One of the most frequent things you hear in the debates over consumers' interactions with financial products is that we need better "financial literacy" to combat predatory lending practices. But what does it mean for a consumer to be financially literate? Is that enough? Especially at this historical moment, where financial expertise seems completely discredited, how do we go about educating consumers in financial literacy?
In 2005, The Department of Defense released their Report On Predatory Lending Practices Directed at Members of the Armed Forces and Their Dependents (opens pdf). In this report, they defined what they considered Predatory Lending and how best to go about combating it. What did they find?
One issue with research and activism into financial education is that the credit card companies are everywhere funding it. Read into the subtext, especially in the comments, at this Felix Salmon post. This isn't bad on first thought, but once you realize that it isn't at all controversial that people who get into the most trouble with credit cards are the most profitable to the companies you must conclude that efforts by credit card companies to educate consumers about how to use their products effectively are either (a) an uneffective gimmick for good press or (b) the equivalent of a manger leaving $20 bills all over the sidewalks at the expense of shareholders. Which do you think it is?
The Department of Defense is, for better or worse, not at all dependent on donations from credit card companies to keep their doors open, so they can go ahead and say whatever they feel like about the matter. How do they define predatory lending (PL) in their report? (Their report doesn't touch on mortgages.) PL seeks out young and inexperienced borrowers with bank accounts and steady jobs who have flawed credit; they make loans "based on access to assets (through checks, bank accounts, car titles, tax refunds, etc.) and guaranteed continued income, but not on the ability of the borrower to repay the loan without experiencing further financial problems." So the first isn't bad; it's what we expect from anyone who is going to be lending to distressed consumers. The second is more worrisome. How much worse does it get?
"Predatory products feature high fees/interest rates, with some requiring balloon payments, while others pack excessive charges into the product. The result of their efforts is to obfuscate the comparative cost of their product with other options available to the borrower." This is where reforms like the vanilla product option would have done a lot of good; high fees and balloons are considered bad, but why? Because, by increasing confusion about the actual price of a commodity, they keep the price mechanism from doing its job. One does not have to be a major Hayekian to think that not being able to use prices as a feedback mechanism to firms, by forcing them to compete on a clearly identifiable price, doesn't allow the market mechanism to do its job.
And lastly: "Most of the predatory business models take advantage of borrowers' inability to pay the due loan in full and encourage extensions through refinancing and loan flipping. These refinances often include additional high fees and little or no payment of principal." This is the subprime model of course; 80% of subprime loans were refinanced within 30 months, collecting a nice prepayment penalty (usually denoted in terms of months of interest, to make it harder for consumers to think in terms of the mortgage itself.)