New Consumer Regulation: Education and Disclosure Is Not Enough
by Ethan Cohen-Cole
Elizabeth Warren’s appointment as special advisor to the president was widely hailed as an achievement for consumer advocates. Professor Warren has long been a strong advocate of the middle class and famously compared financial products to flaming toasters.
The creation of a new agency brings new possibilities and new risks for consumer advocates. Most importantly will be the agency’s approach to regulation. In a two-part posting, I will comment on two key aspects of the new agency’s direction. The first revolves around understanding of consumer behavior and the second around firm behavior.
Part 1:
A core component of the CFPB mission is based around the idea that banks provided risky products to consumers that didn’t understand them. There is abundant evidence that consumers didn’t understand the products they bought; however, it’s far from clear that this is a sufficient role for the CFPB. I’ll argue here that in addition to disclosures, education and information, we need explicit regulation of the products as well.
Effectively, this boils down to a simple question: if banks want to offer a risky product (a flaming toaster) to consumers that fully understand its dangers, should the bank be permitted to offer it?
Let’s compare two views of the world:
1. Banks should be allowed to offer risky products to individuals that understand them. The (simplified) argument is that a combination of financial education, disclosure and product standardization will lead to consumers understanding the risks of the products they purchase and, as a result, will prevent 1) predatory lending and possibly 2) future crises.
2. Banks should not be permitted to do so because
- The average consumer is unlikely to be able to fully understand many existing products.
- Even in the highly unlikely case that individuals fully understand the products, the products may include personal incentives to use them that have systemic consequences. A recent paper finds evidence to support this. Put another way, the toaster might burn down the neighbor’s house too.
I think it would be very hard to argue that the crisis would not have happened or that individuals would have been better off if they had understood the products completely ex-ante. Similarly, it would be hard to claim that the foreclosure mess we now see not would not have happened.
I point to a few reasons in favor of explicit regulation of products (in addition to consumer information and disclosure).
1) Consider a very knowledgeable individual with a poor credit history. When academic and policy makers think about credit quality, we often assume (incorrectly) that an individual with a high credit score is necessarily one who understands the system and one with a low score is someone who doesn’t understand. To see that this is false, one needs only to look at the literature on causes of bankruptcy. If bankruptcy is even partially due to negative personal events such as divorce, bad health, or unemployment, there must be some low score individuals who previously understood the system and had high scores. This soon-to-unlucky person, is offered a loan that he can afford if he keeps his job and can’t afford if he loses it. If he fails to pay, he loses his house and suffers a cost to his credit score, but gains free rent for the period of time it takes to foreclosure. For example, it take a couple years in Florida to foreclosure on a house (Nice NYT graphic). This creates the very real situation in which individuals have a large private gain to taking a risky product and a large public loss if many do the same. Similarly the bank generally has an incentive to issue the loan, even if it knows some borrowers with default.
Unfortunately, complete information, perfect financial understanding and standardized products do not prevent this from occurring. Economists refer to this as an ‘externality.’ The deal works for the borrower and the bank, but at some cost to everyone else. The trick is finding a way to ensure that too many risky loans are not made.
2) The above example is a wildly optimistic one based on the assumption that consumers can correctly calculate the probabilities both that they can repay and the value of the loan (and thus whether they WANT to repay) See, for example. Understanding this, even for the most knowledgeable individuals is not simple. In addition to understanding the product itself, she needs to understand, at the time of the loan, the expected path of interest rates, the distribution of this path, the conditional probabilities of economic outcomes based on these interest rates, their own future job outcomes, etc. As well, the individual needs to understand that the loan will likely be packaged and sold and that the final buyer may have different incentives and policies to pursue foreclosure (see current foreclosure crisis).
Perhaps this is too much information to expect a consumer to know? I can buy a toaster without worrying about the electrical standards that govern its use; I simply trust that I can use it repeatedly without fear of its catching on fire.
If one stays with disclosure and education alone, we run the risk on going down a path in which consumers must digest complex information about increasingly complex products. As a system, we leave to chance that there are counterbalancing forces that prevent many consumers and banks from entering into mutually-beneficial arrangements that are costly to the economy as a whole.
I personally think that the solution lies is the explicit regulation of products that can be demonstrated to be safe for the individual, the bank, and the system.
The question is then how to approach the product regulation itself?
India’s Microfinance Industry Fuels Suicides
Most of us remember Muhammad Yunus’s 2006 Nobel peace prize for microfinance, small loans to start businesses, with extremely low default rates. Now it looks like this industry has done what many American financiers have done, lent more than people can ever pay back, in order to make greater profits. In India and other parts of Asia, however, cultural factors mean that over indebtedness causes more than just sadness and bankruptcy. This lending without regard to ability to repay has causes suicide on the part of borrowers. This is particularly insidious, given that- unlike home loans or payday loans in the U.S. - the whole point of microfinance is to help the poor start businesses.
Moreover, the industry itself faces imminent collapse as almost all borrowers in one of India’s largest states have stopped repaying their loans, egged on by politicians who accuse the industry of earning outsize profits on the backs of the poor. Indian banks, which put up about 80 percent of the money that the companies lent to poor consumers, are increasingly worried that they could now face serious losses. Indian banks have about $4 billion tied up in the industry. Initially the work of nonprofit groups, the tiny loans to the poor known as microcredit once seemed a promising path out of poverty for millions. In recent years, foundations, venture capitalists and the World Bank have used India as a petri dish for similar for-profit “social enterprises” that seek to make money while filling a social need. Like-minded industries have sprung up in Africa, Latin America and other parts of Asia. Some companies have more than doubled their revenues annually. Recently, one of India’s largest for-profit micro lenders, SKS Microfinance, went through an initial public offering, fueling anger. The company is backed by famous investors like George Soros and Vinod Khosla, a co-founder of Sun Microsystems.SKS and its shareholders raised more than $350 million on the stock market in August.
And it’s not just money at stake of course. People are committing suicide over the shame of not being able to pay the debts back. A 30-year-old mother of two boys poured 2 liters of kerosene on herself and lit a match, after she and her husband argued bitterly the day before over how they would repay multiple loans. Shobha Srivinas, was being pressured to pay interest on her 12,000 rupee ($265) loan. Lenders also were demanding that she cover for the other women who had borrowed, since borrowers essentially guarantee each other’s loans in order to use social pressures to ensure repayment. She had her husband are both dead after he was unable to put out the flames and got caught in them himself. More than 70 people committed suicide in this particular Indian state from March 1 to Nov. 19 to escape payments or end the agonies their debt had triggered. According to Malcom Harper, Microcredit has become “Walmartized” by unrestrained selling of cheap products to the poor. “Selling debt is like selling drugs,” says Harper, 75, the author of more than 20 books on microfinance and other topics.“Selling debt to illiterate women in Andhra Pradesh, you’ve got to be a lot more responsible.”
This is obviously not the way Yunus designed the loans. Yunus, 70, had his own ideas about which profits were proper when setting up microloans, which he set at the cost of funds plus 10 percent, he says. Indian micro lenders themselves borrow from banks at 13 percent or more on average and extend credit to the poor. They charge interest rates that can rise to 36 percent. “Microfinance has been abused and distorted,” Yunus said. “I feel so sad because that’s not the microcredit I have created.” He also reports being embarrassed, and is now less happy to be a founder of microfinance.
What’s in Your Wallet Part II: Let’s Shop for Credit Cards
I have been enjoying talking to my UNM colleagues about Katie’s post on what’s in our wallets. There are different credit cards for every demographic imaginable. For example, there are cards with rights to all airport clubs and even the right to a personal shopper, for the truly rich and famous. There is plenty of free pizza to be had with the cards touted to college students.
While I fancy the Costco Amex, my colleague Peter Winograd suggests the US Bank VISA Travel Card (20,000 points qualifies for a $400 ticket on any airline, plus a 10,000-point bonus for first use plus double points for certain categories of purchases); the Compass Bank VISA (5% return on purchases at drugstores, supermarkets, gas stations, plus 1% on everything else); the CitiDividend MasterCard (5% on certain categories of purchases, with the categories changing every three months; 1% on everything else)…
I’d love to hear more about some of the other gems out there so, like Bob (I mean George Clooney), I’d relish some reader participation, particularly thoughts on which cards they love. You can also shop here if you currently have no favorite.
And, I have a question. When should a person actually pay an annual fee on a credit card? I usually (call that always) opt against annual fees, but I am sure there are times when it pays to pay them. Let’s hear it.
Auto Title Lending Data
Todd Zywicki has written several articles (here and in a fuller version here) on auto title pledge lending that cite default rates on auto title loans are 14-17%, while repossessions occur only in 4%-8% of cases and in 20% of those cases the borrower redeems the car. These numbers are cobbled together from several disparate sources, so they might not all fit together, but from this (and borrower characteristics) Todd concludes there’s no basis to claims that auto title lending is predatory.
These numbers long seemed too good to be true to me—they would imply either huge profit margins (which Todd disputes) or huge overhead costs (Todd’s explanation). They also seemed highly skewed by the fact they were counting loans rather than borrowers. Title loans are 30-day loans that can be rolled over, but a roll-over counts as a new roll, which effectively inflates the denominator for default rates.
I came across a rather obscure Tennessee Department of Financial Institutions study (actually cited by Todd) that has some numbers from examinations of title lenders, and it seems to tell a somewhat less rosy story about title lending.
Following a change in Tennessee’s auto title pledge law, the Tennessee Department of Financial Services put out two reports (here and here) on auto title lending in the state based on its examinations of title lenders. The 2008 report has data from 2006. There were 139,319 new title pledge loans made in Tennessee in 2006 (roll-overs excluded), all for $2,500 or less. The average loan was $557.70.
By my calculation, the duration of the average loan was 4.95 months (it actually might be longer, but the report lumps together all longs with 11 or more rollovers—I treated them as all having exactly 11 rollovers for my calculations), meaning there were on average approximately 4 roll-overs or that the real term of a title loan was 5 months on average. 88% of loans outstanding had rolled over at least once.
Tennessee title pledge lending resulted in 18,199 vehicles being repossessed in 2006. While there is not perfectly matched data on loans and repossessions (repossessions in 2006 include loans made in both 2005 and 2006), if we assume a steady level of auto title lending (which probably isn’t right–the number of outstanding loans was 20% higher in Dec. 2006 than Dec. 2005), this translates into 13% of loans (18k/139k) or approximately one in seven resulting in a repossession (not default) rate. That alone is significantly higher than the rate reported by Zywicki.
I had previously been taking this 13% and multiplying it by the roll-over rate, which resulted in a eye-popping 65% repossession rate. Jim Hawkins, in a very helpful comment rightly noted that there’s no reason to multiply this figure by the roll-over rate as the denominator is only “new” loans, not roll-overs. The number that I’ve been interested in is not the percentage of loans that result in repos, but the percentage of borrowers who lose their cars annually. The 139k figure is still likely an inflated denominator for my purposes, as it double counts individuals who took out multiple title loans in a year, but whatever the resulting increase, it surely doesn’t match the roll-over rate. Let’s say it means a 15%-18% repossession rate. If so, that’s quite different from 4%-8% (but hardly 65%…). Todd also cites a range of LTVs on title loans from 33% to 100%; if these loans are at the lower-end of that range, that implies an awful lot of equity stripping going on, which makes me think that title lending is often predatory.
A second point of interest–Tennessee has an (extremely high) pricing cap for title loans: 22% per month. But only about 60% of lenders are pricing at the cap. A substantial minority are pricing beneath it. And the industry has healthy profit margins–13% on average before taxes. And this doesn’t include money taken out by owners in the form of salary or other benefits). That doesn’t fit with Todd’s explanation of low margins due to high overhead costs and stiff competition. To me these sort of margins suggest that the usury cap isn’t restricting credit in a major way and that it might be too high.
Now maybe title lending in Tennessee is just different from everywhere else. For example, if Tennessee permitted much higher rates than other states, then maybe the industry is able to accommodate a riskier borrower base, which would translate into more defaults and repossessions. Tennessee does have a very high bankruptcy filing rate. It’s not clear whether there’s any correlation between title borrowers and bankruptcy filers (Skiba and Tobacman find a correlation for payday and bankruptcy, albeit of relatively small magnitude if I recall), so maybe Tennessee title borrowers are an unusually risk group, which would account for the high repo rate. I have no way of knowing if Tennessee is unique or typical, but the Tennessee data certainly makes me hesitate to accept Todd’s conclusions about title lending.
A final thought: this Tennessee Department of Financial Services report is really good. It’s a shame we don’t see more of this sort of study from state bank regulators, and that they don’t coordinate studies. I think this sort of data is a real service for policy issues. Hopefully this sort of examination-based study is what we will see the CFPB producing.
So here’s a question for Credit Slips readers: am I reading this Tennessee data correctly? Any thoughts on its interpretation?
Hot Pursuit of Customers: The Real Reason More People are Turning to Payday Loans
As one who studies the advertising and marketing plans of payday and title loan companies, I was interested in two Wall Street Journal articles published this week on the topic of payday loans, one claiming that Dodd-Frank has pushed many consumers into the hands of payday lenders, and another describing how hard payday lenders are working to steal customers from banks. Since many payday loan customers do not fully understand the terms of the loans, it isn’t that hard to steal customers from banks. Payday loans, often at least ten times more expensive than credit cards, are easier to get. The lenders are far friendlier to customers and have more locations and business hours. Plus, have you seen the advertising? It makes it sound easy and even fun to take out a 500% loan. Payday loan industry experts now claim that their toughest business challenge going forward is not collecting on bad loans but finding enough new customers to keep the hundreds of thousands of stores afloat. Payday loan volume dropped $38.5 billion in 2009, or 24% since 2007, in part because of state regulation. Industry has successfully dodged regulation in some state, mostly by claiming that customers desperately need these loans for emergencies. The truth of this statement seems critical to the survival of this industry, but let’s look at the industry’s advertising and the real uses of these loans.
Payday lenders are getting quite desperate for customers, and thus now offer loyalty programs to get people to refer their family and friends, whether these friends and family members have an emergency or not. They offer similar loyalty programs to get people to keep the loans out longer, whether they have a continuing emergency or not. They offer more loans as soon as one loan is paid off, whether the customer has an emergency or not. The advertising suggests that people use the loans to get through the holiday gift-giving season, even to go out to eat! It is time to really study how these loans are being advertised, and also to look at how they are actually being used. My own data show that less than 10% of the loans are actually used for emergencies.
As for this idea that Dodd-Frank is the driving force in pushing people into the hands of payday lender, this is not the case. Customers were borrowing from payday lenders when they could use banks well before Dodd Frank or the Credit Card Act. The real cause of this shift is the payday loan industry’s own search for customers, as well as their advertising, which claims loudly and repeatedly that payday loans are good for anyone or everyone, any time, and are not just for emergencies.
Debt Causes Bankruptcy (But Sometimes in Counter-Intuitive Ways)
I like NPR’s Marketplace, but stories like this drive me nuts: “Why bankruptcy claims aren’t as high as one would think.” The story repeats a premise I often hear in media calls that I receive. The conversation usually starts something like this: “Foreclosures are up, unemployment is high, the economy is a wreck: why have bankruptcies stopped climbing?”
Wrong question. But fair enough. I get called because I am supposed to know something about bankruptcy filing rates, and my caller often has just picked up the assignment for the day. If that is the wrong question, what should we be taking away from trends in bankruptcy filing rates?
Bankruptcy is a legal act with legal consequences. Bankruptcy filings are not a bellwether indicator of the economy’s health. Foreclosures, unemployment, and general economic conditions certainly play a role in determining the bankruptcy filing rate, but other factors are more important. At best, the bankruptcy filing rate is a weak and trailing economic indicator.
In trying to understand the bankruptcy filing rate, it is better to focus on the legal consequences and legal incentives for people who file bankruptcy. Specific legal rules mentioned in the NPR story–procedural requirements and rules on home mortgages–are also undoubtedly playing a part, but these rules are too specific to be playing a major role. The explanations are all trees and no forest.
People file bankruptcy to discharge debt (at least in the United States). No debt, no bankruptcy. In the long run, the overall bankruptcy filing rate will rise and fall with the amount of consumer debt. As people accumulate more debt, bankruptcy demand will grow. That is why we see countries often adopting American-style consumer bankruptcy laws featuring debt forgiveness as consumer debt in that country increases. Without lots of consumer debt, talking about bankruptcy filings rates is like talking about snow accumulations in Honolulu.
The long-term growth in U.S. consumer bankruptcies closely tracks the long-term growth in U.S. consumer debt. When the financial crisis hit, consumer credit dried up, and outstanding consumer debt experienced unprecedented declines. There are fewer reasons to file bankruptcy today because there was less borrowing two to three years ago.
Consumer debt also has a profound but perhaps counter-intuitive short-term effect on consumer bankruptcy rates. In the short-run, a decline in consumer credit will lead to a bump in consumer bankruptcy filings. As people run out of options–as they become less able to put this month’s grocery or utility bills on a credit card–bankruptcy becomes a more attractive option. People can and will continue to borrow to stave off the day of reckoning. If a lender is willing to extend credit, further borrowing is a rational decision. After all, the consumer can become “none more broke” by borrowing further but might see things turn around tomorrow if they can get by just one more day on a credit card. Students of option pricing should quickly grasp the point.
The numbers bear out these effects. The graph to the right shows a close relationship between total consumer debt and bankruptcy filings. As consumer debt goes down in a particular month, bankruptcy filings tend to rise. Clicking on the graph should bring up a larger image in a pop-up box, and at the bottom of the post is some information about how the graph was constructed. The correlation is not perfect, but my claim is not that the correlation is perfect. A clear, negative relationship does exist. The takeaway message is that focusing on current foreclosure rates and unemployment to explain bankruptcy filing rates misses more important features of the story.
Right now, both the long-term and short-term effects of consumer credit are working in the same direction to tamp down the bankruptcy filing rate. There are lower levels of consumer debt because of decreased borrowing two or three years ago and hence less overall reasons for people to file bankruptcy. Also, with a reported easing of the consumer credit market, consumer who are at the brink have a slightly easier time borrowing to put off a bankruptcy filing. Given these dynamics, it is not surprising that bankruptcy filings are leveling off or declining and that a mathematical model predicts a decline in the bankruptcy filing rate for 2011.
The macrodata will fail to explain any individual case. A foreclosure, a job loss, a medical problem, and many other problems will be the primary impetus for many consumers will find themselves in bankruptcy court. These reasons explain why someone ends up filing bankruptcy, but they do not provide much help in explaining when they end up in bankruptcy court. Looking at trends in bankruptcy filing rates is all about the “when” question, and here macrodata are very helpful. The ups and downs of consumer debt levels tell us much–not everything, but much–about these trends.
Using data from Epiq Systems on bankruptcy filings and from the Fed for consumer debt, the graph compares monthly changes in the daily bankruptcy filing rate to monthly changes in the total amount of consumer debt outstanding. The graph begins in 2008 because of the anomalous effects the 2007 financial crisis had on outstanding consumer debt. Using 2007 data does not qualitatively change the results. The same phenomenon also can be observed historically, before the 2005 changes to the bankruptcy law. Bankruptcy filings are graphed against the left axis, and total consumer debt is graphed against the right axis. Both axes use different scales to make for easier comparisons. Also, the right axis for consumer credit has been inverted.
CARD Act Compliance Costs Outweigh Fee Benefits?
CARD Act Compliance Costs Outweigh Fee Benefits?
The American Banker has an interesting piece on the impact of the Credit CARD Act. It’s behind a paywall, but here’s the key insight:
Credit card issuers were expected to raise fees and cut rewards to compensate for lost revenue from new regulations. But some have done the opposite, eliminating fees they are still permitted to charge. Most banks have increased certain costs, such as purchase annual percentage rates, and added annual fees for some cardholders in response to the Credit Card Accountability, Responsibility, and Disclosure Act’s new restrictions on rate increases, penalty fees and other terms. The ones that have also eliminated fees — including Bank of America Corp. and Wells Fargo & Co. — claim they did so as part of an effort to be more transparent. Some experts offer another explanation: it may simply be cheaper for issuers to drop these fees rather than bring them into compliance.
At the very least, this indicates that the impact of the Credit CARD Act is more complex than its critics would have it.
What are avoidance powers in bankruptcy?
Bankruptcy relief accomplishes three main goals: i) for the debtor, provides the necessary “breathing room” to propose a debt adjustment plan or reorganization plan; ii) for the debtor’s creditors, ensuring property of the estate (which includes wages earned post-petition) is distributed in accordance with priorities set forth under the Bankruptcy Code; and iii) preservation and maintenance of estate property.
While in many respects, bankruptcy is safe haven for consumers allowing the debtor to keep certain property necessary for the maintenance and support of themselves and their family, the true essence of bankruptcy is orderly distribution of estate property and preservation of the estate for the benefit of the debtor and the debtors creditors. Once accomplished, the creditors should receive all they could have received had the estate been liquidated (which is sometimes nothing), and the debtor gets a fresh start, such as the Chapter 13 discharge.
A part of the “estate preservation” concept in bankruptcy is the notion that certain transfers of property before a bankruptcy case is filed are subject to the “avoidance powers” of a trustee. These powers are found in Chapter 5 of the Bankruptcy Code (sections 544, 546, 547, 548 and 549). In the hypothetical, the estate representative (typically a trustee – but, in certain circumstances, the debtor) can file a lawsuit to recover property transferred to another entity prior to the filing of the bankruptcy petition or avoid liens that were not property perfected, among other things.
A debtor in chapter 13 also possesses certain “avoidance powers.” However, the Bankruptcy Courts throughout the country are split as to what extent a debtor in a Chapter 13 case can utilize such powers. Some jurisdictions allow the debtor in a Chapter 13 case to exercise all avoidance powers as if the debtor was the trustee. Other Bankruptcy Courts have held that, because the goal of Chapter 13 is debt readjustment, as opposed to recovery of property, the Chapter 13 debtor cannot exercise the trustee avoidance powers (also construing section 1303 of the Bankruptcy Code narrowly as juxtaposed with a comparable provision of Chapter 11, section 1107). Other Bankruptcy Courts still are of the opinion that, as long as the Standing Chapter 13 Trustee signs onto the suit as the plaintiff, the Chapter 13 debtor can sue to avoid certain transfers.
Avoidance powers are significant to Chapter 13 debtors for reasons other than preserving the estate for creditors. Oftentimes, creditors will haphazardly make filings in the public records encumbering the chapter 13 debtor’s property that is otherwise exempt from creditors notwithstanding the bankruptcy filing. To this end, and what has appeared to go unnoticed by the Bankruptcy Courts, are the avoidance provisions of 11 U.S.C. 522(f) (avoidance of liens on the debtor’s personal property that the creditor did not particularly lend the money for); and, in particular, 11 U.S.C. 522(g) & (h), which specifically states that the debtor may utilize the trustee’s avoidance powers if i) the creation of the lien or transfer of the property was involuntary; ii) the trustee does not attempt to avoid the transfer; and iii) the property transferred or the lien created affects the debtor’s exempt property.
So what does this all mean? Well, if the mortgagee did not property prefect its lien upon a debtor’s homestead (to the extent the homestead is exempt under state or federal law) prior to when the Chapter 13 case is filed, the Chapter 13 debtor may be able to avoid it all together. If a credit union empties a Chapter 13 debtor’s bank account within 90 days of filing the Chapter 13 case, the debtor may be able to avoid the transfer and recover the funds (to the extent exempt). If an ex-husband is owed a debt from the chapter 13 debtor (and is not considered alimony or support) and takes off with some of the Chapter 13 debtor’s property, the Chapter 13 debtor may be able to recover the property. If a car is repossessed prior to when the chapter 13 debtor filed his/her case, and title has passed to the lien holder, the debtor may be able to recover the vehicle as an avoidable preferential transfer.
