Rethinking Compliance in Consumer Credit

JO ANN BAREFOOT

Prolific consumer credit regulation may be doing more harm than good. Is it time for a new approach?

| SYNOPSIS | Consumer credit protections generated by Congress and the regulators over the last 38 years have had both positive and negative results, according to consultant Jo Ann Barefoot. The positive include increased home ownership by low-income and minority households and more credit opportunity for women. Negative effects include consumer confusion, rising household debt and lower savings rates. Current controversies over subprime mortgages and credit card practices are likely to increase the regulatory burden on banks. Barefoot argues for a new approach to consumer credit compliance, one that upholds the intent of the laws while reducing the paperwork required to implement them.

In 1969, Congress passed the Truth in Lending Act to protect credit consumers by requiring disclosures. The law became the first of many aimed at equipping people to make sound financial decisions by providing them with more information about financial products. Almost forty years later, the legacy of these laws is a massive apparatus of mandatory disclosures that provides consumers with voluminous and complex information at a cost that is now embedded in the price of financial services.

Has this system worked? Are people protected from unfair practices and ill-advised choices in consumer and mortgage credit? Is the regulatory apparatus worth what the public pays for it? Or has it, possibly, evolved beyond a tipping point at which information overload actually harms, rather than helps, public understanding and self protection?

Does anyone even read credit disclosures?

In May, the Federal Reserve Board proposed sweeping changes to Regulation Z's rules for open-end revolving credit, especially credit cards. Led by Sandra Braunstein, consumer and community affairs director, the Fed took the unprecedented step of testing its regulatory ideas with actual consumers. They asked people what they found confusing about their credit cards and what information they wanted, when they wanted it and in what language and formats. Within the constraints imposed by the statute, the agency has proposed a sweeping reform of our open-end credit rules and plans to follow it up with a similar overhaul for closed-end, fixed-term lending, including mortgages. (For more details see Fed proposal)

I have worked with financial consumer protection issues for over 35 years, helping write and enforce the laws and regulations and then working with nearly all the country's largest banks and scores of community banks striving to get compliance right. In my judgment, the Fed's proposal opens a window of opportunity to rethink our old and overgrown legal framework.

The starting point is to assess where we are today. Depending on one's perspective, the picture can be deemed good, bad or downright ugly.

The Good
In the past four decades, consumer and mortgage credit have been democratized. Products which were once available only to the elite and affluent are now accessible to all. One result is that America's homeownership rate is nearly 70%. It is rising fastest, moreover, among minorities and lower-income families. From 1995 to mid-2006, homeownership rates were up 7% for whites, 11% for blacks and 19% for Hispanics. For the period from 2001 to 2003 alone, mortgage lending rose 17% for blacks and 30% for Hispanics.

Similarly, over the past decade, home lending has grown by 45% in low-to-moderate income census tracts, compared to 19% for higher income tracts. The number of Americans living in high-poverty neighborhoods has plunged drastically. And sex-based discrimination, common and explicit before the 1970s, is exceedingly rare.

This progress has been driven by technology, especially in credit scoring and risk-based pricing, and by burgeoning competition. Banks should feel proud of their role in bringing these changes. At the same time, it seems clear that regulation has played an important role in opening markets to minorities and lower income people.

The Bad
The above trends bring to mind the aphorism, "Be careful what you wish for." The same forces that have made credit widely accessible also produced unintended consequences.

In the last two decades, household debt as a share of personal income more than doubled, to 125%. Credit card debt grew from less than 3% of personal disposable income in 1980 to more than 9% last year, when Americans had an average of 12 credit cards per household and 60% carried a monthly balance. Research suggests that half of low- and middle-income families use credit cards for rent, groceries and utilities.

This high borrowing is the flip side of low savings rates. In 2005, America's net savings rate turned negative for the first time since the Great Depression and has stayed there. From 1990 to 2004, median household income rose 11%, median spending rose 30% and median debt rose 80%. Outstanding household debt doubled.

To be sure, some alarmists are over-hyping these issues. A 2006 Federal Reserve report concluded that consumers don't face excessive debt load. Federal Deposit Insurance Corp. (FDIC) chairman Sheila Bair testified in June that since the early 1990s, revolving credit has held steady, around 11%, as a percentage of overall household debt. Furthermore, many of these spending and debt increases are rational and prudent responses to low interest rates.

They also reflect rising living standards that most Americans see as positive; the average house size has risen 40% since 1980. And savings rate figures exclude asset appreciation in home equity and other investments, which are growing sources of household wealth.

Nevertheless, these big shifts in demographics and culture will pose huge challenges in the years ahead. Home equity is being eroded by the refinancing boom; approximately half the proceeds are being spent on consumer goods and services, eroding a key source of family savings. Furthermore, America is headed into a crisis with the rising costs of Social Security and Medicare. Already, half of all doctor visits are by baby boomers. Private pensions are underfunded. Millions of baby boomers are borrowing and spending rather than saving for retirement, while millions of young people live in a consumption-driven culture treasuring instant grat-ification of material wants over traditional virtues like patience, thrift and security.

These trends will affect America's global competitiveness, fiscal burdens and future quality of life. Lenders will find themselves caught in the vortex of political controversy when they are tagged as enablers of high spending and low savings, or "pushers" of easy credit.

The Ugly
Credit democratization and choice have also opened the market to millions of people who are vulnerable to manipulation and abuse or to making poor financial choices. Lack of financial knowledge, limited education, poor language skills and dysfunctional behaviors involving gambling, addictions and employment and legal problems pull many people into credit situations that damage their lives. Another problem: fear of discrimination and/or the legacy of past lack of access to and experience with credit. For instance, one-third of African-American borrowers with good credit think they have bad credit, making them targets for aggressive marketing of suboptimal products.

The most dramatic fallout from these trends is in subprime mortgage lending, which grew from 5% of the market in 1994 to over 20% today. Subprime delinquencies topped 13% in the fourth quarter of 2006. Over the next two years, two million American families may face foreclosure as their adjustable rate mortgages (ARMs) reset to much higher levels, with projected equity losses over $160 billion. Foreclosure proceedings were initiated against one in every 200 homeowners in late 2006. An AP/AOL poll found that the people most likely to have ARMs are minorities, young, low income, poorly educated and unmarried. The FDIC reports that subprime borrowers spend nearly 37% of their after-tax income on mortgage payments and housing costs, which is 20 percentage points above prime borrowers and is up 10 percentage points in just six years.

Not surprisingly, consumer advocates and lawmakers are challenging a wide range of industry mortgage practices, including stated income loans, "payment option" ARMs, negative amortization, interest-only loans, hybrid mortgages, teaser rates, prepayment penalties, yield-spread premiums, equity stripping, loan flipping, refinancing without tangible benefit and mandatory arbitration. Some argue for a "suitability" standard making creditors responsible for assuring that customers take an appropriate loan.

If mortgages are topping the headlines, credit card practices are not far behind. A new book and feature film, Maxed Out, blames credit card debt for widespread wreckage of human lives and even suicide, portraying banks as intentionally misleading and abusing customers. Critics point especially to fees, which are up nine-fold over the past eight years. Consumer advocates charge that the industry uses a two-tiered strategy in which people who pay their full monthly balance receive a high-value product at reasonable cost, while those who don't pay their monthly balance generate most of the industry's profits. Congressional hearings this year raised complaints of abusive practices, even including shifting payment due dates and mailing addresses to make customers miss due dates.

Senators heard, for example, testimony from Wesley Wannamacher of Lima, Ohio, who obtained a credit card from a major issuer in 2001 to finance his wedding. Wannamacher had a credit limit of $3,000, but charged $3,200. The issuer assessed him $4,900 in interest, $1,100 in late fees and $1,500 in over-limit fees (47 times, for being late on three occasions). Ultimately, Wannamacher paid $6,300 on his initial $3,200 debt. He still owed an additional $4,400 when the bank forgave his balance, a few days before he testified.

The bank involved described Wannamacher's case as an aberration. But a growing chorus of critics believes credit cards today victimize millions of people who don't understand their terms and risks. Newsweek consumer columnist Jane Bryant Quinn wrote in April, "Banks don't cancel your cards, as they did in the old days; they just keep charging until you break."

A General Accounting Office (GAO) report faulted the industry for burying key information in unrelated text, failing to group and label related material, using small typeface and wording disclosures at a 10th to 12th grade reading level, when half the United States reads at 8th grade proficiency or below. The GAO found, as did the Fed in its research on Regulation Z, that cardholders cannot find key information.

The people most likely to be mired in high credit card debt and penalties are, again, those considered most vulnerable. Minorities are more likely than whites to carry a credit card balance. Average overall indebtedness of borrowers aged 25 to 34 grew by 47% between 1989 and 2004 and the FDIC says young people "appear less likely to make timely debt payments" than did earlier generations. Meanwhile, 70% of low-and middle-income households that carry at least three months of credit card debt use it for necessities. Families with annual income under $20,000 owe 14.3% of income; families making over $100,000 owe only 2.3%.

Accordingly, industry practices are under fire, including: high interest and penalties, "vanishing" grace periods, "endless" late fees, double-cycle billing, retroactive price hikes on balances incurred under lower rates, universal default, charging for paying online or by phone, marketing to college students, mandatory arbitration and rising merchant interchange fees.

Critics are also attacking lengthy contracts that bury disclosures in dense legalese and fine print. They ask why issuers even permit over-limit card usage and assess high fees for it, rather than simply deny an over-limit purchase. They argue for prominent disclosure of the time and total cost that will be needed to pay off a balance by making only minimum payments. They are challenging the lender's right to make unilateral changes to an active credit card agreement to add or increase fees, lower credit limits, shorten grace periods and impose universal default with only 15-days notice. In testimony at Senate hearings this year, Professor Elizabeth Warren of Harvard Law School said, "Credit cards are unsafe...because they are designed to be unsafe."

Many of these concerns would be addressed by the Fed's proposed new rule, as is the creditors' current right to produce disclosures such as, "This fixed rate may vary..."

Updating the Strategies
These trends suggest that the disclosure model of consumer protection is failing. Not completely, to be sure-the "good" in today's credit picture remains significant. Nonetheless, we face a situation in which:

• The credit industry is producing huge quantities of disclosures, at extremely high expense and fraughtwith high legal liability for errors, all of which raise the price of credit to the consumer.

• The disclosures are too voluminous and complex to be helpful to the customer.

• Their great volume and complexity, in fact, deter consumer understanding. Because customers don't even attempt to comprehend the information, or even read it.

• Despite all these "protections," millions of consumers are being caught in credit products that are harming them.

Surely this is a lose-lose scenario. What are the solutions? We need a combination of five kinds of strategies, updated for the modern world:

1. The market
As information technology continues to improve, sophisticated customers will improve their ability to gather comparison data, understand pitfalls and choose the best deals. Their influence will help shape the market overall. Government should be wary of regulatory actions that try to block market forces that are essentially unstoppable; such policies tend to carry very substantial unintended consequences. The industry, meanwhile, should undertake voluntary self-policing. Any lender that knows it makes money because its customers don't understand the deal should change its business model. Lenders should eliminate disclosures that obfuscate rather than illuminate and should root out products and product terms that build profits based on customer confusion.

2. More "hard" regulation
Congress will almost certainly isolate and outlaw certain practices that are deemed intrinsically unfair, abusive or unsound, regardless of how well they are disclosed. But again, today's competitive market tends to "flow around" such obstacles by inventing different approaches faster than the regulatory process can react. A particular challenge is that credit products are rapidly evolving and are highly individualized, based on customer creditworthiness, needs and usage, making it increasingly hard to pin down a generic "type" of action to prohibit.

Still, it's appropriate to identify truly egregious practices and bar them completely. In general, financial institutions will reap some competitive benefit from such steps since "predatory" practices are used mainly by non-banks. Unfortunately, these benefits will come with a high price tag, since any likely action will probably raise banks' regulatory burden far more than initially anticipated. That has been the story of consumer protection rules in banking from the start.

3. More "soft" regulation
The federal regulators should and will continue to issue rules and guidance. One such move is the June 29, 2007 interagency statement on subprime lending, which curbs stated income lending and effectively bars underwriting to a low but adjustable "teaser" rate. More broadly, the agencies should clarify the Federal Trade Commission Act prohibition on "unfair and deceptive practices" as it applies to credit. These are highly subjective terms that invite after-the-fact interpretation and tend to confound efforts to define and regulate them upfront.

Unfortunately, banks cannot hope for relief from back-end enforcement and litigation by federal enforcement agencies, state attorneys general, consumer groups and private class actions. Still, the primary banking agencies should do the hard work of providing meaningful guidance on what is deemed unfair and deceptive and should provide creditors with reasonable safe harbors for good faith efforts to follow these standards.

4. More consumer education
In theory, this is the best answer. A knowledgeable consumer understands the offered loan product, is alert and wary about adverse terms and knows how to compare choices and negotiate deals. Good education would be a win-win. The public would be better equipped to make good decisions. The industry would be much less vulnerable to requirements aimed at protecting the least sophisticated borrowers in ways that add costs and complexity for everyone. And ethical, reputable companies would benefit over unethical competitors because the market would reward fair products and prices.

Currently, financial education has limited benefit, because the people who need it rarely take advantage of it, or not in time to avoid harm. The problem with consumer financial education is not lack of materials. The banking trade associations, individual banks, multiple federal agencies and numerous non-profits all have excellent materials. The weak link is the low motivation of consumers to learn and the absence of an effective delivery system to bring them knowledge in a way that connects with their interests and lifestyles. My own view is that financial education should be routinely provided in grade school, high school and college. At the same time, government or a private "trusted source" should harness the Internet to provide true, trustworthy, widely recognized ways of comparing products and recognizing abusive loans and lenders.

5. Better disclosure
The notion that disclosure is better than regulation is grounded in sound market principles and is essentially right. A well-informed consumer can theoretically stand with the lender on a level playing field and protect himself. After 40 years of heavy reliance on the disclosure model, however, we return to the question: are these disclosures protecting the consumer? And are they delivering high protection at a cost commensurate with their value? The answer has to be... not well enough.

A New Model
It is time to begin to build a new model designed specifically for the modern market, rather than retrofitted for it. Doing this would be difficult both substantively and politically. Sweeping change would raise risks and costs for lenders and cause even more confusion for customers short term. The financial services industry, despite its enormous current regulatory burdens, would worry about opening settled law and regulations to pursue uncertain reforms that would, at best, create transition problems and, at worst, could ultimately impose even more burdensome requirements. Consumer advocates, meanwhile, would resist streamlining disclosures for fear of letting lenders "hide" adverse information.

This would be the kind of major policy shift that evolves over years of study and debate. The Fed's proposed Regulation Z rule can spark that dialogue. Former treasury secretary William Simon once said the United States deserves a tax code that looks like someone wrote it on purpose. The same is true for consumer financial laws. Instead of "tinkering" with our Rube Goldbergian regulatory contraption, we should consider starting over and building a sleek machine for the Information Age.

The essential element would be shorter disclosures. Rather than attempting to capture every nuance of a loan, these notices would explain the main issues—and because they're short, they would be read. They should be displayed prominently and segregated from other material. They should use standardized terms and laymen's language. Their terms and formats should not be designed by lawyers but instead, as the Fed's new proposals, by market-testing what consumers understand and find useful.

It is time to recognize that in credit disclosures, the perfect is the enemy of the good... and that less can be more.