, the GSEs are the only secondary market to speak of. The Redwood
and other private-label deals have financed some 16,000 loans since 2008--that's not a
meaningful secondary market. I don't see that changing in any meaningful way until (1)
the various servicing and trustee problems (including reps and warrants) are solved, and
(2) there’s greater certainty about where housing financing reform is going. No one
wants to invest a lot in creating a private-label securitization platform now that might not
work after potential reforms.
All of this is to say, it might not matter how much liability exists for an ATR
violation. The real issue in terms of availability of credit is going to be the depth of the
secondary market, and these days that is a function of what the GSEs will buy. That's not
a legal issue, but a question of their risk appetite (and consider how a monopolist will
accept lower volumes in exchange for higher margins) and public relations, in which any
change to the credit box is perilous.
CHAPTER 16
An overview of Bankruptcy- The Ultimate Consumer Protection
January 23, 2014
The concept of bankruptcy is written into the US Constitution as one of the powers that is
expressly granted to the Federal Government and not the states. A fair number of the
drafters of that constitution spent time in debtors’ prisons as did David Copperfield’s
close friend Wilkins McCawber.
Current bankruptcy law in the United States provides several kinds of bankruptcy magic
to the consumer or business that chooses to file. The first and simplest is the automatic
stay which is similar to a temporary restraining order or a preliminary injunction. It tells
nearly every type of creditor to stop whatever action it is taking against the bankruptcy
debtor. In order to continue any such actions the creditor must come to court and meet a
set of complicated standards to obtain relief from the stay. One of the most interesting
aspects of the stay is that it is not granted by order or a judge but rather by the mere filing
of the bankruptcy petition. To learn more about the stay consider taking a course in
bankruptcy law.
The second basic type of bankruptcy magic is the discharge of debt. In the overwhelming
majority of consumer cases the court issues a routine order discharging the debtor from
all liability on unsecured debts about sixty days after the filing. That order also releases
the consumer from personal liability on secured debts although it does not extinguish the
lien on the secured creditor’s collateral. Our inquiry will focus on the bankruptcy
discharge.
For more than a hundred years American law has provided consumers with an
opportunity to wipe out their debts. This is often referred to as the “fresh start” and much
of the debate about bankruptcy relief is whether it gives the consumer a “head start”
rather than a “fresh start.”
There are two types of consumer bankruptcies, chapter 7 and chapter 13. For the most
part, the debtor or her counsel decide which chapter makes the most sense. In some areas
of the country local custom or judicial behavior or something else skews the mix in favor
of chapter 7 or in favor of chapter 13. Chapter 7 is intended to be a quick simple process
in which a debtor says “I owe too much and can pay nothing. Take any non-exempt
assets I have and sell them for the benefit of my creditors. In the meantime let me get on
with my life and let me keep all my future wages for any work I do starting the day after I
file.”
In chapter 13, on the other hand, the debtor generally must pay some prescribed portion
of her earnings for the benefit of her creditors for a three or five year period after filing.
The means test is intended to shut the door to chapter 7 to creditors who “fail” the test,
which means to the drafters that these are people who have sufficient earning capacity in
relation to their debt that they should either not file bankruptcy or that they should file a
chapter 13 and commit the prescribed portion of those earnings for the benefit of their
creditors.
Over the past thirty years the numbers of Americans filing bankruptcy has been an up and
down story. It grew enormously in the same years that the increase in consumer credit
exploded; in the last five years is had decreased. Here is a chart of those filings. A great
many of these cases are short and uncomplicated. The debtor’s attorney, or the debtor
herself or a bankruptcy preparer files the necessary papers and information about herself,
her debts and her assets; a few weeks later she appears before a lawyer who is a
bankruptcy panel trustee and answers questions; in most cases that is her last appearance
and she will receive a bankruptcy discharge in the mail. Others are more complicated.
ADD: Numbers of filing 1990 – 2013
If she filed too recently, or if she is proven to have committed various types of fraud her
discharge will not be granted at all. Even if she does receive her discharge, as we will
study in greater detail in a few pages, various types of debts are or may be excepted from
discharge. Not surprisingly, most taxes and all types of family support are automatically
excepted from her discharge. The Code also includes 22 specific types of conduct which
Congress has determined should not be subject to the discharge, but most of these require
some action to assure they are not discharged. These vary from obtaining the credit
under certain false pretenses to damages from a willful and malicious act, to educational
loans to fines and penalties from violation of election laws. The exceptions also include
various types of credit card charges which we will review in a bit more detail in a
moment.
The discharge is of enormous benefit to the debtor and is of little financial consequence
to the creditor since there is very little likelihood that this debtor would have paid much
on the bill even if the charge had not been discharged. There is not so much controversy
over the discharge of the honest debtor who does not have the assets or the potential
earnings to satisfy any portion of her debts. Consumer bankruptcy law is very
complicated in that it attempts to distinguish between those consumers who are honest
and do not have the assets or potential earnings to satisfy any meaningful portion of their
debts and those who may have the potential earnings to satisfy a meaningful portion of
their debts.
The Means Test:
The rules for keeping out debtors who hide their assets are simple, but the rules for
keeping out debtors who folks think should pay some or all of their debts because they
have the potential earnings is much more complicated.
To obtain a discharge under chapter 7 the debtor must turn over to a trustee for the
benefit of the creditors all assets other than a few selected items which States (or the
Federal Government in some states) have marked as exempt from collection activities of
creditors. This makes little difference to 99% of people who seek bankruptcy relief
because they simply do not have many such assets. They may for example keep all or
most of the tax sheltered retirement assets, some portion of their homestead and “tools of
the trade.” .
But what about human capital and the chance to earn more than the average person earns
in the years to come. Should a graduating doctor be able to discharge her credit card
debts when she may earn enough to pay a healthy portion or all of those debts. She has
amassed no non-exempt assets while she was a student but she has the potential to do so
in the future and why should she be able to discharge past debts when she has future
earning capacity? None of this seemed to matter much to folks until the 1990’s. The
number of people filing bankruptcy was marching upward at a rapid clip. One group
asserted this was inevitable given both the huge increase in credit card debt and the
lending to folks who had previously been deemed unworthy of credit cards The other
group argued more loudly and more effectively that the loosening of the bankruptcy
standards in 1979 was the primary cause of the increase and therefore the rules needed to
be tightened. The battle continued from the machinations of the Bankruptcy Review
Commission in 1994 through various iterations of what became the 2005 amendments to
the Bankruptcy Code but ended in many changes, the most important of which was the
imposition of a means test to close the door to a simple discharge of a debtor who the
systems thinks should pay.
Professor Douglas Baird asserts that ”The strongest objection to the introduction of
means testing is not that a discharge should be available to high-income debtors who
could pay much of what they owed. Indeed most courts had already found that the filing
of a bankruptcy petition by someone who had the ability to repay debt was itself grounds
for dismissing the case. Rather, the problem associate with means testing was one
associated with many reform efforts. The game may not be worth the candle. Any
mechanism sufficiently fine-tuned to catch bad actors without foreclosing access to the
fresh start to people who in fact deserved it is too complicate and imposes too many
costs, particularly on those whose right to a fresh start is not in doubt.” Baird “The
Elements of Bankruptcy at page 36.
Although it is technically possible for a Judge to find abuse of the system and shut the
chapter 7 door to a debtor whose “current monthly income” is below the median for their
census area, it is very unusual and thus debtors whose “current monthly income” for the
six months prior to filing is below the median for her census area will find the chapter 7
door open. This is true likewise for those whose current monthly income ( a defined
term) is above the median if the amount left after subtracting defined allowances for
living expenses and the payment of secured and priority debt is low enough to miss
various defined trigger points. These trigger points are based on either: the total amount
of the discretionary dollars that the formula determines would be available to pay that
debt over sixty months or; the ratio of those dollars to the amount of unsecured debt
scheduled by the debtor.
The means test is only applicable to those debtors whose debts are primarily consumer
debts.
The bankruptcy discharge not only provides the debtor with an affirmative
defense to any effort to collect a discharged debt but it also provides an injunction against
parties who try to collect or otherwise enforce such a debtor
Debts That Are Not Dischargeable
The law provides a laundry list of individual debts that are not subject to discharge even
if the debtor receives one. tort or debts that society determines of particularly (once again
in the words of Professor Baird “important.” These include child support, alimony and
many tax obligations.
They also include student loans. Others are debts that arose out of bad conduct such as
deliberate torts.
Thus, a bankruptcy discharges all of a consumer’s unsecured debts unless they are of the
type excepted from discharge or unless the debtor “reaffirms” the debt in a manner that
comports with the rules of “reaffirmation.”
For purposes of our course one of the most interesting of these exceptions is credit card
debt incurred shortly before bankruptcy and /or for "luxury" items. Should debts be
discharged if they were incurred on the eve of bankruptcy? What about debts for
luxuries? And, under what circumstances should we conclude that a debtor
misrepresented her likelihood of paying for the expense she put on her credit card.
See text of 11 U.S.C. 523 (b)(2) especially subsection (C).
Special Rules for Dischargeability of Student Loans in Bankruptcy
Student loans are, for the most part, not dischargeable in bankruptcy. That means that if
you have a student loan, in most cases you will not be able to eliminate the student loan
debt in bankruptcy. Student loans used to be dischargeable under certain circumstances
prior to October 2005. However, in October 2005, the bankruptcy law on student loans
was rewritten to make all educational loans nondischargeable.
Can I File Bankruptcy on Student Loans in San Diego?
If you are asking the question, can I file bankruptcy on student loans, in most cases the
answer is no. With the revisions to the Federal bankruptcy law in 2005, and the Brunner
Test, which is controlling law in San Diego County as well as throughout the State of
California, there is a very tough standard that you would need to meet in order to be able
to wipe out student loans in bankruptcy. Under this standard, set forth by the Brunner
Test, you need to show that you are so physically or mentally disabled that you cannot
engage in substantial gainful employment. For this reason, it is rare case in which a
borrower is able to eliminate a student loan in bankruptcy.
History
Prior to 1998, you could file a Chapter 7 or Chapter 13 bankruptcy on student loans if the
loan had been in repayment status (not including any deferment period) for at least 7
years at the time that your case is filed.
On October 7, 1998, the Bankruptcy Code was amended to make it more difficult to file
bankruptcy on student loans. The 1998 law made student loans nondischargeable if the
loan was made or guaranteed by the Federal Government unless you could show that
nondischargeability would pose an “undue hardship” upon you and your dependents.
Student loans still remained dischargeable if the loans were not made or guaranteed by
the Federal Government.
On October 17, 2005, the New Bankruptcy Law went into effect and drastically changed
your ability to discharge student loans for most people. The new law, in effect, treats
privately funded student loans in the same manner as government backed loans were
treated since 1998: you cannot eliminate them in most cases. The only exception is that
if you can meet the standard set forth by the Brunner Test.
Under the new law, in effect since 2005, all educational loans, whether governmentbacked student loans or privately funded loans, are nondischargeable in either a Chapter 7
case or Chapter 13 case unless you can show that nondischargeability would post an
“undue hardship” upon you and your dependents.
Undue Hardship – The Brunner Test
The Bankruptcy Code does not define what constitutes an “undue hardship.” To
determine whether or not an undue hardship exists, sufficient to allow you to obtain a
Hardship Discharge of an educational loan in bankruptcy, the Court will apply a specific
test, known as the “Brunner Test.”
The Brunner Test is a 3-Part test first established in 1985 by the Second Circuit Court of
Appeals. At the time the test was established, it was not controlling in the State of
California. Fifteen years after the decision was made by the Second Circuit Court of
Appeals, the Federal Circuit Court having jurisdiction over California, namely the Ninth
Circuit Court of Appeals, made the test applicable in California.
On September 11, 1998, the Ninth Circuit Court of Appeals, which is the Federal Circuit
Court that has controlling jurisdiction over California Bankruptcy Courts, formally
adopted the Brunner Test and made it the applicable test in our state. Since that time, the
Brunner Test has been the controlling test that is applied by California Courts and judges
in deciding whether to grant you Hardship Discharge of your educational loans when you
file for bankruptcy.
Under the Brunner Test, the Court will apply a 3-Part test to determine whether an undue
hardship exists sufficiently for the Court to grant you a Hardship Discharge when you file
for bankruptcy: (1) You must establish that you cannot maintain, based upon your
current income and expenses, a minimal standard of living for yourself and your
dependents if you are forced to repay your loans; (2) You must show that additional
circumstances exist indicating that your current state of affairs is likely to persist for a
significant part of the repayment period of your loans; and (3) You must have made good
faith efforts to repay your loans.
In practice, it is very difficult to obtain a Hardship Discharge under the Brunner Test.
Once you pass the first part of the test- you establish that you cannot maintain a minimal
standard of living if forced to repay your student loans- you must still show the Court that
your situation is not going to change for a significant part of your repayment period.
It will not be presumed by the Court that your current state of affairs is not going to
change for a significant part of your repayment period. Rather, you must make an
affirmative showing and prove to the Court that you have an insurmountable barrier to
financial recovery that is likely to remain with you for a substantial portion of your
repayment period.
Technically, under the Brunner Test, your barrier to financial recovery does not
necessarily need to be so extreme that it rises to the level of a physical disability, learning
disability, mental illness, or other similar extreme circumstance.
In reality, bankruptcy judges frequently reserve granting a Hardship Discharge to the
extreme case- a case where you are physically unable to work and there is virtually no
chance that you will recover and obtain gainful employment in the future. If there is
hope for you to engage in gainful employment, most judges would expect you to find a
job and pay off your loans.
Even if you have an extreme case, you must further show that you have made good faith
efforts to repay your educational loans. This means, for example, attempting to work out
a repayment plan, consolidating your loans under the Federal Direct Loans consolidation
program, and other similar good faith efforts to repay your educational loans prior to
filing bankruptcy and requesting a Hardship Discharge.
Partial Discharge
Discharging student loans in bankruptcy is not always an all-or-nothing proposition.
Bankruptcy Courts are Courts of Equity and judges have equitable powers and may
exercise their equitable powers to partially discharge a portion but not all of your student
loans based upon your individual circumstances.
To obtain a partial discharge of your student loans you will still need to meet all 3 parts
of the Brunner Test with respect to the portion of your educational loans that you are
seeking to discharge. If and only if you meet all 3 parts of the Brunner Test, then the
judge may exercise his or her discretion to grant you a partial discharge of your student
loan debt.
HEAL Loans
Health Education Assistance Loan (HEAL) Act loans are subject to an even stricter
standard (stricter than the Brunner Test) and are harder to discharge than any other type
of educational loan debt. In particular, discharging a HEAL Loan in bankruptcy requires
a finding by the Court that, among other findings, it would be “unconscionable” not to
discharge a HEAL Loan. Unconscionability is a very difficult standard to meet.
Adversary Proceeding Required
If you can establish that your case meets the standard for granting a hardship discharge or
partial discharge of your student loan debt, you will need to initiate an adversary
proceeding in your Chapter 7 or Chapter 13 case and request that the Court make a legal
determination that your loans are discharged by your Chapter 7 or Chapter 13 discharge.
KEY QUESTIONS
Student Loans in Bankruptcy by Chen
http://www.policyarchive.org/handle/10207/bitstreams/19283.pdf
NON BANKRUPTCY RULES FOR FORGIVENESS
Effect of the Discharge on Secured Debt
The effect of the discharge on a debt that is secured by collateral is more complicated and
the treatment of secured claims in bankruptcy is more complex than the treatment of
unsecured claims. Although the personal liability of the debtor to pay her debts is
extinguished by the bankruptcy discharge , the liens that secures the debts are NOT
extinguished or discharged by the bankruptcy. The good news for the consumer debtor is
that an “automatic stay” stops collection action including foreclosure and repossession as
of the date of the filing of the bankruptcy; the bad news is that it is possible and are
likely that these activities will begin again after the secured creditor has obtained relief
from the automatic stay or after the bankruptcy is over.
Here are some of the various rules that govern the treatment of a claim secured by
collateral.
In a chapter 7 case:
1. if the debtor has no equity in the property then the creditor will likely be able to obtain
relief from the automatic stay to foreclose or repossess, or may simply wait until the case
is over to start or restart its possessory enforcement activities; or the debtor may
“redeem” the collateral by tendering in cash an amount equal to the value of the
collateral. Any claim remaining to the secured creditor is an unsecured claim which is
discharged. Or the debtor may agree to repay the entire debt due to the secured creditor
even though part of that debt is under secured by “reaffirming” that debt. This is a
controversial provision. If the debtor reaffirms the debt, she “waives” her right to a
discharge on this debt and if the debtor later defaults she will be liable for any deficiency
claim
2. if the debtor has equity greater than its exemptions then the Trustee may choose to sell
this property, pay the claim of the secured creditor, pay the debtor the value of her
exemptions and then pay the balance to unsecured creditors in accordance with their
claims.
Questions re :reaffirmation procedure and history
In a chapter 13 case
1.
The debtor’s plan may force the mortgagee to accept back due payments over
several months, but the debtor may not change future payments in any way on a debt that
is secured solely by a first mortgage on the debtor’s principal residence.
2.
With regard to debts secured by anything other than the debtor’s principle
residence, if the debt was incurred more than 910 days before the filing of the bankruptcy
the debtor’s plan may reduce the amount of the secured claim to the value of the
collateral. Any balance is treated with the unsecured claims.
3.
With regard to debts secured by anything other than the debtor’s principle
residence if the debt was incurred within one year of the filing of the bankruptcy the
debtor‘s plan may not reduce the amount of the secured claim to the value of the
collateral.
4.
With regard to purchase money debts secured by a motor vehicle that was bought
for personal use and which was incurred more than one year but less than 910 days
before the filing of the bankruptcy, the plan may not reduce the amount of the secured
claim to the value of the collateral.
MAIN Q
Whom should we release from debts without the requirement that they use any of their
future income to repay those debts?
III. THE SWEAT BOX: from an article by Ronald Mann at _________
If the most prominent feature of the statute is unlikely to generate a substantial increase
in payouts to card issuers, how can we be sure that issuers will profit from the new law?
My answer is to emphasize an entirely different intersection between the statute and the
business model of the credit card issuer. In my view, the most important aspect of the
new law is not the increased payouts associated with means testing, but the way in which
the law encourages debtors to defer bankruptcy filings. To explain, let me talk briefly
about the business models of credit card issuers and then about how the Act interacts with
those models at the point of the bankruptcy filing decision.
A. The Business Model
Although credit card issuers have different business models, it is reasonable to place them
along a spectrum from transaction-based to debt-based. Transaction-based issuers
(like American Express and Diners Club) try to earn interchange fees that exceed the cost
of funds and their transaction costs. Thus, those issuers attempt to maximize the number
of cardholders that use their cards frequently for high-value purchases. Debt-based
issuers, by contrast focus on debt servicing revenues. Thus, they attempt to maximize the
number of customers who do not repay their account balances in full each month. That
strategy would not seem unusual, but for the fact that the most profitable customers are
sometimes the least likely to ever repay their debts in full.
For many other types of lenders—a commercial lender like a mortgage company,
perhaps— the most profitable customers are the ones least likely to default. The lender
sells a relatively static product, such as a thirty-year fully amortizing mortgage loan for
75% of the value of the property, with a price at a more or less fixed level above the cost
of funds. That lender profits a small amount on each loan that is repaid in a timely
manner, and loses substantially on the loans that are not. The model works because the
number of loans paid in full in accordance with their terms is perhaps fifty times the
number of loans that default. Competition in that market drives the major lenders to very
similar prices. Profitability depends on lowering administrative costs, while at the same
time limiting bad loans through the exercise of judgment about the quality of potential
borrowers. In sum, the model works best if all borrowers retain robust financial health
throughout the term of their obligations.47
The business model of the debt-based credit card issuer is quite different. These lenders
depend more heavily on automated techniques of data-mining and information analysis
than on skills of subjective case-by-case judgment.48 Thus, only the most
technologically adept can hope to remain profitable in the industry. The competitive
pressure49 has led to a rapid increase in concentration in the industry, so that the ten
largest issuers in the United States now hold about
88% of all credit card debt in the country; the top five hold more than 70%.50
The successful credit card lender profits from the borrowers that become financially
distressed. Financially secure customers or “convenience users” do not generate any
interest income, late fees, or overlimit penalties. The only source of revenue they
provide typically comes from annual fees in some instances and interchange revenues.51
These charges might be substantial in some cases, but they only account for about 20% of
industry revenues.52 Thus, for
issuers that rely on lending, “convenience users” are useful only because of the
possibility that they will mature into borrowers—as caterpillars mature into butterflies.53
For the credit card lender, the first hint of sustained profitability comes when the
cardholder (now borrower) stops regularly paying her balance in full each month.54 If
we imagine that this is caused by some adverse event affecting the borrower’s wages or
some unusual expenditure that the borrower hopes to amortize against future wages, we
might analogize the situation to that
of a commercial borrower that loses a major customer or suffers a drop in earnings
because of
poor cost controls. In the case of the commercial borrower, the adverse events, if
material, will lower the loan officer’s expectations of profit from the transaction. The
analogy is not perfect, because the credit card borrower’s problem might involve no
adverse event, but simply a momentary bout of profligacy or exuberance, motivated
perhaps by the hope of an increased income in months to follow. Still, whatever the basis
for the decision to carry a balance, this is not an event of concern. Rather, it suggests
imminent profit, because the decision to carry a balance leads immediately to interest
charges on the cardholder’s account, which accrue at a rate far exceeding the lender’s
cost of funds. Moreover, once the borrower begins to carry a balance, the likelihood of
late and overlimit fees can increase substantially.
As the spiral increases, the distinction between the two models grows starker. When the
first lost customer becomes the failure of an entire product line, the commercial loan will
become a problem, probably suitable for a “special assets” division with officers
particularly skilled at minimizing the losses from bad loans.55 As the credit card
borrower spirals downward, however,
with the monthly balances growing to amounts that equal, or even surpass, the borrower’s
annual income, the issuer begins to earn large monthly profits on the relationship. The
question for the lender is how long the borrower will remain in the unstable position
before failure occurs.
If this seems implausible, consider the evidence of the stark increases in charge offs
related to the recent increases in minimum payments. In 2003, American regulators,
acting through the Federal Financial Institutions Examination Council (an interagency
group that oversees standards for federal examination of financial institutions), issued a
“guidance” suggesting that lenders should not permit negative amortization and should
require repayment in a “reasonable” time.56
When I first read this guidance, it seemed a trivial policy event, because it required so
little that it seemed targeted primarily to the subprime lending market.57
Still, the annual reports of major American card issuers suggest that the guidance had an
important effect even on mainstream lending practices. For example, MBNA reported
that it promptly changed its standard procedure for calculating minimum payments from
2.25% of the principal balance to a requirement that each borrower pay 1% of their
principal in addition to interest and fees.58 Thus, assuming that the interest rate is 24%,
the minimum payment on a
$5000 balance would increase from $112.50 to $150.59 Take note: this requirement
that each borrower repay 1% of the principal each month does not mean that the loan will
be repaid in 100 months. A borrower who made the minimum payments under that plan,
and never made any future purchases, would not repay the outstanding debt for
approximately 27 years, because the
minimum payment would decline steadily as the outstanding balance declined.60
Yet even changes of this magnitude will apparently cause major disruption in the
industry.61
The basic problem is that even minimum-payment increases as slight as those mentioned
above are likely to push many borrowers past the point of liquidity. Hard as it may be to
believe, it appears that a change from a $112.50 to a $150 minimum payment will be a
change from a difficult payment to an impossible payment for some borrowers. Thus, the
increased payment minima are expected to increase delinquency and chargeoff rates
markedly. Indeed, industry analysts expect the effects to be substantial enough to force
major changes in the fee practices of card issuers.62 The most salient example of this
change was the 94% decline in MBNA’s profits early in 2005, which sources in the
industry link to the increase in MBNA’s minimum payments.63 The fact that such a
slight alteration in minimum payment requirements has such a substantial effect on
delinquency, chargeoff, and bankruptcy rates64 suggests that those lenders
are keeping an astonishing share of their portfolios balanced on a razor’s edge.65
After obtaining a successful portfolio, the standard way to increase profits is to focus on
those customers who are unable to take their business elsewhere. If the customers do not
have realistic options, lenders are free to raise the interest rates and fees that they charge
to those borrowers.66 Ordinarily, a lender that unilaterally raises the fees that it is
charging its most
profitable customers might fear the loss of those customers to competitors. In this
particular context, however, the risk that competitors will “poach” these profitable
customers is relatively slight.
One problem, discussed by a group of researchers at the Federal Reserve Bank of
Philadelphia in a recent paper, is that the “switching costs” are too high.67 An issuer
that tries to attract distressed customers from a competitor will face an adverse
selection problem.68
Recognizing that the existing issuer is likely to know more than the new issuer about the
distressed customer, the new issuer must be concerned that the distressed customer that it
attracts will be so close to failure that the relationship will be unprofitable.69 The basic
idea is that an issuer that targets the distressed customers will get the worst of them (those
that are so close to
complete failure that they will be unprofitable).70 The best of the distressed customers
(the ones
far enough from complete failure to remain profitable) will remain with their existing
lender.71
That problem, they argue, makes it hard for competing issuers to make strong efforts to
obtain their business and in turn makes it easier for existing lenders to earn more profits
from their captive customers.72
Other practical problems complicate the job of attracting the distressed customers of
another card issuer. For one thing, the typical way of attracting customers from another
card issuer is to offer a low “introductory” rate for balance transfers—often near 0%. But
when the customers are already in distress, it might be difficult to profit (even over time)
from an advance at a very low interest rate. To be sure, the new issuer might be able to
profit if it could undercut the existing issuer’s rate and still charge a credible rate—
beating a 24% or 30% rate with an offer of
18%—but as a marketing (or behavioral) matter, I doubt that a campaign targeting
customers with a “great new rate of 18%” would be cost-effective. The new lender also
must confront the problem that it can obtain the customer only if it repays the entire
nominal balance of the debt owed by the customer. As discussed below, that amount is
likely to substantially exceed the issuer’s “real” economic investment in the customer,
and often will significantly exceed any amount that the issuer expects the borrower to
repay. Collectively, those problems make me think that the issuer has quite a firm grip
on its customers who have fallen into serious distress.
Another key part of the business model, related to the high switching costs for distressed
borrowers, is the increasing ability of the leading issuers to collect substantial revenues in
the form of late and overlimit fees. It is commonplace that the average amount of those
fees has been rising over the last several years.73 What is more interesting, and to the
point, is that the aggregate amount of those fees, as a share of outstanding debt,
has doubled since 1990, increasing from about 70 basis points per year in 1990 to 140
basis points per year in 2004.74
Referring back to Figure 1, this landscape suggests a three-pronged business strategy for
the credit card lender: (1) limit the share of financially stable customers (the left part of
the curve); (2) maximize the share of the portfolio that is at any time in the central
(rising) part of the curve, and; (3) minimize losses from the borrowers who fail.
The first prong (the left part of the curve) suggests that one strategy would be to use
information technology to segment the market so that an issuer focused on lending
revenues will have a relatively small share of customers at any given time that use the
card only for payment transactions. More importantly, such an issuer hopes to attract the
types of users who will use the card for borrowing transactions and thus become revenuegenerating users. To be sure, some issuers offer products designed to be profitable even
in the hands of nonborrowing users. The products might bear annual fees or higher
interchange fees. But even here, the goal is to target frequent card users. Because the
marginal interchange revenue from each payment transaction typically exceeds the
marginal cost of processing and because there is a fixed cost for issuing and maintaining
each account, high-volume users are more profitable than low-volume users. Hence, the
worst customers are those who accept cards and use them infrequently. Conversely, a
customer who uses the card constantly for multiple transactions each day with a large
dollar volume each month can be reasonably profitable for a lender, even if the
cardholder pays off her entire balance each month.
To be sure, if the lender seeking new customers cannot tell which of its nonborrowing
customers are likely to mature into borrowing customers, the lender’s strategy might be
to acquire as many high-volume customers as possible, whether or not they borrow,
hoping that the larger the portfolio of customers, the greater the number of highly
profitable borrowing customers the issuer will have in the end.75 But even that
strategy focuses attention on the
middle part of the curve, which clearly is where the real profits are made.76
The third prong (the right part of the curve) simply recognizes that issuers face the bloodfrom-a-stone problem discussed in the previous part of this essay.77 Little can be done
to increase the recovery from people in severe financial distress. Therefore, it is unlikely
that the Act will substantially increase recoveries from that portion of the curve. If most
bankruptcy filers are in severe financial distress, the obvious solution is for lenders to cut
their administrative costs and liquidate the debt when distress becomes overwhelming.
Although my thoughts on this topic are relatively impressionistic, discussions with
industry sources suggest that the major credit card issuers are increasingly moving
towards selling defaulted credit card debt (at a price of approximately 10–12¢ on the
dollar).78 The developing market appears to suggest that the
debt is more valuable in the hands of the smaller companies that can collect more
aggressively than reputable large companies.79
That leaves the second prong, or the central part of the curve. This part of the curve
covers the spectrum from those who carry balances, to those who routinely make
minimum payments, to those who miss payments altogether. As the discussion above
suggests, the strategy makes sense only if the lenders can obtain an adequate return from
their borrowers during the period they are in that part of the curve—the “sweat box” in
my terms. If this seems implausible, notice that the interest rates that borrowers pay
while they are in the sweat box greatly exceed the cost of the lender’s funds. Thus, if the
borrower resides in the sweat box for very long—making substantial interest payments at
a high rate—the lender with a lower cost of funds in effect receives a return of the funds
that it has lent each month.
To quantify this effect, I ran a simple experimental spreadsheet to see how hard it would
be for a lender to recapture its investment. In general, the experiment80 assumes the
following:
•
The lender’s cost of funds is 3%.81
incentives of borrowers to avoid financial distress and bankruptcy. Instead, I suggest, the
proper approach should allocate losses between borrowers and lenders in a way that
minimizes the net costs of financial distress. Generally, I argue that this calls for placing
more risks on lenders, so that they will have an incentive to use information technology
to limit the costs of distress. Accordingly, I believe that the Act is a move in the wrong
direction. See Mann, supra note 24.
•
The lender charges 18% per month for the first three months that the borrower
pays the minimum payment, 24% per month for the next three months, and 30% per
month thereafter.
•
The monthly minimum payments are 2% while the annual interest rate is 18%,
2% + $50 when the annual interest rate is 24%, and 2.5% + $50 when the annual interest
rate is
30%.
•
The borrower incurs a $40 late or overlimit charge every other month starting
with the seventh month that it makes the minimum payment.
Applying those assumptions to a borrower who starts out with a balance of $2000 and
makes no new purchases, the stated balance at the end of 25 months is still $1270 (more
than half the original loan). But looking at the “economic” balance—applying the
lender’s cost of funds to the monthly balance instead of the stated interest rate—the entire
loan has been repaid (with $6 to spare). A slightly different example is arguably more
provocative: if we assume that the borrower makes a $100 purchase every three months
and run the example for 34 months, we have a stated balance of $2070 (slightly more
than the initial balance), but in “economic” terms the entire loan has been repaid (with
$26 to spare). A final experiment, assuming a more aggressive issuer, assumes that the
interest rate is 30%, 36%, and 42%, and that there is a $50 late or overlimit fee every
month starting in the sixth month; in this example the economic balance is repaid in the
thirty-second month, while the total stated balance remains more than
$2800. If we imagine borrowers who limp along, carrying those balances for decades—
neither discharging them in bankruptcy, nor ever paying them off entirely, perhaps
making an occasional minor purchase—we can see how profitable this business model
can be.
I note that a recent survey of balance-carrying Americans suggests that the median family
with a balance has been carrying it for thirty months (with an average of forty-three
months).82
The examples above suggest that this is just about long enough for the lender to recover
its investment, but not nearly long enough for the cardholder to repay its debt.
B.
The Effects of the Act
With that business model in mind, let us turn now to the Act. Although the Act might
have limited effect on transaction-based credit card issuers, I argue that the Act will have
a major effect on debt-based issuers. Specifically, the dominant impact of the new law
occurs in the central part of my curve, as the Act operates to delay the time of filing for a
considerable group of financially distressed card users.83 If those card users continue to
make payments until shortly before they surrender and file for bankruptcy, the delay in
filing—lengthening the time in the “sweat box”—will increase the profits the lenders
receive from those accounts, or decrease the
losses the lenders will face when those customers ultimately file for bankruptcy.84
Put simply, the issuers have persuaded Congress to take the line in Figure 1 that
demarcates the zone of high profitability from the zone of failure, and move it over by
several months. One economic perspective on this situation would view the consumer
credit industry as a private wage insurer, providing emergency funds to households in
distress, while the bankruptcy system provides consumption insurance, protecting against
sharp income dropoffs.85 The strengthening
of the sweat box effect restricts the amount of consumption insurance that is provided
publicly and thus increases the importance of wage insurance.
Once the point is made, it is easy to see that several of the Act’s notable features are
likely to defer the time of filing. Two distinct strategies are apparent: provisions that
increase the cost of filing and provisions that decrease the benefit of filing. If we think of
the bankruptcy decision as a determination of the point in time at which the benefits of
bankruptcy are sufficient to overcome the natural aversion to the admission of failure that
a bankruptcy filing represents, and if we expect that in most cases the starkness of
financial distress will make the filing inevitable, we would expect these provisions to
have the effect of delaying the time of filings, but not decreasing the aggregate number of
them.86
The most obvious example, of course, is the stark increase in filing fees wrought by
section
325 of the Act, so that it now costs $299 to initiate a chapter 7 bankruptcy proceeding.87
The fee increase is a valuable example of the effect of the statute, because the large
fee—going to the government not to creditors—directly reduces the recoveries to be
expected for creditors. The only value it represents to creditors is that it can defer—or
deter—bankruptcy filings.
Another simple and effective rule in this category is the extension of the period during
which the debtor cannot file a new bankruptcy petition.88 Thus, the well-counseled
debtor who chooses to file in response to a particularly distressing situation must accept
that a bankruptcy filing will not be possible in the years to come even if the subsequent
situation becomes worse
than the current one. This would seem a relatively small problem if we were still in a
world in
which a bankruptcy filing provided a substantially complete fresh start. But as studies
show, a large share of bankrupts continue to experience financial distress that is as bad
as—or even worse—than the distress they faced before their filing.89
Another important obstacle is the increased bureaucratic responsibility of attorneys who
represent borrowers, which flowed from the general congressional condemnation of the
bankruptcy bar.90 This was a favorite theme of Senator Grassley:
Today, many lawyers who specialize in bankruptcy view bankruptcy as an opportunity to
make big money for themselves. This profit motive causes bankruptcy lawyers to
promote bankruptcy as the only option even when a financially troubled client has an
obvious ability to repay his or her debts. In other words, this profit motive creates a real
conflict of interest where bankruptcy lawyers push people into bankruptcy who don’t
belong there simply because they want to make a quick buck.
****
Mr. President, I think there is a widespread recognition that bankruptcy lawyers are
preying on unsophisticated consumers who need counseling and help
in setting up a budget and who do not need to declare bankruptcy. Bankruptcy lawyers
are the fuel which makes the engines of the bankruptcy mills run.91
The best example here probably is section 707(b). This provision—in the style of
Sarbanes- Oxley—now requires the debtor’s attorney to certify that the lawyer has
investigated the accuracy of the borrower’s filing information. One could say that this is
nothing new, just a restatement of Rule 11 in another context. But provisions like
section 707(b)(4)(A)— specifically requiring the debtor’s attorney to pay the costs and
attorney’s fees incurred in connection with a successful motion to convert under section
707(b)—make it likely that consumer bankruptcy attorneys will in fact spend more
resources collecting verifiable evidence of a pre-filing investigation than they did under
pre-Act law.92 Indeed, some observers view
much of the Act as laying an elaborate trap for those who make a living out of
representing consumer bankrupts.93 Regardless whether the heightened investigation
requirement has other salutary effects, it seems likely to increase the cost of a bankruptcy
filing. Those who supported the Act suggested it would increase costs by about $150 to
$200 per case, and there is little
reason to think that they were exaggerating.94
Another example, typical of the drafting style of the Act, comes from the new rules in
section 526 concerning debt relief agencies, which arguably apply to attorneys.95 If
they do, there is a new avenue for attorney liability in connection with assistance
provided to consumers.96 Even if they do not, those rules clearly will have the effect of
limiting access to the bankruptcy courts previously provided by non-attorney petition
preparers.97
Although it is too soon to know the impact of those rules—the magnitude of the impact
probably will shrink over time, as attorneys adjust to the new system—they surely will
raise filing costs in the short term. As filing costs rise, even the most desperately
insolvent must delay bankruptcy, at least until they can save the amount necessary for the
filing fee and the attorney’s fee.98
The new rules about credit counseling interpose another hurdle. Codified in Bankruptcy
Code section 109, these rules generally require borrowers to seek credit counseling
shortly before filing for bankruptcy.99
Given the urgency with which the
financial position of consumers deteriorates, and Congress’s effort to close any avenue
by which judges might forgive
noncompliance, these rules can lead to great hardship in particular cases, as judges
already have
noted.100 But the major effect, it appears, will be to make it harder, more timeconsuming, and
more expensive for consumers to file for bankruptcy.101
As with the rules discussed above, it is difficult to predict exactly how much of a hurdle
this will be. Early indications are that in many cases debtors will have access to
expeditious credit counseling, often over the Internet.102 But part of this hurdle surely
is psychological: the humiliation of going through counseling doubtless will slow some
cognizable group of people,
for some time, from filing.
The second strategy is more indirect, but no less effective: to lower the benefits of
bankruptcy. It is here that I see the most salient effect of the means-testing requirement.
If filing will not provide as much of a fresh start as it formerly did, then well-counseled
debtors might wait to file until they are in deeper distress. The other obvious example is
the expansion of the categories of nondischargeable debts.103 Here, for example, is one
of the rare explicit references
in the Act to the “open end credit plan” that is the regular product of the credit card
issuer.104
Specifically, post-Act section 523(a)(2)(B)(iv)(II) prevents a discharge of any cash
advances exceeding $750 during the 70 days preceding bankruptcy. Given the frequency
with which distressed borrowers might be borrowing on a credit card to repay other
pressing obligations, this provision can convert garden-variety dischargeable unsecured
debt into nondischargeable debt that will pass through bankruptcy unaffected.* * * * *
The discussion in this section is speculative. It depends on a variety of empirical
assumptions about the behavior of distressed borrowers that are difficult to verify
empirically. For example, I assume that the bill will have only a minor effect on the
number of people who choose to file, although it will have a noticeable effect on when
they file.105 That assumption
makes sense if you believe (as the data indicate) that the overwhelming majority of filers
are in such distress that they are all but compelled to file. As discussed above, there is
data to support that assumption, but it certainly is not conclusive. Similarly, I assume
that consumers are making payments right up to the moment that they file, and that the
statute thus slows down both bankruptcy and the termination of revenues for the issuers.
A contrary assumption certainly is plausible: the statute might defer the bankruptcy
filing weeks or months past the point of hopeless distress, but payments might stop at
the same time as they would have before the Act.106 These are empirical questions of
course. I can imagine testing them, but I certainly
acknowledge that it would be difficult.
IV. THE REALITY
Finally, I close with a few early assessments of the post-Act landscape, which tend to
suggest, in hindsight, that credit card issuers overestimated the net profits they would
earn from their investment in the Act. My discussion here is consciously tentative,
resting as it does on data available in the first few months after the Act went into effect. I
discuss three separate questions, in decreasing order of generality: (1) the overall filing
rate, (2) the share of Chapter 13 filings, (3) and the amount paid to unsecured creditors in
chapter 13 cases.
106.My intuition that the borrowers often pay until close to the bankruptcy date is
supported by the rising complaints in the 1990s about “trapdoor” debtors. See Elizabeth
Warren, The Changing Politics of American Bankruptcy Reform, 37 OSGOODE HALL
L.J. 189, 198–99 (1999) (discussing complaints by creditors about “trapdoor” debtors,
who file for bankruptcy before they are even delinquent on their debts). As the text
suggests, credit card issuers now recognize that it is to their advantage to have the
trapdoor debtor, rather than the debtors that stop paying months before bankruptcy
overtakes their affairs. Conversations with issuers suggest that in the current market
about 20% of bankruptcy filers are current on their debt at the time of their bankruptcy
filing. Although the issuers with whom I had this conversation collectively had only
about a 20% market share of American credit card debt, they assured me that between
them their portfolios surely included the overwhelming majority of American bankruptcy
filers: each of the two indicated that their portfolio included about 75% of all American
bankruptcy filers.
Source: Author’s Calculations Based on Data from Lundquist Consulting
Several things about that figure are noteworthy. First, it displays the massive spike in
filings in October of 2005, just before the October 17 effective date of the bill. Logically,
that spike would consist of the “normal” October 2005 filings, plus two groups of people:
early filers and new filers. The early filers are those who eventually would have filed
anyway, but who chose to file early because of concerns about the onerous provisions of
the Act. The new filers are people who but for the Act would never have filed—who
would have “toughed it out” without a bankruptcy filing—but chose to file because of
concerns that the Act’s procedures would be unduly harsh if they later turned out to need
bankruptcy relief.
My conversations with industry sources suggest that the spike was much larger than was
expected. Thus, at the time, it was thought that much of the spike was new filings. But
the shape of the curve in subsequent months suggests that a large share of the spike, at
least, consisted of early filers. The reason for this is that ten months after the Act became
effective, in August 2006, filings were still trending steadily upward from the
preternaturally low level they reached shortly after the Act became effective. To see this
point, consider Figure Three, which shows weekly filings for the first thirty-five weeks of
2004 and 2006, as well as a “difference” line, which shows the excess of the 2004 filings
over the 2006 filings.107 As the trend line superimposed over the difference line
illustrates, the difference has declined steadily during the first eight months of 2006.
Two filing trends connected with the passage of the statute readily could explain those
trends. First, the “early filing” effect discussed above: a lot of people filed before
BAPCPA who otherwise would have filed later. That effect should depress filing rates
after BAPCPA until it plays out. Second, the “deferral” effect discussed in Part III: the
provisions that make filing more costly, more bureaucratic, and more humiliating should
defer filings until people are deeper in distress. That effect should depress filings initially
but ultimately fade away as well.
It is too early to assign any specific share to the two effects. It is provocative, however,
to see the period over which those effects have played out. I would not have expected
pre- BAPCPA early filers to have filed ten months early. But if we discard that
explanation, we have to think that the deferral effect operates over a similarly extended
period. If so, the steady upward trend in filing rates reflects the period during which the
deferred filings are slowly rising to their “normal” level. If we have not yet reached that
level, BAPCPA is deferring some filings more than ten months.
It is far too soon to be sure of the level at which filings will stabilize after BAPCPA. The
data above illustrate graphically that the filing rates remain far below the pre-BAPCPA
levels. Yet the steady convergence of post-BAPCPA filing levels with pre-BAPCPA
filing trends suggests that we cannot yet be sure that the decline, if any, will be
substantial.
B.
Chapter 13 Filings
The second important question about the Act’s effect on credit card issuers is how it will
affect the share of filings made under chapter 13, as opposed to chapter 7. The purpose
of the means test, after all, is to force borrowers into chapter 13. But the provisions of
the Act that relate to chapter 13 provide a strong countervailing influence. As discussed
by Bill Whitford and Jean Braucher in their contributions to this symposium, those
provisions remove the incentives for most filers to choose chapter 13.108 Thus, it is
entirely possible that the Act as a whole will
have the effect of lowering the rate of chapter 13 filings—a perverse outcome for credit
card issuers used to receiving nothing in chapter 7, but a realistic one nonetheless.
Again, it is far too soon to tell, but the early data are instructive. Figure Four shows the
percentage of chapter 13 filings (as a share of all bankruptcy filings) for the last two
years. Not surprisingly, the share of chapter 13 filings immediately after the Act is
unusually high: the overwhelming majority of early filers would have been chapter 7
filers (as we can see from the October 2005 datapoint). Those left behind would be
chapter 13 filers.
What is interesting about Figure Four is that the chapter 13 rate is still falling steadily,
several months after the Act’s effective date. Here, the data suggest a little more basis for
a prediction than they did with respect to the overall filing rate. Although the chapter 13
share of filings has not yet fallen below the typical pre-Act share of about 30%, it is
important to recognize that the higher rate in Figure Four is a share of an unusually low
overall rate. Thus, as Figure Five illustrates, the gross number of chapter 13 filings now
is much lower than it was before the Act. That suggests to me the likelihood that, as the
total number of filings returns to a
stable level, the share of chapter 13 filings will stabilize at a level below the pre-Act
level. As with the total filing data, it is too soon to be sure where the filings will
stabilize, but it does seem clear already that BAPCPA is not going to cause a major shift
in favor of chapter 13 filings.
C.
Returns in Chapter 13
The final question is what credit card issuers can expect to receive in the chapter 13 plans
approved under the Act. Here, Bill Whitford’s piece in this symposium provides a
fascinating account of how the happenstance of a Michigan senator’s political weight in
the Republican Party led to car lenders getting an unusually strong provision for
their benefit—one more instance of the credit card issuers failing to get the statute that
they “paid for” back in 1998.109
The key here is the amendments to Bankruptcy Code § 1325.110
That oddly
written provision appears as a “hanging” unnumbered paragraph at the end of §
1325(a)—after
§ 1325(a)(9) but apparently operating to amend § 1325(a)(5):
For purposes of paragraph (5), section 506 shall not apply to a claim described in
that paragraph if the creditor has a purchase money security interest securing the debt that
is the subject of the claim, the debt was incurred within the
910-day period preceding the date of the filing of the petition, and the collateral for that
debt consists of a motor vehicle.
Although the new language is so obscurely written that it could be interpreted in various
ways—perhaps the intention is that there should be no allowed secured claims for
car lenders111 —the most likely intent112 seems to be that the entire amount of the car
lender’s claim should be treated as an allowed secured claim for purposes of §
1325(a)(5).113
That interpretation would have the effect of placing car lenders in a
position quite similar to the position home lenders have held since the decision in
Nobelman v. American Savings Bank.114
What that means for credit card issuers, in turn, is that there is greater pressure in debtor
budgets to pay funds to the holders of car loans, leaving lower amounts available for
unsecured creditors.115 Conversations with bankruptcy judges in the early days after
the Act suggest to me that this particular provision is leaving unsecured creditors
(including credit card issuers) with no
recovery much more frequently than was the case in the pre-Act environment. Scholars
herald
the arrival of chapter 13 “zero-payment” plans—which pay nothing whatsoever to
unsecured creditors.116 Thus, there is good reason to think that credit card issuers in
fact will do worse under post-Act chapter 13 plans than they did under pre-Act chapter 13
plans. Hence, even if the Act does increase the share of bankruptcy filings that fall under
chapter 13, it is not clear that this
will produce any increased recovery for card issuers.
V. CONCLUSION
The credit card is perhaps the most important financial innovation of the twentieth
century; it introduced substantial efficiencies in both payment and borrowing markets.
The credit card, however, is associated with increases in spending, borrowing and
financial distress.117 It is not clear why that is the case, although academics have
suggested it may be due to cognitive
impairments, compulsive behavior, excessive or unfair advertising, or fraudulent
contracting practices.118
Reform-minded governments around the world currently are struggling with how to
respond to the problems with credit cards without undermining the efficiency of payment
and lending markets.119 Some responses focus on the payment functionality. Because
credit cards might encourage consumers to spend too much, and perhaps more than they
can repay out of monthly
incomes, credit card use can lead to unplanned debt. The best responses to this problem
shift routine payment transactions to debit cards and include such things as point-of-sale
disclosures and limitations on advertising, credit card surcharges, and limitations on
teaser rates and affinity and rewards programs.120
Other responses focus on the credit function. Because the credit card is so easy to use
(that is, the transaction costs of credit card lending are so low), borrowers underestimate
the risks associated with future revenue streams. The response is to intervene in the
market for consumer lending or adjust the types of relief available in bankruptcy.121
Although policymakers around the world are loosening the rigor of their consumer
bankruptcy systems—in large part due to the introduction of American-style consumer
credit—the legislative desire to protect the credit card’s unique place in the U.S.
economy was one of the most important motivations for the
bankruptcy reform statute. Oddly enough, the credit card industry successfully
convinced
bipartisan majorities in both the House and Senate that there were serious deficiencies in
the American bankruptcy system within which the card has had its phenomenal success.
Thus, the central idea behind the “fresh start”—that the complete liquidation of all
debts—has shifted towards a presumption in favor of repayment.
Given the difficulties of sorting out the various factors that influence consumer
bankruptcy filings, even hindsight is unlikely to give us a confident understanding of the
effects of the Act on bankruptcy filings. For example, I doubt that the Act will deter
borrowing to any significant extent. I am also skeptical that it will reduce the number of
bankruptcies in any substantial way. Moreover, I think it most improbable that consumers
will see the benefit of any increased bankruptcy payouts in the form of interest rate
reductions. Still, these assumptions will be hard to test with quantitative data alone,
especially in the early years of the Act’s operation. Thus, in the end, I expect that an
informed sense of the actual impact of the Act will come only after years of experience.
For now, I can offer just the speculations on which this essay is based.
ADDITIONAL DISSENT TO RECOMMENDATIONS
FOR REFORM OF CONSUMER BANKRUPTCY LAW
Submitted by Honorable Edith H. Jones and Commissioner James I. Shepard
The assistance of
Professor Richard E. Flint and Ms. Kelly J. Wilhelm is gratefully acknowledged
I. General Observations
The consumer bankruptcy recommendations of a five-four majority of the Commission
speak volumes about the error of entrusting reform to defenders of the institution that
needs reforming.(2711) Many of these recommendations are not only unrealistic, they are
simply deaf to the public debate over and frustration with this nation's bankruptcy
system. And in conspicuous areas, the majority recommendations are also mute. It is
foolish not to view with alarm the fact that 1.2 million people filed for bankruptcy relief
in 1996, nearly 30% more than in the previous year, and that a similar proportional
increase appears to be happening during 1997. When filings rise dramatically while
unemployment is declining, it is inevitable that the next economic downtown will
produce a cataclysm of filings. When the cataclysm occurs, the stability of our creditdriven economy could be shaken.
The Commission's response to this reality, novel in our history, is silence. The reporter's
introduction to consumer bankruptcy purports to conclude that the cause of the high rate
of bankruptcy filings is debt. That controversial conclusion(2712) is about like saying
that the cause of the high rate of divorce is marriage. Even if the debt-causes-bankruptcy
theory is portentous, it is founded in politics and economics, not law. Because neither the
reporter nor any member of this Commission is an economist, it is out of our bailiwick to
speculate on the economic causes of increased filings. But if too much debt is the source
of the bankruptcy problem, Congress should address it directly rather than indirectly
through bankruptcy law. This Commission's report should not be taken seriously on
purely economic issues.
There remains a normative question which is very much within our competence to
evaluate: whether a bankruptcy law that permits well over one million people a year to
break their contracts and discharge debts -- during "good times" -- is functioning
correctly. In this respect, the five-member majority tome on consumer bankruptcy is
silent. Silence serves a number of purposes. It furthers the interest of those who file
consumer bankruptcy petitions, many of whom advocated from the beginning of the
Commission that the bankruptcy law wasn't broken, and the Commission shouldn't fix it.
Silence stifles debate over whether bankruptcy relief should be means-tested like all other
programs available in the social safety net. Silence ignores creditors' complaints that their
interests are systematically short-changed by the Framework, while those of debtors are
enhanced.
Silence also obscures the impact of the Framework proposals, by concealing that those
proposals create even more incentives than now exist to seek bankruptcy relief and that
they favor Chapter 7 discharge over Chapter 13 repayment plans. Nowhere, as far as I
can tell, does the Framework justify these untoward consequences. The Framework
induces more people to seek bankruptcy relief by significantly increasing exemptions; by
treating reaffirmations as installment redemption on discounted collateral; by voiding
liens on any household good less than $500 "value;" by degrading rent-to-own contracts
from rental agreements to security interests; and by allowing full dischargeability of any
credit card debt incurred within the authorized credit limits more than thirty days before
bankruptcy. The general lesson from these changes is: go on a shopping spree and declare
bankruptcy in thirty-one days. The Framework is silent on any notion of personal
responsibility for one's debts.
Similarly disadvantageous to creditors and to bill-paying Americans who bear the hidden
bankruptcy tax,(2713) the Framework effectively discourages Chapter 13 filings. This
effect results (1) from allowing the debtor to make no more payments on secured debt in
Chapter 7 (through reaffirmation) than would be required in a Chapter 13 cramdown
plan, (2) from measures that may increase Chapter 13 payment requirements without
increasing debtors' incentives to file in Chapter 13, and (3) from enhancing the exemption
levels. The synergistic effect of these changes is skewed toward increasing use of Chapter
7.
The Framework's silence about its impact on Chapter 7 filings is unsurprising, because it
is completely irreconcilable with the early versions of the Framework that purported to
enhance and encourage the use of Chapter 13. The Framework has in fact departed
entirely, and entirely without explanation, from its initial premises. In March, the
Framework was initially presented to the public as an integrated plan calculated to make
the debtor's choice between Chapters 7 and 13 relief consequential. The Framework
sought to enhance use of Chapter 13 and to balance debtors' and creditors' rights. As a
tradeoff for this first Framework's attempt to ban all reaffirmations, the use of Chapter 13
would afford secured creditors higher and more certain payments on unsecured
deficiency claims.(2714)
As it matured into the final product, none of the first Framework's aims have been
preserved. The five-member Framework sent to Congress in fact blurs the line between
Chapter 7 and Chapter 13 significantly by conflating reaffirmations and installment
redemption. As its general thrust is to encourage Chapter 7 liquidations rather than
repayment plans, unsecured creditors have no corresponding assurance of receiving
payments in Chapter 13. Other measures that would have protected creditors appeared in
the March draft and were inexplicably dropped thereafter, removing any pretense of
balance between debtors and creditors. The five-member majority proposals that go to
Congress, unlike earlier drafts of the Framework, have dropped the following provisions:
a more rigid limit on serial filings; affidavit practice to speed up relief from the automatic
stay; reliance on the impending Rash decision for valuation for collateral; and dismissal
of failed Chapter 13 plans rather than automatic conversion to Chapter 7. Admittedly, the
present Framework eliminates the wholesale stripping of junior home mortgages, but the
Framework remains, on balance, disrespectful of the state-law rights of secured creditors.
Elsewhere, several of us have identified other "process" and substantive objections to the
consumer Framework.(2715) In particular, the General Critique of the "Framework" lays
bare the unstated political and economic assumptions which guide that document.
Consistent with all of those objections, I have additional serious objections to
recommendations and omissions of the consumer bankruptcy chapter. These are:
•
The Commission's failure to consider mean-testing for consumer bankruptcy
relief;
•
the Commission's failure to address changes to § 707(b), and "substantial abuse"
provision; and
•
the Framework's recommendations for dischargeability of student loans, credit
card debt, the Chapter 13 superdischarge, and state court default judgments.
Congress should consider means-testing for consumer bankruptcy relief; it should amend
§ 707(b); and it should decline to accept the Commission's recommendations that
enhance discharge of debts for unjustifiable reasons.
II. Means-Testing Bankruptcy Relief
In 1980, just after the Bankruptcy Code was passed and amid an economic recession,
annual filings stood at slightly over 330,000. Sixteen years later, following a sustained
period of economic growth, the number of filings has risen suddenly and dramatically
from just under a million to 1.2 million consumer bankruptcies in 1996. The
disproportionate increase has continued in the first part of 1997.
We now have an anomalous situation in which unemployment is falling but bankruptcy is
rising. Moreover, it has been estimated that Americans pay a hidden bankruptcy tax of
$300-400 per household as the losses occasioned by higher bankruptcies are redistributed
through higher-priced goods and services.(2716)
This is not the place to speculate on all of the causes of increased filings. But no one
suggests that the filings are any longer demographically confined to the lowest
socioeconomic groups or those who have irrevocably lost their jobs or have become
physically disabled -- seeking bankruptcy protection has become more and more common
among fully employed middle- and upper-class people. See Appendix attached hereto.
More disturbingly, many debtors are now filing for bankruptcy protection before actually
defaulting on debt. Id. As Congressman Pete Sessions recently described it, bankruptcy is
"for some people . . . just another tool of financial management." Further, contrary to the
implications drawn by many bankruptcy practitioners and academics before the
Commission, the rapid increase in filings cannot mean that the bankruptcy system
requires amendment to soften its impact on debtors. If it were unfair to them, there would
not be a vast migration toward bankruptcy when, as we see today, employment prospects
seem brighter than ever.
In part, the bankruptcy boom springs from the intention of the 1978 Code. The drafters of
the Code, many of whom have actively influenced this Commission's work, consciously
sought to remove the social stigma from filing bankruptcy. The Code, for instance,
replaced the term bankrupt with "debtor" and described a case filing as seeking an "order
for relief." If you craft a social welfare statute, people soon learn to appreciate the
benefits of seeking welfare.
Social and moral changes have also accelerated the trend to accepting bankruptcy as a
feature of "normal" life. Movie stars, governors and "famed heart surgeons" have taken
advantage of the process to discharge their debts, so why shouldn't ordinary Americans?
To take just one example from the wealth of bankruptcy- promoting advertising and
literature a book titled Debt Free! offers "Your Guide to Personal Bankruptcy without
Shame."(2717)
A prominent bankruptcy judge once commented to me that when he graduated from law
school around 1950, there were two things that "people never did: divorce and
bankruptcy." This comment captures an insight often overlooked by those who make
their living from the bankruptcy process. Declaring bankruptcy has a moral dimension.
To declare bankruptcy is to break one's contracts and agreements. Our society cannot
function if it becomes widely acceptable to do this. In fact, the sanctity of contract -enforced by the rule of law -- animated the growth, development and prosperity of the
Western world. Enforceable contracts permit economic freedom to flourish and provide
opportunity for all precisely because they are the product of voluntary action rather than
state-sponsored preferences, priorities, or corruption. To regress from a norm in which
contracts are enforceable threatens the foundation of our economic engine.
Beyond contracts and mere transactional effects are the distrust, disaffection and
misunderstanding that erupt in a society which broadly permits such promise-breaking as
occurs in bankruptcy. The large number of heartfelt and often poignant letters received by
the Commission from creditors who were short-changed by debtors in bankruptcy attests
to this sad reality. No doubt, bankruptcy is a necessary feature of Judeo-Christian
capitalist societies, but to advance the equally moral goals of protecting social cohesion
and general welfare, it cannot become more than an act of grace available to those who
are truly and seriously needy. We must not, to paraphrase Senator Moynihan and former
Treasury Secretary Lloyd Bentsen, "define bankruptcy deviancy downward."
Finally, bankruptcy has a macroeconomic effect on the cost and availability of credit.
Graphically demonstrating this impact are hundreds of letters the Commission has
received from credit unions. Credits unions' losses in bankruptcy directly affect their loan
rates and practices, and in the past three to four years, those losses have dramatically
increased. Other lenders, large and small, have had similar experiences. The rising
number of bankruptcies will increase interest rates for all consumers and will cause
businesses to scrutinize credit more closely and discriminate among borrowers. The real
losers as the supply of consumer credit tightens are those at the bottom of the ladder. In
the final analysis, bankruptcy "reforms" that favor bankrupts do not favor bill-paying
customers. Without further belaboring what should be an obvious point, bankruptcy as a
social welfare program is subsidized by creditors and, through them, by the vast majority
of Americans who struggle and succeed to make ends meet financially.
In light of these considerations, it is hard to justify why the Commission has not formally
considered means-testing for bankruptcy relief, as a device to limit the adverse
consequences of the filing explosion. Several factors have contributed to this failure.
First, the advocates of means-testing received no encouragement or assistance from the
Commission's staff. Second, the creditor community has until recently been reluctant to
articulate a concrete proposal for means-testing. Third, the professionals who have been
heavily involved in the Commission process exhibit the general reluctance of the legal
profession to contemplate "reform" that may disturb their customary practices. Fourth,
analogizing the bankruptcy system to the welfare office, or to similar programs that
routinely engage in means-testing, discomfits bankruptcy professionals. Finally, it is a
complex task to create fair and efficient means-testing criteria that would not
administratively bog down the bankruptcy courts.
If the Commission had engaged in this important debate, we might have considered at
least five different options for means-testing. It appears that the primary considerations in
setting up such a program are fairness and ease of administration together with the
maximum feasible simplicity. The point of means-testing is to permit Chapter 7 discharge
and liquidation of debt only to those debtors who are truly unable to repay their debts in
the future. Those debtors who are income-earning, however, should not receive the
benefits of the full discharge and the automatic stay to the extent that they are able to
repay creditors the secured and a portion of the unsecured debts they have incurred. Each
of the following proposals, listed in no particular order of importance, has the potential to
accomplish the objective of means-testing within the noted constraints.
1. Section 707(b) could be amended to require that the court dismiss or convert the case
of a debtor who has filed for Chapter 7 if, on the motion of a party in interest or the U.S.
Trustee, it is found that the debtor has the ability to repay a portion of his debts in
Chapter 13. This option would permit debtor-selection of bankruptcy relief to begin with,
utilizing creditor oversight and the courts to determine the appropriateness of that relief
within statutory guidelines. The provision might set as a threshold the debtor's ability to
pay back 10% of unsecured debt within five years, or any other amount chosen by
Congress.
2. Any debtor whose family income exceeded $35,000 or $40,000 per year, a solid
middle-class income, might be permitted to file for Chapter 7 liquidation relief only by
agreeing to pay for and submit to a full bankruptcy audit conducted by the panel trustee.
3. A presumptive income ceiling for the availability of Chapter 7 relief could be defined.
Thus, any debtor whose family income exceeded an average middle-class income, say
$35-40,000 per year, would presumptively be required to seek Chapter 13 repayment plan
relief unless the debtor could establish extraordinary and compelling circumstances
justifying Chapter 7 liquidation. Those circumstances could be codified and should
include no less than serious and costly medical or health conditions; unique family
circumstances (large number of dependents); being a fraud victim; or being out of work
and unemployable for a sustained period of time.
4. A "least-common-denominator" means test would automatically channel any debtor
seeking bankruptcy relief into a Chapter 13 proceeding if she is able to repay a minimum
level of unsecured debt within five years. This proposal is administratively feasible,
because it uses the information now recorded on the debtor's bankruptcy Schedules I and
J, reflecting income and monthly expenditures, and derives the debtor's "disposable
income" from those charts. A debtor and her attorney would immediately discern whether
Chapter 7 or 13 relief was permitted and would so certify to the court. Court intervention
would be required only for challenges to the certification or questions raised by the U.S.
Trustee. The reform proposals of Four Dissenting Commissioners include proposals to
enhance the integrity of debtor's schedules and thus, one hopes, to limit manipulation of
this alternative.
5. The needs-based test suggested by some creditors derives from the assumption that all
debtors should be directed into a Chapter 13 repayment plan to the extent their family
income exceeds average costs of living in their area, as determined by statistics from the
Bureau of Labor Statistics. Immediate questions are raised about the complexity and
fairness of this proposal, but those objections may be allayed in various ways. First, BLS
statistics are already in use in one form or another by Chapter 13 trustees as a gauge
against excessive expenditures claimed by Chapter 13 debtors. Second, if BLS statistics
are fair geographically, they can be administratively disseminated to bankruptcy courts,
trustees and debtors' attorneys and promptly updated. Third, the use of similar measures
by family courts and tax collection agencies in working out debtor payment plans suggest
their feasibility for bankruptcy plans. Fourth, the statute could except debtors from this
standard under circumstances in which its application would be clearly unjust. Finally, to
the extent this standard would require debtors to make higher payments than they
presently contemplate, it is because such debtors have higher expenses and, presumably,
higher income-earning history than average Americans. The proposal is therefore a
progressive one, which would have its smallest impact on low-income debtors.
Three vehement objections to means-testing bankruptcy relief, and requiring many
income-earning debtors to pay back some portion of their debts, have been frequently
voiced. The first is that, given the current high failure rate of cases in Chapter 13, it can
hardly be expected that when debtors are forced into debt payment plans, they will be
more likely to complete their court-ordered obligations. While this is certainly a
possibility, it is mitigated by the alternative that such debtors would face. If they did not
complete their Chapter 13 plans, their cases would be dismissed, and they would again be
at the mercy of creditors. The option of converting to Chapter 7 liquidation in a meanstesting regime would necessarily be limited for those debtors who originally qualified
only for Chapter 13 payment plans. It should also be noted that none of the presentlyconceived means-testing proposals requires a particularly draconian level of debt
repayment. Moreover, once debtors become well aware that their earning capacity will
limit the debt relief to which they may be entitled, they can plan their lives accordingly. It
is patronizing and short-sighted to assert that debtors are too stupid and undisciplined to
adjust their expenditures to the default standards that society will maintain.
Second, it is often cavalierly asserted by bankruptcy professionals that requiring people
to repay some portion of their debts amounts to unconstitutional "involuntary servitude."
One court appropriately dismissed this odd notion as follows:
Debtors further argue that § 707(b) is unconstitutional as a violation of the 13th
Amendment in that the statute "could force persons into a state of involuntary servitude,"
debtors' brief p. 9. [Under Section 707(b), debtor's liquidation petition may be dismissed
if the debtor could repay significant debt in a Chapter 13 case.]
The 13th Amendment proscribes slavery or its functional equivalents, e.g. peonage, U.S.
v. Kozminski, 487 U.S. 931, 941-42, 108 S. Ct. 2751, 2759, 101 L.Ed.2d 788, 804ff.
(1988). As noted above, § 707(b) is intended to prevent debtors who are capable of
paying their just debts from discharging them by misuse of an extraordinary privilege to
which they are not properly entitled. If this violates the 13th Amendment, then it would
seem that having to pay one's just debts is "slavery" or "peonage" -- put another way,
debtors would read the 13th Amendment as if it provided a Constitutional right to a
Chapter 7 discharge! The great majority of Americans who work hard to pay off their
voluntarily-incurred debts might be a bit surprised to hear the Protestant Ethic described
as "slavery." Judicial review of voluntarily-filed Chapter 7 cases for abuse does not force
anyone to work and does not force debtors to divert any part of their income to payment
of debts. Such judicial review merely requires debtors who already work and have
enough income to pay their debts to "take their chances" under State law if they refuse to
meet their obligations, by refusing in turn to grant equitable intervention to protect such
debtors from State debt-collection mechanisms where insufficient cause for such
intervention has been shown.
In re Tony Ray Higginbotham, 111 B.R. 955, 966-97 (Bankruptcy N.D. Oklahoma 1990);
see also In re Koch, 109 F.3d 1285, 1290 (8th Cir. 1997) ("Congress is free to limit
Chapter 7 protection to truly needy debtors who cannot fund a Chapter 13 plan . . . .").
A third complaint by those who resist means-testing is that debtors cannot pay back
anything, according to some empirical studies, or alternatively, there is no good proof
that they can repay a portion of unsecured debts. I am not an economist or statistician and
will not debate these hypotheses, although they are strongly controverted.(2718) Having
been a member of the Commission's Consumer Bankruptcy Working Group, however,
and having read the thousands of pages submitted to us on consumer bankruptcy, I draw
two firm conclusions. First, too many letters from lenders and news articles depict
instances of filings by people with steady jobs whose lifestyles got out of control or who
gambled (sometimes literally) with their finances and lost. See, e.g., Appendix hereto. If
they have steady income, and no exceptional problems such as physical disability, it does
not seem unfair for society to ask them to repay some of their unsecured debts. Second, if
by some chance it is true that no debtor can afford to repay some unsecured debts, then
the critics of means-testing will be vindicated by that very program. No means-testing
proposal I have seen would impoverish anyone with an impossible level of debt
repayment. On the contrary, if all debtors are so needy as the means-testing critics
contend, none of them will qualify for debt repayments, and all will receive a Chapter 7
discharge.
The arguments for means-testing are clear and are also consistent with accepted public
policy for similar situations. Means-testing is not a radical idea. We already use it to
determine child care benefits, Medicaid benefits, social security benefits, supplemental
security income, food stamp benefits and student aid benefits at the federal level alone.
Moreover, as one professor has put it:
Lack of means testing creates the moral hazard problem of allowing abusers to self-select
their own debt remedy. This can do nothing but exacerbate abuse. Would we, for
example, allow welfare recipients to select their own benefits? Would we allow golfers to
determine their own "gimmies"? Of course not. So why allow debtors to select their own
remedy? Would they not simply act in their own interest on average, therefore
exacerbating abuse? The answer is probably "yes," so means testing (or some other gate
keeping" machinery) is the only way to eliminate this moral hazard.
Letter from James J. Johannes, Firstar Professor of Banking and Director, Puelicher
Center for Banking Education, University of Wisconsin-Madison, to Mr. Brady
Williamson (June 17, 1997).
The Commission has in my view neglected its duty to investigate alternatives to the
present-day reality of excessive bankruptcy filings. I hope that Congress will take up the
challenge.
IV. Dischargeability Issues
A. General Observations
While the Commission's Report acknowledges that it "did not undertake the task of
honing the list [of exceptions to discharge] down," it did recommend certain clarifications
and amendments to enhance fairness to all parties, to achieve uniformity in the law, to
alleviate confusion, and to reduce the costs of litigation.(2732) However, a review of the
suggested changes to Section 523(a) reveals a noticeable shift in the present balance of
the law to a decidedly anti-creditor position. While the changes suggested by the
Commission's Report might achieve its stated goal of uniformity, the price to creditors
and to society as a whole is far too great. The goals sought to be achieved by the
Commission through changes in dischargeability policy can be achieved without
distorting the basic creditor-debtor balance of the present law. Although a fundamental
purpose of consumer bankruptcy is the discharge of certain obligations, that purpose must
be juxtaposed with and limited by legitimate concerns about culpable debtor conduct, the
maintenance of the integrity of the bankruptcy system, and common societal good. Given
the rising numbers of bankruptcy filings and the increasing amounts of debt being
discharged through bankruptcy proceedings, it is incumbent that any recommendations
for change in dischargeability policy be accompanied with an evaluation of the impact of
the decision upon both the debtor-creditor relationship and society as a whole. As will be
shown below, the Commission's Report failed to take this part of the process into
consideration when arriving at its recommendations.
B. Dischargeability of Student Loans
The Commission's Report recommends that the provision of the Bankruptcy Code which
makes student loans [other than loans for medical education governed by special federal
legislation] nondischargeable in both Chapter 7 and Chapter 13 be overturned.(2733) The
Commission's recommendations are based upon several conclusions: the present undue
hardship exception is subject to "disparate multi-factor approaches;"(2734) many of the
present defaults are from fly-by-night trade or technical schools which often do not even
provide educational services;(2735) and its rejection of the premise that the
nondischargeability of student loans is necessary for the continued viability of the
guaranteed student loan program.(2736) The Commission's proposal will clearly
eliminate any confusion or nonuniformity of decisions in the area of dischargeability of
student loans. However, in reaching its decision the Commission discounted all the
evidence presented to it on the impact this change would have on the continued viability
of the guaranteed student loan program.(2737) Instead, the Commission relied upon nonstatistical information provided to it by the General Accounting Office that implied that
the student loan program was instituted with default in mind and that the taxpayers were
intended to pick up the tab for students' inability to repay loans.(2738) Furthermore, the
Commission's proposal is based upon its own admission that in many cases the present
cost of certain education does not translate into sufficient income to repay the
loans,(2739) and therefore, society needs to treat these loans as mere grants or subsidies
whose costs must be borne by taxpayers.
Section 523(a)(8) provides useful and practical boundaries concerning educational loans
by (1) preventing abuse of the educational loan system with restrictions on the ability to
discharge student loans shortly after graduation and (2) safeguarding the financial
integrity of governmental entities and nonprofit institutions who participate in education
loan programs. The nondischargeability of guaranteed student loans helps to maintain the
solvency of educational lending programs in order to enlarge access to higher education.
Congress has within the last six years reviewed the advisability of nondischargeability
and determined that it should remain.(2740)
The Commission's Report shows a lack of understanding of guaranteed student lending
practices. First, creditors in the majority of these cases lend money to individuals who
might not qualify for credit under traditional credit criteria. The borrowers usually lack an
established asset base or income-generated track record and have no collateral to justify
the loan. The loan is made with the view that it is an investment in the borrower's future
ability to generate income as a result of the increase in human capital due to education.
Further, the lender is well aware that it takes time following graduation for a student to
develop a career and sufficient earning capacity to repay the loan. In fact, this projected
increased earning potential achieved through education is the primary factor considered
by a lender in making loans under the student loan program.(2741) The unique character
of educational lending led Congress to enact special lender protection under the
bankruptcy laws. The Commission's comparison of educational loan creditors to creditors
who lend debtors money to buy pizza highlights the naivete of the Commission's
understanding of the student guaranteed lending industry.
The Commission's Report is more an indictment of schools which do not adequately
educate or train the students than it is a justification for making these loans
nondischargeable.(2742) If shortfalls in the educational system are the problem, it should
be addressed directly. Blame for a perceived lack of training or benefit should not be
imposed on the taxpayers or the many non-profit institutions who provide funds to
students. Congress has already made the public policy choice that the potential for abuse
in the educational loan system outweighs the debtor's right to a fresh start.
Finally, the Commission's treatment of student loans as a "subsidy" similar to the GI Bill
is a gross mischaracterization and a disservice to those who earned their right to GI Bill
benefits.(2743) It is highly unlikely that Congress contemplated that the student loan
guarantee program was a mere mirage -- just a method to give students a cash subsidy or
grant at the taxpayer's expense. The nondischargeability provision is intended to maintain
the solvency of educational lending programs and thus promote access to higher
education.(2744) Our present Code recognizes that through the hardship exception under
certain circumstances some of these loans cannot be repaid. If the Commission felt that
the hardship discharge needed to be clarified to ensure some degree of uniformity, it
could have proposed that solution.(2745)
In closing, it should be pointed out that there was no public outcry presented to the
Commission for elimination of this exception. In fact, the report directed to be prepared
by the Commission's Reporter did not recommend the repeal of this section.(2746) The
overwhelming evidence received by the Commission opposed this repeal. If this repeal
occurs, non-profit entities and governmental units will be forced to raise their fees to
cover the rising losses. Non-profit entities may discontinue providing loans;(2747) and
taxpayers will just end up picking up the tab.(2748) The concerns raised by these
constituencies were overlooked by the Commission. The proposed recommendation, like
many finally approved by the Commission, was just not supported by the record before it.
This section should remain unaltered in both Chapter 7 and 13.
C. Credit Card Debt
There is uniform agreement that Section 523(a)(2)(A) is ill-equipped to deal with the
question of the nondischargeability of debt incurred from the use of a credit card in those
cases which do not involve actual fraud in the application for the card.(2749) The
Commission correctly identifies the multitude of problems facing the courts as they have
attempted to apply this section of the Code to the use of credit cards.(2750) The
Commission then notes that the proliferation of cards and bankruptcy filings demand
more orderliness in approaching the issue of nondischargeability debts incurred with
properly obtained credit cards.
However, the Commission's Report fails to identify the problem which it is trying to
remedy. Instead, it merely assumes that some credit card debt is to be nondischargeable
[no reason given], and then draws a bright line rule for the sole purpose of bringing some
uniformity into the area. Its arbitrary thirty-day rule is totally disingenuous. Discharge is
to be given to the "honest but unfortunate debtor;" in large part, debts are to be denied
discharge due to the bad conduct of the debtor. The Commission's proposal is devoid of
any discussion of the moral turpitude of the debtor or his intentional wrongdoing as a
basis for the nondischargeability of credit card debt.
The thirty-day period is also purely arbitrary and has no basis in reality. If its purpose is
to balance rights of debtors and credit card lenders by assuring a period in which abuse of
credit cards will not be tolerated while also forcing lenders to be more careful in
extending credit, it fails. The proposal explicitly renders fully dischargeable all credit
card debts incurred within the credit limits 31 days or more before bankruptcy. This is an
open invitation to abuse and manipulation. Further, there is no way creditors can have an
opportunity to forestall such abuse by tightening credit because not even one billing cycle
would elapse from the dates of abuse until the debtor filed bankruptcy.
Like so many of the Framework proposals, this one will discourage extensions of credit
to marginal borrowers. It may be debtor-friendly, but is in no way consumer-friendly.
The Report is correct in that the common law fraud principles should not apply in their
entirety to credit card debt. Thus, issues such as whether the debtor knowingly made a
misrepresentation or intended to deceive the creditor, or whether the creditor justifiably
relied to his detriment on a misrepresentation, should not be the touchstones for this new
nondischargeability section. The Report is also correct in its conclusion that a bright-line
rule would necessarily reduce judicial time and resources. However, the Commission's
proposal is a type of rough justice that totally misses the mark. It seriously undermines
the integrity of the bankruptcy process by failing to equate nondischargeability to any
concrete standard. Outside of taxes and family support obligations, certain debts are
considered to be nondischargeable for the simple reason that the conduct of the debtor
was not at an acceptable level. The evidence before the Commission clearly identified the
evil which needed to be addressed -- the incurring of credit card debt while a person
either contemplated bankruptcy [pre-bankruptcy planning] or had no reasonable ability to
repay the debt [constructive fraud].
The following proposal addresses the evil and attempts to impose some degree of
uniformity into the bankruptcy process. The goal of this proposal is to prevent a debtor
from discharging credit card debt when he knew or reasonably should have known that he
had no expectation of repaying it. In line with Congress's earlier decision to add section
523(a)(2)(C) (the "luxury goods" provision), a new section should be added to Section
523 as follows:
All debts incurred through credit card use within sixty (60) days before the order for
relief under this title are presumed to be nondischargeable. A debtor may rebut this
presumption by showing the following: (1) that at the time a particular credit card debt
was incurred, the debtor was not contemplating bankruptcy and (2) that at the time a
particular credit card debt was incurred, a reasonably prudent person [not the debtor]
would have expected that there was an ability to repay the debt.
This proposal addresses culpable conduct, as nondischargeability policy ought to do.
Moreover, enactment of this provision should not prevent applicability of section
523(a)(2)(A) or (B) if, before the sixty-day period, the debtor incurred credit card debt
with intent to defraud.
Final Discussion Question.
To what extent is consumer bankruptcy discharge important to the economy as a liquidity
measure?
Chapter 17
Consumer Borrowing/Lending Around the World.
You are the chief staff person to a United Nations Committee charged with a set of
standards for consumer lending/borrowing around the world. The notion is to recognize
that different countries will call for different regimens of regulation depending on a
variety of factors.
Here are some of the factors that will affect the policy decisions that the
regulators/legislators from each country should consider
A.
Cultural of Borrowing / Purchasing
Remember the introductory readings from Schor, Warren and Caldor and the chapter on
Behavioral Economics? They are addressed to borrowers in the United States, but they
point out the various sources of borrowers’ decisions. The essential notion is that before
we can decide how much and what kinds of regulations will be optimal for a particular
country we need to understand the borrowing behaviors of folks in that country. There
are at least two basic reasons to regulate consumer borrowing/lending. The first worry is
that if it is unregulated it will lead to frequent economic crashes which will cause massive
damage of various types. Hyman Minsky asserts that overspending by consumers will
inevitably lead to an economic crash when the bubble bursts. Is this every eighty years
(1929 -2005) or every fifty years or every decade?
The second worry is micro rather than macro, unless we regulate, individual citizens will
make decisions which will cause them harm. In a society where neither of those harms is
likely to occur, then the need for regulation is reduced. If we conclude that consumer
behavior is likely to lead to both of these results then the need for such regulation is
heightened.
Once we decide on the level of regulation we need to decide what kind. For example, if
we think consumers will act in their interests if they understand financial decision making
and the essence of the specific borrowing transaction then we might increase the level of
financial literacy education and the amount of disclosure requirements.
If we think the problem is not one that can be ameliorated by disclosure or education then
we might need to prohibit certain kinds of credit offerings such as payday loans or invoke
doctrines such as the denying enforcement of credit transactions where the consumer
should not have been eligible for the credit extension.
So, the first item on our survey might be aimed at evaluating the proclivity of consumers
in that country to borrow beyond their ability to repay or to use a dangerous borrowing
product. We might inquire about the following topics:
Financial literacy of the population;
The role of peer pressure;
Undue optimism;
Hyperbolic discounting ;
Others – level of desperation
Middle class chasing the rich ; recent US study
What will we expect the consumers to do now or as they become more able to buy
i.e. China and India etc..
Other items of interest would include:
. Chronology of various technological developments. For example in the US the credit
card controlled the consumer payment market before the debit card could make any
headway; in Canada they were available and presented together and the relative use of the
debit card was enormously higher than in the United States in 2005. Another litmus test
is the availability of sophisticated credit reporting systems. For example in the
Philippines there are five debit cards for every credit card.
. Percentage of home ownership, home mortgages and car ownership These are major
items. In the US they constitute a significant percentage of the debt service requirements.
In EU countries not so much. See the chart below on home ownership by country, on car
ownership by country and by percentage of mortgage debt in Europe.
. Effectiveness of enforcement mechanisms. How high are the barriers to collecting in the
event of default by the borrower?
Effectiveness of Enforcement mechanisms;
a.
Collection potential/barriers
b. Institutional factors
b.
c.
d.
e.
f.
g.
h.
availability of funds to lend;
Political instability or stability;
Infrastructure of lenders;
Economic and employment demographics
Rising middle class; how rapid?
Visa/Mastercard availability
Profit potential
Consumer Regulation Scorecard
Proclivity to make damaging borrowing decisions
Chronology
Home Ownership
Enforcement Mechanism
Institutional or Policy Factors
Availability of funds to lend/borrow
Infrastructure of lenders
Economy and Employment
Profit Potential
Visa/Mastercard
Financial Sophistication of Borrowers
Consumer Regulation Scorecard
A quick look at selected countries
CANADA
Up until 2002 the contrast between the behavior of Canadian consumer and US
consumers was stark and fascinating. Canadians simply did not borrow at the same pace
or use the same kinds of credit mechanisms as consumers in the U.S. Starting in about
2002 this contrast dimmed and Canadians began to act more and more similar to U S
consumer borrowers. This was true both for credit card debt and for mortgage debt. The
numbers for credit card debt are a bit misleading because the US market increased an
matured by 2000 while the market in Canada had grown much more slowly during the
1980’s and 1990’s. As a result of these differences comparing percentage growth or
decline from these bases may be deceiving.
Still, Canada suffered much much less than the United States from the worldwide
economic recession of 2007 and bounced back much more quickly. Canadian consumer
continued to purchase and continued to borrow and this buoyed their economy.
However, starting in late 2011 it became clear that they were now exhibiting some of the
same conduct that US consumers had exhibited in the two decades leading up to the 2007
crash.
Although U.S consumers have reduced outstanding balances or deleveraged since the
recession (although much of it involuntarily) Canadians have done just the opposite. As
a share of disposable income, debt grew more slowly in Canada than in the US
throughout the 2000’s and Canadians held lower levels of consumer and mortgage debt.
that trend was reversed. While the U.S. debt to income ratio fell back to 110%, the ratio
in Canada surpassed 150% and reached new highs with each passing quarter. Credit and
mortgage debt alone surpassed 140% of disposable income, well above the peak reached
in the U.S. just prior to the recession. In Canada, between 2006 and 2011 household
balances of consumer credit and mortgage debt each expanded by around 50%, an
average annual pace exceeding 8% and twice the growth in disposable income. Moody’s
analytics 2012. (Storm Clouds Gather Around Canadian Consumer Credit by Deritis and
Hopkins) For various reasons the pace of borrowing in Canada slowed from 2011. It is
interesting to note that home equity second mortgages, or second mortgages of any type
are very rare in Canada.
BRAZIL
Going further south perhaps the most interesting story is that of Brazil. One of the key
BRICS nations with a solid and expanding economy and enhanced political stability, the
door to the middle class, the door to enhanced purchasing power is wide open for
Brazilian citizens. So, what do we know about their purchasing habits?
Huge increase in mortgage debt as the expanding economy allows many first time home
buyers;
Lower interest rates are keeping the total monthly debt down even as the total amount of
debt increases significantly.
Government wants people to borrow and lend to spur the economy even as the default
rate is high.
Best example are the car loan experiments. In 2008 the government provided incentives
to spur the sale of new cars and made financing more available
This spurred the sale of cars but not long after lead to a spike in the number and rate of
defaults. In response, policy makers said they were taking actions to prevent a credit
bubble after vehicle financing surged 49% in 2012, payment terms expended to as much
as 80 months. This seemed to work. Then, in May 2012, once again in order to increase
the sale of cars the government encouraged banks to lend more broadly and more dollars
on car purchases. Brazil does have an asset backed securities industry, the so call FIDC
which grew to 312 funds worth 59 billion reals (32 billion dollars) from 2001 to 2012.
Pyroll loans are a major source of crdit in Brazil. Credit cards were stymied for a time
because of large charges that Mastercard and Visa iboth imposed. When the market was
opened up to competition those charges were reduced and it is possible that new sources
of reals available to lend will provide an increase in credit card debt.
SOUTH AFRICA
Consumer loans not backed by assets tripled in South Africa from 2009 to 2012. They
rose by 39% in one year During a deadly miners strike it was estimate that most of the
moner were so indebted that they needed the pay increases of up to 22% just to take hime
a modest chuck of their paychecks. The raio of household debt to disposable income is
76.% in mid 2012. and now account for ten percent of the consumer credit, up from 8 per
cent a year earlier. Reports indicate that nearly one half or in default and that a
significant proportion is subject to wage garnishment.
Every month millions of people in China experience sufficient upward mobility that they
can begin to purchase appliances and other non necessities; every month millions move
up to the point where they can buy smart phones and computers; every month millions
step up ready to purchase their first car.
Consider these issues for the following countries
Korea
Also China and Indonesia readings
Eastern Europe??
South America: Brazil and Chile
Chile
EU
France, Germany, UK and Turkey
Asia
China
Indonesia
South Korea
India
Africa South Africa
Nigeria
Consumer Credit in China
Published : January 02, 2013 in Knowledge@Wharton
"I'm a little embarrassed." Liu Jing leaned in closer and lowered her voice, revealing for
the first time a hint of discomfort since the
topic of credit cards had been broached. After a pause, she smiled, took a breath and said,
"but let's chat."
Liu was born in Henan, a province in central China 600 miles northwest of Shanghai.
Despite coming from a solidly
working-class family, she was encouraged to study hard as a child and prepare for the gao
kao, China's rigorous college-placement examination. She received high marks and
earned a coveted position at a public university in Beijing. While she had studied English
in Henan, it was not until she arrived in Beijing that she discovered her gift for language.
After four years at the university and despite never having left mainland China, Liu
gained a strong command of English and an understanding of Western culture and
business practices. She stood out as a model of success within China's stunted education
system. She cultivated her skills by befriending Western exchange students and young
British expatriates working in the capital. Due to her competent English, she landed a
position as a junior executive at a digital advertising firm. While her salary was slightly
below the entry-level standard for white-collar jobs in China, the position allowed her to
remain in vibrant, growing Beijing.
Soon after entering the workforce, however, Liu began to grapple with economic reality.
Her salary barely covered her rent and other basic necessities. She also realized that with
Western friends came lifestyle choices. If she wanted to maintain her English skills, she
would have to be comfortable accompanying her Western friends to restaurants and bars,
which meant additional spending.
On the back of a napkin, Liu spelled out her financial conundrum. As a junior executive,
she netted 5,000
RMB (US$800) a month after taxes. From this, she paid 2,000 RMB (US$320) per month
in rent for a
shared flat near Beijing's fourth ring road. This left her with 3,000 RMB (US$480) a
month in disposable
income, or 100 RMB (US$16) a day. With this sum, she had to cover her remaining
living expenses. Liu
tried to stretch her income as best she could, but when she suddenly lost her job due to a
company
acquisition, she was hard-pressed to make ends meet.
At this moment, a friend recommended that Liu apply for a UnionPay credit card from
one of China's large state-owned banks. She was hesitant at first, given the Chinese
cultural tendency to avoid borrowing, but this was the help she needed. As she was no
longer employed and was in a weak position to apply for a line of credit, she begged a
friend in the accounting department of her former company to forge the necessary
documents to show she was still employed and had a monthly income. Begrudgingly, her
friend helped. A month later, Liu had her first credit card.
At first, Liu used the card to make ends meet. She would borrow against her credit at the
beginning of the month and pay off most of the balance within 30 days. But as time went
on, the allure of this "extra" income and the social benefits it allowed compelled Liu to
slowly increase her borrowing. She soon discovered that borrowing is a slippery slope.
After using the card for one year, she had accumulated debt of 15,000 RMB (US$2,400),
or three times her previous monthly income. "I don't really know exactly how my credit
card works, like how much interest I need to pay every month," she acknowledged. Even
so, she was acutely aware that this money would need to be repaid eventually.
She had no plan for paying off the balance. She would try to save more, and perhaps her
next job would pay her a higher salary. Until then, Liu Jing, an exemplar of China's new
middle class, was trapped.
A Variety of Credit Options
Despite a personal credit system that is underdeveloped by Western standards, China has
a long history of informal personal finance. Both usury and interpersonal interest-free
lending date back nearly 3,000 years to the Western Zhou period. Cooperative loan
societies, known as she, originallyestablished by Buddhist monasteries, were set up to
fund large one-time expenditures such as funeral or travel expenses.
Non-religious organizations also were formed to service other sectors of society. Mutual
financing associations, known as hui, allowed members to contribute a set amount to a
common pot each month. A lottery system, often a simple shake of the dice, determined
who could use a portion of the funds that month. Participants would usually use the
money to purchase large and relatively expensive assets. A farmer could use the funds to
buy a new cow, or a merchant could invest in a new riverboat. The hui were hyper-local,
and participation was often driven by patrilineal duty. This tradition continues in China
today, where it is not uncommon to find small villages pooling their resources to help a
resident make a critical investment.
While traditional Chinese society offered a wide variety of credit options to both wealthy
merchants and peasants, by the early 20 th century, China's personal credit industry was
in flux. With the rise of larger and more sophisticated banks in China during the 19 th
century, most high-level lending began to flow
through official banks. In 1929, the Chinese Communist Party banned usury on an
individual level. When the People's Republic of China was founded in 1949, private
lending institutions were banned nationwide. The only remaining options for personal
credit were the remnants of the traditional hui and she lending networks. The market for
private lending remained shut until the 1980s, when, following the start of
Deng Xiaoping's Reform and Opening movement, banks began formal lending programs
and modern credit systems began to develop.
Since being introduced in 1985, the number of credit cards issued in China has grown at
an astonishing rate, reaching 285 million in 2011, five times the number in 2006. Growth
has remained consistently high and is expected to continue at 31% per year over the next
five years, according to an RNCOS report on
the industry. According to the 2012 Chinese Credit Card Industry Bluebook, US$1.2
trillion of purchases were made with credit cards in China in 2011, a year-on-year
increase of 48%. This figure represented almost 40% of all purchases of consumer goods.
In 2000, the corresponding proportion was less than
10%.
MasterCard projects that annual credit card spending in China will more than double by
2025, and over the next decade, the country is expected to become the largest credit card
market in the world by number of issued cards, overtaking the United States. Although
the figure is high, it is worth noting that in China, credit cards are still used mostly for
large-ticket items, while cash is still the predominant payment method for smaller
purchases. Indeed, one study on credit card holders in Shanghai showed that 80% of
purchases below 100 RMB (US$16) are still made with cash.
Despite these optimistic growth projections, China's cash-centric consumer culture and
traditional beliefs about personal finance have meant that consumers are resistant to
change, thus slowing the adoption of electronic payment methods. Many of these cultural
beliefs stem from Confucian values, which see borrowing as shameful because it means
living beyond one's means, and which state that a good person always saves for the
future. Indeed, studies have shown that the majority of Chinese consumers remain
uncomfortable about borrowing for daily consumption.
However, recent studies, including one by Fudan and Monash Universities, have also
shown that these traditional value systems are changing, and that Western consumptiondriven lifestyles are finding their way into China, especially among the youth. This is
demonstrated by the materialization of a new class of yue guang zu, those "with no
savings at the end of the month." This group includes young urban students and
professionals under 35, largely in first and second tier cities, who have begun to abandon
some of the cultural taboos surrounding borrowing money in order to fund their modern,
highly consumerist lifestyles, in some cases spending well beyond their means.
Many of these changes in the cultural attitude toward credit have been driven by
aggressive marketing by banks issuing credit cards, which offer rewards, discounts and
lucky drawings to encourage spending. A number of banks now make it very easy to
obtain a card, even for young consumers with no income. Some bank customers have
even reported receiving in the mail high-limit credit cards for which they never applied.
While most young people remain responsible for fear of losing control of their finances, a
small but growing group of ka nu, or "card slaves," has emerged. These ka nu usually
begin using credit cards for convenience and security or because of the special offers, but
end up losing control over their spending, usually to meet a social expectation or to
maintain "face" among friends and co-workers.
The needs of the family have always come before those of the individual in traditional
Chinese culture. This, in combination with demographics, has exacerbated the trend
toward increased reliance on credit. China's rapidly aging population and the
government's one-child policy have created a "sandwich generation": those married with
a young child and aging parents who have significant financial responsibilities that lead
to higher credit card use. A Jiao Tong University study also examined attitude factors that
drive credit card use, concluding that "social power," the desire to display material
wealth, played a significant role in the willingness to take on debt. These findings point
to the adoption of Western consumer-centric attitudes and the shedding of traditional
reluctance to take on debt among young, urban Chinese.
Paying off Debt
"I have access to credit, but would only use it as a last resort," said Zhou Lin, a young
entrepreneur based in Beijing. In 2007, Zhou opened her first boutique in Beijing's
Haidian District, selling Korean and Japanese apparel to fashion-conscious university
students. Since then, she has opened new stores and expanded beyond brick-and-mortar
to new sales channels, including a robust e-commerce platform. With a keen aesthetic
sense and an ability to hone in on China's ever-changing fashion trends, she is part of a
wave of young Chinese entrepreneurs with their fingers on the pulse of China's consumer
demand.
Zhou readily admitted that she had more than one credit card. "I applied for them because
of the benefits they provide. This one gives me deals when I travel abroad. The bank that
offers this card organizes shopping events in Beijing, and if you use your card, you can
get deals." Almost all of Zhou's friends had cards as well. She noted that having a credit
card in the early 2000s was a status symbol. If you had one, it meant that you or your
family had money. In recent years, however, the plastic cards have become commonplace
and no longer bestow an air of privilege upon their holders. "I'll carry them when I travel
outside of China for business," Zhou added. "If something goes wrong and I have to stay
for an extra few days to meet with suppliers, I know my credit will cover me." Despite
having multiple credit cards, Zhou rarely, if ever, used them in China. When shopping in
Beijing, for example, whether for personal purchases or for business, her cards rarely left
her purse. She attributed this behavior to her experiences with credit when she was 19.
When she left Shanghai to attend a university in Beijing, Zhou's father issued a duplicate
of his credit card under her name, for use in an emergency. While a common practice in
the West, Zhou's situation was
quite rare in China at the time. She was the only one among her college friends with a
credit card.
One day, after a prolonged argument with her father over the phone, Zhou decided to take
revenge and used the card to go on a spending spree. She recalled that when her father
received the bill, he was outraged and devastated. He spent the next few months paying
off her debt. This taught Zhou an important lesson: Credit is dangerous and its use has
serious implications -- a belief consistent with traditional Chinese values.
Despite rapid economic growth, the Chinese government has recently been attempting to
spur consumer spending, which has remained stubbornly low as a proportion of GDP.
Before the global financial crisis, the cliché was, "Chinese save, Americans consume,"
with the average saving rate in most Chinese households running at over 40% of annual
income. However, as consumption plummeted in Western countries in the wake of the
financial crisis, the Chinese government realized the importance of encouraging domestic
spending as a way to compensate for diminished demand for its exports, and it has
attempted to change the savings culture. In the U.S., the credit card industry helped give
rise to the middle class and the culture of consumerism. The Chinese government has
begun deregulating the industry in an attempt to achieve the same result.
One significant concern is whether regulatory oversight of Chinese banks is sufficient to
prevent a consumer-credit bubble. Asia as a region has seen a number of such events over
the last 15 years, and Hong Kong, Taiwan and South Korea have all experienced a credit
card crisis driven by excessive household spending, which severely threatened the
stability of domestic banks.
Regulators are encouraging Chinese banks to improve their risk management, debt
collection and
new-product development,and industry insiders have called for the loosening of
consumer credit to be
backed by a sound risk-management infrastructure, transparency and a continued focus
on solid criteria
for lending. Even so, important questions remain as to whether Chinese consumers, with
very little prior
exposure to credit, can safely handle large-scale growth in credit availability.
As China continues to evolve culturally and its financial institutions continue to mature,
growth in the availability of consumer credit is only natural. Will a sophisticated
ecosystem around personal credit, including the regulatory system and a cultural
familiarity with and acceptance of credit, develop as it has in Western societies? Will the
typical Chinese credit card customer look more like Liu Jing, on a slippery slope to
insolvency, or like Zhou Lin, whose early credit-related mishaps fostered a mature
respect for the benefits and risks of credit? The impact of consumer credit will have farreaching implications for the overall direction of Chinese economic development.
This article was written by William Hart, Thomas Kidd, Lane Rettig and Nicholas
Walker, members of the Lauder Class of 2014.
This is a single/personal use copy of Knowledge@Wharton. For multiple copies, custom
reprints, e-prints, posters or plaques, please contact
PARS International: reprints@parsintl.com P. (212) 221-9595 x407.
Indonesia Impedes Card Collectors
By ERIC BELLMAN
JAKARTA, Indonesia—Until about four years ago, Rusmani, an administrative assistant
for a Jakarta electronics company, didn't even know what a credit card was. Today she
has 13.
The 28-year-old Ms. Rusmani—like many Indonesians she goes by only one name—
earns less than $1,000 a month. She got her first card in 2010 from PT Bank Central Asia
because the salesman offered her a free appointment book and told her that the card gets
her free drinks at her favorite coffee shop, Starbucks SBUX +1.67%. Since then, she has
been regularly contacted by all of the 20 banks that offer cards in Indonesia. They call her
on the phone, they come to her office and even show up at her home, she says, once with
a birthday gift.
Her card collection is so big now that she has to carry two wallets.
"Maybe the banks think I'm rich," said Ms. Rusmani, as she pulled out her latest card—
still unsigned and unused—from the envelope it was delivered in.
Credit cards are just taking off in Southeast Asia's largest economy, and the high interest
rates banks can charge make the business particularly profitable. The number of credit
cards in Indonesia has jumped 60% in the past five years to around 15 million last year,
compared with a population of close to 250 million. The value of transactions through
cards has almost tripled to around $21 billion.
Jason Schneider
The intense competition for millions of potential customers, though, is creating a new
class of card holder—one who carries 10 or more cards just for the freebies and discounts
they promise.
Ms. Rusmani says that her PT Bank Negara Indonesia card gets her 50% off at Pizza
Marzano, her HSBC Holdings HSBA.LN +0.46% PLC card gives her free movie tickets,
her Australia and New Zealand Banking Group Ltd. ANZ.AU -H,80% card grants her a
10% discount on gasoline and her PT Bank Permata BNLIJK +0.65% card provides 15%
off her grocery bill as well as some flights. By spending around $100 a month on her
different cards, she estimates that she gets close to $40 in discounts.
The plastic perks have been so successful at boosting business that the central bank
slapped new restrictions on cards this year, concerned the marketing blitz could trigger a
debt bubble. The restrictions will force millions of people to give up some cards,
according to industry estimates. They also could derail the plans of card companies like
Visa Inc. V +0.65% and MasterCard Inc. MA+1.28% and big global banks like Citigroup
Inc., C +0.91% HSBC and Standard Chartered STAN.LN +3.20% PLC, which were
targeting Indonesia as one of the last great untapped markets for them.
Banks say that while they usually lose money on the discounts, they can make up those
losses many times over if the card holder starts regularly using the card, paying more than
35% a year in interest on their balances.
Steep discounts to encourage consumption on credit happen in other markets as well,
including China and Brazil. Card issuers say they spend more on these kinds of
promotions in emerging markets to be known to consumers as card use takes off.
Indonesia still has a credit-card penetration rate of less than 15%, compared to more than
25% for Malaysia and Singapore, said Heri Gunardi, executive vice president and
coordinator of consumer finance at PT Bank Mandiri, Indonesia's largest card issuer.
"Our population is very big but [card] penetration is still low," said Santoso, senior
general manager and head of consumer cards at Bank Central Asia, one of Indonesia's
largest card issuers. "And the margins are still very high, which is why we can afford
these promotions."
But the archipelago's central bank, Bank Indonesia, is worried. The authorities are
concerned that inexperienced banks and borrowers could trigger a credit-card debt bubble
like the one seen in South Korea in 2003, when the government's crackdown on credit
cards resulted in a decline in consumer spending.
While Indonesia's nonperforming loan rate from credit-card debt has actually fallen in the
past four years to around 3.5% last year from around 9% in 2009, the central bank says it
doesn't want to take any chances.
"Although our stress tests didn't show any bubble, we don't want a credit-card crisis,"
said Boedi Armanto, Bank Indonesia's head of accounting and payment system
department. He said some banks at times offer cards to customers without finding out
how much the people earn, which could lead to problems.
Starting this year, cards can only be issued to people who are older than 18 and earn more
than $300 a month. The combined credit limit isn’t allowed to go beyond three times the
card holder’s monthly salary. Meanwhile, anyone making less than $1,000 a month will
only be allowed to hold two cards.
Because of the new rules, as many as four million cards will have to be canceled this
year, said Steve Marta, general manager of the Indonesia Credit Card Association. As
millions of multiple card holders this year decide which two cards to keep, the perks and
discounts may only get more generous.
"It will be more competitive now because banks are pursuing the same group of people
trying to hold on to their customers," Mr. Marta said.
Ms. Rusmani says she doesn't mind thinning out her deck of cards as long as she can
keep the two that give her the biggest discounts. "If I don't get a discount then there is no
reason to use a card," she said.
— Andreas Ismar contributed to this article,
Page 1 of 2
Needless to say home ownership is a key component of consumer credit.
Here is a recent listing of Home ownership by country
Rank Countries
Amount
#1
Ireland:83%
#2
Italy:78%
=3
United Kingdom:69%
=3
Australia:69%
=5
Finland:67%
=5
Canada:67%
=7
United States:65%
=7
Belgium:65%
=9
Sweden:60%
=9
Japan:60%
# 11
France:54%
# 12
Denmark:53%
# 13
Netherlands:49%
# 14
Germany:43%
Weighted average: 63.0%
Another crucial factor is vehicle ownership.
List of countries by vehicles per capita
From Wikipedia, the free encyclopedia
Jump to: navigation, search
Map of vehicles per capita 2011
This article is a list of countries by the number of motor vehicles per 1,000 people. All
figures include automobiles, SUVs, vans, and commercial vehicles; and exclude
motorcycles and other motorized two-wheelers.
Rank
This article is a list of countries by the number of road motor vehicles per 1000
inhabitants. Please consider that car is different from road motor vehicle as the latter
includes automobiles, SUVs, trucks, vans, buses, commercial vehicles and freight motor
road vehicles. The present list excludes motorcycles and other two-wheelers.
Rank Country
Motor vehicles per
1000 people Notes
1
San Marino
1,263 2010[1]
2
899
Monaco
2008[1]
3
797
United States
2010[1]
4
750
Liechtenstein
2010[1]
5
745
Iceland
2010[1]
6
739
Luxembourg
2010[1]
7
717
Australia
2013[2]
8
712
New Zealand
2010[1]
9
693
Malta
2010[1]
10
679
Italy
2010[1]
11
677
Guam
2004[3]
12
Puerto Rico
635
2010[1]
13
624
Greece
2010[1]
14
612
Finland
2010[1]
15
607
Canada
2009[1]
16
593
Spain
2010[1]
17
591
Japan
2010[1]
18
584
Norway
2010[1]
19
578
Austria
2010[1]
19
578
France
2012[4]
21
572
Germany
2010[1]
22
23
566
Switzerland
2010[1]
24
560
Lithuania
2010[1]
25
559
Belgium
2010[1]
26
548
Portugal
2010[5]
27
537
Poland
2010[1]
27
Bahrain
537
2009[1]
29
532
Qatar
2007[1]
29
532
Cyprus
2010[1]
31
528
Netherlands
2010[1]
32
527
Kuwait
2010[1]
33
520
Sweden
2010[1]
34
519
United Kingdom
2010[1]
35
513
Ireland
2009[1]
36
510
Brunei
2008[1]
37
485
Czech Republic
2010[1]
38
480
Denmark
2010[1]
39
476
Estonia
2010[1]
40
469
Barbados
2007[1]
41
434
Lebanon
[6]
42
393
Bulgaria
2010[1]
43
Croatia
380
2010[1]
44
379
South Korea
2013[7]
45
364
Slovakia
2010[1]
46
362
Belarus
2010[1]
47
361
Malaysia
2010[1]
48
353
Trinidad and Tobago
2007[1]
49
346
Israel
2012[8]
50
345
Hungary
2010[1]
51
336
Saudi Arabia
[6]
52
324
Taiwan
2013[9]
53
319
Latvia
2010[1]
54
314
Argentina
2007[1]
55
313
United Arab Emirates
2007[1]
56
309
Montenegro
2011[10]
57
293
Russia
2010[11]
58
Suriname
291
2010[1]
59
290
Libya
2007[1]
60
275
Mexico
2010[1]
61
249
Brazil
2011[12]
62
238
Serbia
2010[1]
63
235
Romania
2010[1]
64
230
Antigua and Barbuda
2009[1]
65
223
Saint Kitts and Nevis
[6]
66
219
Kazakhstan
2010[1]
67
215
Oman
2007[1]
68
214
Bosnia and Herzegovina
2010[1]
69
206
Thailand
2012[13][14]
70
204
Saint Vincent and the Grenadines
2008[1]
71
200
Turkey
2012[15][16]
71
200
Uruguay
2009[1]
72
Iran
200
2012[17]
73
188
Jamaica
2010[1]
74
184
Chile
2010[1]
75
179
Fiji
2010[1]
76
177
Costa Rica
2010[1]
77
176
Seychelles
2010[1]
78
175
Mauritius
2010[1]
79
174
Belize
2007[1]
79
174
Tonga
[6]
81
173
Ukraine
2010[1]
82
166
Saint Lucia
[6]
83
165
Jordan
2010[1]
84
165
South Africa
2010[1]
85
163
Dominica
[6]
86
159
Nauru
2004[18]
87
Moldova
156
2010[1]
88
155
Georgia
2010[1]
89
155
Republic of Macedonia
2009[1]
90
149
Singapore
2010[1]
92
147
Venezuela
2007[1]
93
146
Kiribati
2008[1]
95
133
Botswana
2009[1]
96
132
Panama
2010[1]
97
128
Dominican Republic
2009[1]
98
125
Tunisia
2010[1]
99
124
Albania
2010[1]
100
122
Grenada
[19]
101
114
Zimbabwe
2007[1]
102
114
Algeria
2010[1]
103
107
Namibia
2010[1]
104
Turkmenistan
106
2008[1]
105
105
China
2013[20]
106
103
Armenia
2007[1]
107
101
Azerbaijan
2010[1]
108
101
Cape Verde
2007[1]
109
95
Honduras
2008[1]
110
95
Guyana
2008[1]
111
94
El Salvador
2007[1]
112
89
Swaziland
2007[1]
113
81
Bahamas
2007[1]
114
77
Hong Kong
2010[1]
115
77
Samoa
2007[1]
116
76
Sri Lanka
2012[21]
117
73
Peru
2010[1]
118
73
Syria
2010[1]
119
Mongolia
72
2008[1]
120
71
Colombia
2009[1]
121
71
Ecuador
2010[1]
122
70
Morocco
2007[1]
123
68
Bolivia
2007[1]
124
68
Guatemala
2010[1]
125
60
Indonesia
2008[1]
126
59
Kyrgyzstan
2007[1]
127
57
Bhutan
2009[1]
127
57
Pakistan
2010[1]
128
57
Nicaragua
2010[1]
129
54
Paraguay
2009[1]
130
54
Vanuatu
[6]
131
50
Iraq
[6]
132
45
Egypt
2009[1]
133
Palestine
42
2010[1]
134
41
India
2011[22]
134
38
Angola
2007[1]
135
38
Cuba
2008[1]
136
38
Tajikistan
2007[1]
137
37
Uzbekistan
2004[23]
138
37
Micronesia, Federated States of
2007[1]
139
35
Yemen
2007[1]
140
33
Comoros
2007[1]
141
33
Guinea-Bissau
2008[1]
142
31
Nigeria
2007[1]
143
30
Philippines
2010[1]
144
30
Ghana
2009[1]
145
28
Maldives
2010[1]
146
28
Djibouti
[6]
147
Afghanistan
28
2010[1]
148
27
Congo, Republic of the
2007[1]
149
27
Sudan
2007[1]
150
26
Madagascar
2009[1]
151
24
Kenya
2010[1]
152
23
Vietnam
2013 [24]
153
22
Benin
2007[1]
154
22
Senegal
2008[1]
154
21
Cambodia
2005[1]
154
21
Zambia
2008[1]
155
20
Laos
2007[1]
155
20
Cote d'Ivoire
2007[1]
155
20
Slovenia
2011[25]
156
14
Cameroon
2007[1]
156
14
Gabon
2004[26]
156
Mali
14
2009[1]
157
13
Equatorial Guinea
2004[27]
157
13
Papua New Guinea
[6]
158
12
Haiti
[6]
158
12
Mozambique
2009[1]
158
12
Burkina Faso
2010[1]
159
11
Eritrea
2007[1]
159
11
North Korea
2006[28]
160
8
Malawi
2007[1]
160
8
Uganda
2009[1]
161
7
Myanmar
2010[1]
161
7
Tanzania
2007[1]
161
7
Gambia
2004[1]
161
7
Niger
2009[1]
162
6
Burundi
2007[1]
162
Sierra Leone
6
2008[1]
162
6
Chad
2006[1]
163
5
Congo, Democratic Republic of the
2007[1]
163
5
Guinea
[6]
163
5
Mauritania
[6]
163
5
Nepal
2007[1]
164
4
Central African Republic
[6]
164
4
Lesotho
2004[29]
165
3
Ethiopia
2007[1]
165
3
Somalia
[6]
165
3
Liberia
2007[1]
165
3
Bangladesh
2010[1]
165
3
Solomon Islands
2004[30]
166
2
São Tomé and Príncipe
2007[1]
166
2
Togo
2007[1]
Excerpts from: Why The Worst Is Yet To Come For Indonesia's Epic Bubble Economy
Record low interest rates have fueled an epic credit and consumption boom in Indonesia,
which is no small matter given the fact that domestic consumer spending accounts for
nearly 60 percent of the country’s overall $878 billion economy. For the past half-decade,
Indonesia’s annual GDP growth rate has averaged about 6 percent – the fastest in
Southeast Asia – thanks largely to their consumer spending boom.
According to Moody’s, Indonesia’s compound credit loan growth rate has been over 22%
for the past six years, while non-mortgage consumer credit nearly tripled in the last five
years. During this time, credit card use has greatly proliferated, with the number of credit
cards jumping by 60 percent, while the actual value of transactions almost tripled. Fears
of a consumer debt crisis forced Bank Indonesia to limit the number of credit cards a
single person is allowed to hold, while barring Indonesians who earn less than $330
(USD) a month from being issued credit cards.
With such rapid consumer credit growth, it’s unsurprising to see a concomitant rise in
consumer spending:
Automobile registrations have more than tripled since 2004:
International automakers including Nissan, Toyota and General Motors have taken notice
of Indonesia’s automobile boom, and committed up to $2 billion to expand their
manufacturing operations in the country in the next few years. Cheap financing has also
been fueling a surge in motorbike sales, an indicator of domestic consumption, which
grew 13.9 percent in August from a year earlier, after growing 21.3 percent in July. Retail
sales that have been growing at an annual rate of 10 to 15 percent in recent years have
attracted numerous Western consumer brands like L’Oreal, Unilever and Nestle that are
seeking to cash in on Indonesia’s spending boom.
Indonesia Also Has A Property Bubble
Cheap credit and property bubbles go hand in hand, and Indonesia’s bubble economy is
no exception. Though data for all Indonesian property markets are scarce, property
markets in Jakarta and Bali are becoming frothy, especially at the higher end of the
market. Jakarta condominium prices rose between 11 and 17 percent on average between
the first half of 2012 and 2013, after rising by more than 50 percent since late 2008.
Luxury real estate prices in Jakarta soared by 38 percent in 2012, while luxury properties
in Bali rose by 20 percent – the strongest price increases of all global luxury housing
markets. A small two-room apartment on the outskirts of Jakarta can cost nearly $80,000
USD (RM253,373), making housing unaffordable for many ordinary Indonesians.
The surge in real estate activity spurred a 70 percent rally in Indonesian property shares
in the first five months of 2013 (though they have sold off since then). Even Indonesia’s
central bank has become worried about a property and credit bubble, causing them to
issue new rules to curb speculation, including mandating a minimum 40 percent down
payment for the purchase of a second house or apartment (bigger than 70 m²).
Bank Indonesia has plenty to worry about when it comes to a mortgage bubble: from
June 2012 to May 2013, outstanding loans for apartment purchases nearly doubled from
IDR 6.56 trillion (USD $659.3 million) to IDR 11.42 trillion (USD $1.15 billion). In July,
the Bali branch of Bank Indonesia gave a warning that it was “on alert” for a possible
bursting of the island’s property bubble. Indonesian property boom apologists cite
soaring incomes and economic growth as a justification for the rise of property prices, but
the problem with their logic is that the country’s economic growth itself is being buoyed
by a credit-driven bubble.
-------------------------------------------------------------------------------This article is available online at:
http://www.forbes.com/sites/jessecolombo/2013/10/03/why-the-worst-is-yet-to-come-forindonesias-epic-bubble-economy
Banks From Around the World Target Middle Class With Financing for Autos, Home
Kathy Chu
Updated April 22, 2013 7:53 a.m. ET
HONG KONG—Lenders from around the world are fueling a boom in short-term loans
across Asia, helping push debt to record levels as a burgeoning middle class strives for a
better lifestyle and banks look to diversify away from the slow-growing West.
As China's middle class grows, so does their debt. Shaun Rein from China Market
Research talks about what Chinese consumers are buying with the 320 million credit
cards currently in circulation in China.
Nonmortgage consumer credit in Asia outside of Japan rose 67% in the past five years to
$1.66 trillion by the end of 2012, according to data provider Euromonitor International.
In the U.S. the rise was only 10% during the same period as consumers cut back on debt
following the financial crisis.
The lenders are targeting Asia's middle class, which is expected to grow by an average of
more than 100 million people each year. They are pitching everything from credit cards
to short-term installment loans for motorcycles and appliances. Interest rates can range
from 15% for secured auto loans to as much as 40% for unsecured loans, appliances and
electronics, driven by high demand for loans and little or no credit history for the
borrowers. Loans are typically paid back over six months to five years.
For lenders suffering from a glut of deposits, low interest rates and weak economies in
the West, Asia is crucial for their growth. By 2020, more than half of the world's middle
class is expected to reside in Asia, compared with one-fourth in 2009, estimates
Brookings Institution economist Homi Kharas.
Rising borrowing is expected in economies at this stage of development, and many of the
companies have experience lending in markets such as these.
Enlarge Image Close
But some people are concerned about the growth. "The worry that's developing is that
debt is being pushed onto borrowers who might not have the capacity to repay," says
Frederic Neumann, co-head of Asian economic research for HSBC Holdings HSBA.LN 1.03% HSBC Holdings PLC (UK Reg) U.K.: London GBp606.20 -6.30 -1.03% April 7,
2014 5:08 pm Volume : 18.91M P/E Ratio 10.98 Market Cap GBp115.66 Billion
Dividend Yield 8.23% Rev. per Employee GBp247,733 04/07/14 Barron's: HSBC
Highlights Tape... 04/04/14 Consolidation Wave Likely for ... 04/03/14 Soft Yen Helps
Tokyo Shares More quote details and news » PLC.
In Jakarta, Wiwik Sugiarti lined up at a department store with half a dozen others in
February to arrange financing for a $400 LG Electronics 066570.SE +2.84% LG
Electronics Inc. S. Korea: KRX KRW68800 +1900 +2.84% April 7, 2014 3:00 pm
Volume : 1.68M P/E Ratio 70.42 Market Cap KRW10948.04 Billion Dividend Yield
0.29% Rev. per Employee N/A 04/04/14 Apple, Android Continue to Lea... 03/25/14 LG
Offers Fresh Peek at Its Ne... 03/21/14 What WSJ Canada Is Reading Fri... More quote
details and news » ' television set, months after buying a refrigerator and DVD player on
credit.
"It eases my monthly budget," says Ms. Sugiarti, 37 years old, the owner of a small
grocery shop. "I can buy two or three things at the same time and not have to worry about
how to pay for it now."
In China, Citigroup Inc., which became the first Western bank to issue its own credit
cards there last year, is seeing one of its fastest growth rates in credit-card accounts in the
world, a bank spokesman said. The bank wouldn't disclose details on that growth.
France's Crédit Agricole SA ACA.FR -2.00% Credit Agricole S.A. France: Paris €11.73 0.24 -2.00% April 7, 2014 5:39 pm Volume : 4.55M P/E Ratio N/A Market Cap €29.96
Billion Dividend Yield N/A Rev. per Employee €650,889 03/28/14 France's Ceva
Spearheads Riski... 03/27/14 Banks Lead U.K. Shares Lower 03/25/14 Yuan Swings
Between Gains and ... More quote details and news » plans to expand its auto loans in the
country by more than one-third this year to roughly 54,000 through a joint venture with
local partner Guangzhou Automobile Group Co. 2238.HK +0.36% Guangzhou
Automobile Group Co. Ltd. Hong Kong $8.34 +0.03 +0.36% April 7, 2014 4:01 pm
Volume : 8.20M P/E Ratio 16.52 Market Cap $57.87 Billion Dividend Yield 1.82% Rev.
per Employee $599,351 More quote details and news » Amsterdam-based PPF Group
NV's Home Credit, which lends in places such as Belarus and Slovakia, said it is
approving about 5,000 loans daily in China for mobile phones, appliances and
motorcycles, more than double the number in 2011.
In Indonesia, where nonmortgage consumer credit nearly tripled in the last five years,
domestic lenders Astra International ASII.JK +2.56% Astra International Indonesia:
Jakarta IDR8000 +200 +2.56% April 7, 2014 4:14 pm Volume : 78.39M P/E Ratio 16.70
Market Cap IDR315771.71 Billion Dividend Yield 1.60% Rev. per Employee
IDR1,462,470,000 More quote details and news » and PT Bank Danamon's Adira
Finance are expanding, despite tighter lending standards, while Japanese lender Mizuho
Financial Group 8411.TO -2.38% Mizuho Financial Group Inc. Japan: Tokyo ¥205 -5 -
2.38% April 7, 2014 3:00 pm Volume : 78.14M P/E Ratio 6.81 Market Cap ¥5091.70
Billion Dividend Yield 3.41% Rev. per Employee ¥50,165,400 03/27/14 Japanese Banks
Name First Wome... 02/26/14 New Fed Rules Could Impact 17 ... 02/03/14 Asian Banks
Push Into New Mark... More quote details and news » has purchased an Indonesian autofinance firm to get a foothold in the country's fast-growing consumer-finance market.
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Even in India, where defaults on personal debt rose sharply during the global financial
crisis, the number of credit cards outstanding ticked up 7% to 18.9 million last year,
driven in part by Western players such as Citigroup and Standard Chartered STAN.LN 0.71% Standard Chartered PLC U.K.: London GBp1255.00 -9.00 -0.71% April 7, 2014
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Lenders emphasized that they are being careful when they offer credit and said they were
focusing on middle-class borrowers who could afford what they are buying.
Citigroup is expanding credit-card, mortgage and other consumer lending in a
"disciplined manner in several high-growth markets" in Asia including China, India,
Taiwan and Australia, bank spokesman James Griffiths said. In the first quarter of 2013,
Citigroup's consumer lending in Asia grew 1% year over year to $69.3 billion.
Throughout Asia outside Japan, car and motorcycle loans nearly doubled from 2007 to
2012 to a record $219.7 billion. Appliance and electronics loans also more than doubled
in the region to a high of $10.9 billion, Euromonitor data show. During this time, creditcard loans grew 90% to a record $234.1 billion, according to Euromonitor.
Overall debt levels in many Asian economies are lower than in the West, but debt
burdens relative to individual income are up to 30% higher compared with the U.S. in
countries such as Malaysia, China, South Korea, Thailand, Indonesia and India, HSBC
research shows. An added concern is that debt is a bigger burden for low-income people
who have smaller financial cushions when times get tough.
Asia has a tortured history with debt. Over the past decade or so, Taiwan, South Korea
and Hong Kong have all grappled with credit-card meltdowns that destabilized their
economies.
Mindful of the risks, regulators in Asia are taking action. In the past year and a half,
China, Malaysia and Indonesia have reined in mortgage, credit-card or motorcycle
lending. Bank Indonesia Deputy Director Yunita Resmi Sari said the central bank
imposed a minimum down payment for car and motorcycle loans last year to limit banks'
credit risk and to ease consumers' debt burden.
Consumer groups in Asia, which until recently were focused on issues such as high utility
bills and rising food prices, are also becoming concerned about aggressive lending and
debt collection.
A leading Vietnamese provider of motorbike loans, Kuong Bank, advertises online a
1.91% monthly interest rate, equal to a more than 20% annual rate, but doesn't explain
that borrowers pay interest on the full loan amount even as the balance is paid down, says
Alice Pham, director of the Hanoi chapter of Consumer Unity & Trust Society, a research
and advocacy group.
Kuong Bank didn't respond to requests for comment.
—Resty Woro Yuniar in Jakarta and Miho Inada in Tokyo contributed to this article.
Write to Kathy Chu at kathy.chu@wsj.com
EXECUTIVE SUMMARY TURKEY
Consumer lending registers another year of strong growth
The post-recession growth in consumer lending continued at an equally fast pace during
2013, as both outstanding balance and gross lending registered positive growth, though
the outstanding balance growth was slower. Despite the decline in consumer optimism
which has been growing since the end of the recession in 2012, consumers are still
confident about the current and future outlook of the economy, and are willing to finance
their spending with consumer loans. Despite government measures to reduce loanfinanced spending, declining APR also had a major influence on the growth in consumer
lending.
Government introduces new measures to strengthen consumer lending
With the years of successive positive growth starting from the end of the recession, the
government felt the need to introduce new measures to cut back consumer spending as
well as to improve the health of the consumer lending category, which is essential to the
functioning of the banking system. With major restructuring of the banking system
following the recession of 2001, Turkish banks have become less vulnerable; yet, the
growth in consumer lending and banks’ efforts to seize shares in this category have
loosened their lending discipline. Starting in 2013, the government has introduced a
series of measures including a centralised credit scoring system, helping banks to
evaluate potential borrowers, thereby decreasing the risk of defaulting on consumer
loans.
Banks continue to dominate consumer lending in Turkey
Consumer lending in Turkey is dominated by major private banks, such as Garanti
Bankasi, Yapi ve Kredi Bankasi, as alternative lending institutions are almost nonexistent in major categories, except for auto lending. Only in auto lending, are there other
lending institutions that have a significant share of loans extended. New lending
institutions are expected to enter the mortgages category in 2013, and new players are
expected to enter the category considering the growth potential in mortgages.
Mortgages/housing category grows as property boom in major cities continues
Despite being relatively new to the Turkish market, mortgages/housing grew strongly
within consumer lending in 2013. Growing middle-class demand for new housing and the
supply created by government agencies and private property developers also created a
major market for mortgages/housing. Private banks compete with each other, while
cooperating with developers to attract borrowers by offering accessible low-cost loans to
consumers. The government’s major move for urban renewal is expected to result in even
higher growth, with the government subsidising part of the interest charged for these
loans.
Consumer lending is expected to continue to see growth in all major categories
Compared to the review period, consumer lending is expected to register strong growth
over the forecast period. In terms of outstanding balance, growth will be even stronger
due to increasing payment periods as a result of declining APR and growing confidence
in the general outlook of the economy.
Consumer Lending in Turkey - Industry Overview
EXECUTIVE SUMMARY
Consumer lending registers another year of strong growth
Government introduces new measures to strengthen consumer lending
Banks continue to dominate consumer lending in Turkey
Mortgages/housing category grows as property boom in major cities continues
Consumer lending is expected to continue to see growth in all major categories
KEY TRENDS AND DEVELOPMENTS
Urban renewal reform fuels further growth in mortgages/housing
Positive growth continues across all consumer lending categories
Government introduces new regulations to guarantee the health of the banking system
Country Report
Consumer Lending in Indonesia
Mar 2014|Pages: 14
EXECUTIVE SUMMARY
2013 another strong year amidst more restrictions
Consumer lending in Indonesia boomed over the review period, driven by the rising
number of middle-class households and continued economic growth. With Indonesian
consumers growing more accustomed to the concept of borrowing money from the bank,
more banks shifted their focus towards consumer lending. At the same time, the
Indonesian government monitored the development of the country’s consumer lending
industry and started to pass more legislation towards the end of the review period so as to
prevent a credit bubble or overheating of the market. Some of these regulations were
already in place over 2012/2013, including ‘Loan to Value’ legislation which regulates
the minimum down payment amount for a loan application. This new legislation has been
cited as the main reason behind slower gross lending growth in 2013 compared to 2012.
Other legislation starting to be implemented is that with regard to the maximum number
of credit cards which can be owned.
Demand for apartments and small homes supports mortgages/housing growth
Unlike in many other countries, mortgages/housing is not the main contributor to the
consumer lending industry in Indonesia. Instead, auto lending – chiefly for motorcycles –
was the most popular type of consumer lending over the review period. However, with
urbanisation and the rising middle-classes, an increasing number of younger Indonesian
families are purchasing their own homes instead of living with their extended family.
This has led to strong growth in demand for small houses, and more recently in the cities
for apartments among those with limited budgets. In turn, growth in mortgages/housing
gross lending and outstanding balance has also been strong as more consumers turn to
financial institutions to finance the purchase of their home.
Local banks remain the top lenders to consumers in Indonesia
As a still growing industry, the consumer lending environment in Indonesia still has
relatively few players. The majority of loans to consumers over the review period derived
from several key banks, many of which are government-owned, including Bank Rakyat
Indonesia (BRI), Bank Negara Indonesia (BNI), Bank Tabungan Negara (BTN) and Bank
Mandiri. The government-owned banks typically have a strong focus on
mortgages/housing. In comparison, private local banks also offer more varied types of
consumer credit, ranging from auto lending to multi-purpose loans (covered as part of
other personal lending). These loan products cover smaller amounts than
mortgages/housing and have shorter payment periods.
More controlled consumer lending environment will keep growth in check
To continue on from the several new regulations drawn up towards the end of the review
period in an attempt to prevent the consumer lending industry from overheating, the
Indonesian government is expected to implement further restrictions to regulate consumer
lending over the forecast period. Amidst rising concerns about the growing proportion of
non-performing loans among lower-income households in 2013, more regulations linked
to income levels may be announced. All in all, the government’s efforts along with
steadier demand are expected to result in less robust growth in gross lending and
outstanding balance over the forecast period.
Consumer Lending in Indonesia - Industry Overview
EXECUTIVE SUMMARY
2013 another strong year amidst more restrictions
Demand for apartments and small homes supports mortgages/housing growth
Local banks remain the top lenders to consumers in Indonesia
More controlled consumer lending environment will keep growth in check
KEY TRENDS AND DEVELOPMENTS
More legislation in place to prevent a credit bubble
Mortgages/housing growth continues to soar
More banks step up their loan offers to attract more consumers
EXECUTIVE SUMMARY CANADA
Rate of increase in consumer lending slows in 2013
Both mortgages/housing and consumer credit lending slowed in 2013, but remained
firmly in positive territory. Lower margins for prime mortgage loans are guiding
chartered banks to seek higher growth lending opportunities. Record low mortgage
payments as a percentage of income are keeping consumers spending, but the days of
double-digit gains in home equity are past. Consumer borrowing will become more
dependent on gains in income rather than home-asset appreciation going forward.
Low interest rates to prevail at least to end of 2013
The Bank of Canada is holding the line on interest rates, as a revised GDP forecast places
growth lower than expected. Mortgage rates have hit record lows as chartered banks have
looked to revive tepid mortgage lending in the face of slowing housing activity since the
second half of 2012. Lower interest rates are also underpinning growth in non-card
lending, particularly in auto lending.
Lower margins on prime mortgages polarise lenders
Margin compression on residential mortgages is forcing non-bank lenders out of the
prime lending market. Growth in sub-prime mortgages and uninsured mortgages may
cause regulators to scrutinise the lending practices of financial institutions for excessive
risk going forward. Sub-prime lending is benefiting from favourable margins, and a
larger pool of borrowers who have failed to qualify under the tightened mortgage
regulations enacted since July 2012. Sub-prime lending is further bolstered by
immigration-driven population growth and an increase in self-employed Canadians.
Automobile loans drive non-card lending
Following record auto lending growth in 2012, the pace of auto lending in 2013 has
slowed but still represents one of the strongest opportunities among non-card lending
categories. Auto lending durations are getting longer, and this is allowing consumers to
purchase the vehicles they desire at record low monthly payments. Automakers are
ramping up their new product introductions to capitalise on pent-up demand for new cars
following years of recession-mediated purchase deferrals.
A balanced real estate market bodes well for consumer credit
The 2013 real estate market is returning to more sustainable levels in terms of both
volume and value, which suggests moderate growth in both mortgages/housing and noncard lending going forward. If regulatory tightening of mortgage rules alone fails to cool
housing activity in the longer term, look for modest increases in interest rates once the
Canadian economy returns to GDP growth targets.
Consumer Lending in Canada - Industry Overview
EXECUTIVE SUMMARY
Rate of increase in consumer lending slows in 2013
Low interest rates to prevail at least to end of 2013
Lower margins on prime mortgages polarise lenders
Automobile loans drive non-card lending
A balanced real estate market bodes well for consumer credit
KEY TRENDS AND DEVELOPMENTS
Tighter mortgage regulations cool the Canadian housing market
Continuation of low interest rates a key support for residential lending
Consumer debt continues to rise as a percentage of disposable income
Consumer Lending in Germany
Jan 2014|
EXECUTIVE SUMMARY
2013 consumer lending primarily for home building, renovation and durables
The German economy slightly cooled down in 2013, but consumer sentiment remained
strong. Low unemployment, especially among young and middle-aged people, helped
underpin many people’s readiness to take out new loans. Loans are primarily taken out
for lasting assets such as home renovation, durables and home building. However, some
German families also take out loans to cope with the rising cost of living, seeking to
bridge monetary shortages via consumer credit.
Consumers turn their back on overdrafts following negative media reports
Overdrafts represented a key credit vehicle in Germany up to 2013, as nearly all
consumers own a current account, but credit cards have only a very limited presence. In
the past, most Germans had tolerated double-digit interest rates that most banks charge on
overdrafts, because overdrafts do not require any paperwork. However, criticism by
several consumer protection agencies, which featured across all major media in 2012 and
2013, has made consumers more aware of the losses incurred when using the overdraft
option. More consumers thus avoided the use of overdrafts in the first place by taking out
alternative types of loans.
Home and education lending see strongest performance in 2013
Home and education lending have seen the strongest performance in 2013. In terms of
home lending, strong performance is a result of the need for refurbishment in many
German post-war buildings. In terms of education lending, rapid growth is a result of
tightened curricula that leave students no time to have a job outside their studies. Both
home and education lending are driven by public subsidies that are managed by the
public body Kreditanstalt für Wiederaufbau (KfW).
Growth of direct banks continues in 2013, but loses some momentum
Direct banks such as Ing-DiBa, Comdirect Bank, 1822direct and Netbank gained share in
consumer lending during the review period due to their offering flexible lending
conditions and attractive rates of interest. The speed of growth of these banks has
somewhat slowed towards the end of the review period, when compared to the first
decade of the millennium, but has not stopped. Consequently, the two principal banking
associations Deutscher Sparkassen- und Giroverband eV (DSGV) and Bundesverband
der Deutschen Volksbanken und Raiffeisenbanken eV (BVR) lost ground in consumer
credit, as well as the three major commercial banks Deutsche Bank, Commerzbank and
HypoVereinsbank.
Steady outlook for consumer lending in Germany over 2013-2018
Consumer lending is expected to remain quite stable in terms of outstanding balance,
gross lending and non-performing loans over the forecast period. This is likely due to the
tight lending criteria of German banks designed to prevent any type of credit bubble in
the private lending sector. The high competitiveness of the German economy within the
Eurozone and low unemployment will contribute to the stability of the consumer lending
business. Home lending is expected to see the fastest growth in absolute terms, as
Germans are keen to cocoon in times of global turmoil.
Consumer Lending in Germany - Industry Overview
EXECUTIVE SUMMARY
2013 consumer lending primarily for home building, renovation and durables
Consumers turn their back on overdrafts following negative media reports
Home and education lending see strongest performance in 2013
Growth of direct banks continues in 2013, but loses some momentum
Steady outlook for consumer lending in Germany over 2013-2018
KEY TRENDS AND DEVELOPMENTS
Repayment cycles become shorter due to low interest rates
Confidence in real estate drives mortgages and home lending growth
More consumers seek cheaper alternatives to overdrafts
Country Report
Consumer Lending in China
Jan 2014
EXECUTIVE SUMMARY
Consumer lending slows further but remains robust
Consumer lending slows further in line with a decelerating local economy and uncertain
global outlook. However, overall consumer lending retained its robust double-digit
growth pace in 2013, supported by the strong market demand for mortgages/housing and
card lending. On the other hand, other consumer lending categories, such as auto lending
and home lending, continue to register a strong growth momentum, boosted by
consumers’ growing acceptance of credit consumption and the rising pursuit of personal
wellbeing.
Mortgages/housing remains dominant in the market
Mortgages/housing has taken the lion’s share of total consumer lending in China over the
review period, owing to the explosive development of the housing market. To curb
speculation and prevent the bubble bursting, relevant authorities have introduced a series
of measures, including increased down payments and housing loan rates to buyers of
second homes and no loan at all to buyers of third properties. As a result,
mortgages/housing has experienced decelerating value growth over the review period, but
still remains dominant in total consumer lending in 2013, thanks to the strong market
demand from newly-weds and ongoing urbanisation.
Non-banking institutions are strong in innovative new launches
Apart from banks, other non-banking institutions are also active in launching innovative
consumer credit products. Alibaba Financial Co Ltd trial launched credit payment service
to AliPay users who make online purchases on the online shopping platforms under
Alibaba Group via their mobile phones and tablets. The automatically-granted consumer
credit to AliPay users, ranging from RMB200 to RMB5,000, based on their age, job and
online transaction records, makes it easier for mobile transactions, a move that is likely to
be followed by other third party payment service providers in China over the forecast
period.
Supporting rules and regulations to promote consumer lending
The State Council’s green light to the reduced card transaction fee since February 2013,
proposed by People’s Bank of China, has resulted in a positive impact on card lending,
which experienced the most robust value growth in outstanding balance in the same year,
in addition to its relatively small consumer base as compared to non-card lending. On the
other hand, Chinese consumers are more open to consumer credit, in line with their rising
product awareness and increasing personal wealth.
Consumer lending to maintain steady forecast growth
Consumer lending is expected to maintain steady forecast value CAGRs in both
outstanding balance and gross lending over the forecast period, to be underpinned by the
steady market demand for consumer credit, particularly card lending. Dominant
mortgages/housing is expected to record a declining percentage of total consumer lending
value sales over the forecast period, following strict control of the housing market to
prevent further bubbles.
What’s the state of credit quality in the market?
Has the economic downturn reset the lender competitive landscape?
Consumer Lending in China - Industry Overview
EXECUTIVE SUMMARY
Consumer lending slows further but remains robust
Mortgages/housing remains dominant in the market
Non-banking institutions are strong in innovative new launches
Supporting rules and regulations to promote consumer lending
Consumer lending to maintain steady forecast growth
KEY TRENDS AND DEVELOPMENTS
Mortgages/housing represents a rising share of total consumer lending
Card lending remains robust
Cardless and contactless consumer credit emerges
Country Report
Consumer Lending in India
Jan 2014
EXECUTIVE SUMMARY
Consumer lending grows at a high rate in 2013 despite tight economic conditions
Consumer lending grew at a higher rate in 2013 than in 2012 and in 2011. This was
despite negative economic sentiment in terms of low growth, high inflation and high
interest rates. The high growth was partly due to smart positioning of products by banks,
such as pushing credit cards, housing loans and auto loans to self-employed individuals
and partly it was because the impact of recession was less on individuals compared to the
corporate segment. Not only growth was higher in 2013, but bad assets were also on the
lower side than in previous years.
Sentiment remained negative in Indian economy in 2013
The overall sentiment remained negative in the Indian economy through 2013. The
growth in gross domestic product was a fraction of its peak level in 2007. Inflation
continued to remain high in certain pockets, as the price of vegetables soared. The Indian
rupee depreciated significantly throughout the year. Reserve Bank of India – the apex
body – did not find conditions conducive to cutting key rates. In the absence of rate cuts,
banks were not in a position to cut lending rates, which was considered important to
boost credit growth. The only silver lining was that the retail side of lending performed
better than the corporate side, giving breathing space to all financial institutions
Scheduled commercial banks continue to lead consumer lending in 2013
Banks such as State Bank of India, Punjab National Bank, ICICI Bank Ltd, HDFC Bank
Ltd, Bank of India, Bank of Baroda and Axis Bank Ltd continued to dominate consumer
lending in 2013. These entities fall under scheduled commercial banks (SCBs). The
reason that these entities dominated was their decades-long experience in the Indian
market, huge capital bases and wide branch networks. Apart from banks, several nonbanking financial companies (NBFCs) were also a part of consumer lending. Such
entities were smaller in scale than banks because they could not raise money through
savings and current deposits. NBFCs had to raise money from money markets and,
therefore, they operate on a much smaller scale than banks. Apart from NBFCs, several
microfinance institutions (MFIs) also operated in this business. SCBs, NBFCs and MFIs
continued to attempt to reduce the share of informal money lenders in 2013.
Card lending witnesses fastest growth in 2013
Credit card outstanding balance witnessed the fastest growth in 2013. This was because
retail banking consumers continued to report significant growth in disposable incomes.
Based on this, banks felt assured of their creditworthiness and focused more on credit
cards in 2012 and 2013. Banks realised that the slowdown affected the corporate segment
more than retail consumers. This was because a very small fraction of Indians worked in
the corporate sector. A large part of the population continued to be self-employed in
small businesses. Such consumers continued to post growth in their income and bankers
realised their continued creditworthiness. Therefore banks targeted such individuals to
grow their credit card portfolios.
Consumer lending expected to post strong growth over the forecast period
Consumer lending is expected to see continued strong growth in outstanding balance in
constant value terms over the forecast period. This will be due to rising disposable
incomes, the growth of banks and other financial institutions and increasing financial
inclusion. More consumers will come under the ambit of organised means of financing,
rather than informal money lenders, who generally charge exorbitant rates of interest.
Consumer Lending in India - Industry Overview
EXECUTIVE SUMMARY
Consumer lending grows at a high rate in 2013 despite tight economic conditions
Sentiment remained negative in Indian economy in 2013
Scheduled commercial banks continue to lead consumer lending in 2013
Card lending witnesses fastest growth in 2013
Consumer lending expected to post strong growth over the forecast period
KEY TRENDS AND DEVELOPMENTS
Fall in gold prices affects gold loan companies in the first half of 2013
Mortgages/housing lending witnesses stronger growth in 2013
Reserve Bank of India (RBI) accepts applications for fresh banking licence in 2013
Consumer Lending in Chile
Jan 2014|
EXECUTIVE SUMMARY
Consumer lending records another year of growth
Consumer lending posted year-on-year double-digit current value growth between 2010
and 2013. Auto lending and home lending supported fast growth, with ongoing
urbanisation boosting consumer interest in automotive and home improvement purchases.
Regulatory change increases control over the industry
Following two important decisions by the Supreme Court of Justice, Chile’s regulatory
agencies started to make significant changes to the laws governing consumer finance.
The main modification is the ban on unilateral adjustments to contracts, a fairly common
practice in the industry.
Traditional banks continue to lead consumer lending
Consumer lending continues to be dominated by traditional institutions. Banco Santander,
Banco de Chile and Banco del Estado de Chile are the top players in consumer credit and
mortgages/housing. These banks are expected to remain the leaders in the forecast period.
Consumer unease puts pressure on banking legislation
Student demonstrations and the proliferation of citizens’ organisations increased the
pressure on the authorities to implement restraints on financial activity. The increase in
the educational levels of Chileans has helped to create more active and involved citizens,
who demand reform of the major institutions of the country to make them more
transparent and open to scrutiny.
Consumer lending’s future remains unclear
The erratic performance of the main Asian economies has generated doubts about the
economic prospects of Chile. As the country is highly dependent on copper exports to
China and other Asian countries, a significant drop in the manufacturing activity of Asia
would have a negative impact on Chile’s balance of trade. Chile faces a deficit scenario
from 2013. This situation could become serious if the unemployment rate rises and the
state’s budget decreases.
Consumer Lending in Chile - Industry Overview
EXECUTIVE SUMMARY
Consumer lending records another year of growth
Regulatory change increases control over the industry
Traditional banks continue to lead consumer lending
Consumer unease puts pressure on banking legislation
Consumer lending’s future remains unclear
KEY TRENDS AND DEVELOPMENTS
Consumer credit booms, though some doubts remain
“110% credit” supports the expansion of mortgages/housing loans
Supreme Court decisions accelerate regulatory change
http://www.rebels.co.za/images/downloads/8-TransUnion_Owen_Sorrour.pdf
Final Discussion Question:
What are the primary benefits and detriments of regulations that free up the flow of
consumer credit? To those that limit the flow of consumer credit?
Where is the sweet spot?
To what extent would one set of rules for all countries in the world be a good or bad
idea?