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.)
So what is to be done? The DoD, after instituting a wide range of financial education programs, concluded:
Although the Department of Defense provides extensive financial training, a significant number of Service members ... still fall victim to easy credit widely available around bases or online. Education does not trump the marketing of these loans and the easy availability of quick cash with few questions asked... Additional educational efforts to curb the use of potentially harmful short-term lending products can only go so far. As with many other forms of abusive practices, some limits are also needed in the supply of these services.
Education helps, but there are some things that should be off-limits. So what do they propose in terms of additional limits? They requested, among other items:
- "Require all fees, charges, insurance premiums and ancillary products sold with any extension of credit to be included within the definition of finance charge for the computation and disclosure of the APR."
- "Lenders should be prohibited from directly or indirectly imposing, charging, or collecting rates in excess of 36 percent APR with regard to extensions of credit made to Service members and their families. This APR must include all cost elements associated with the extension of credit, including the "optional" add-ons commonly used to evade ceilings, such as credit insurance premiums...It is understood that such an interest rate cap may limit the availability of credit to certain Service members...A clear, unambiguous rate ceiling is justified given the high fees, interest and other charges associated with loans to Service members."
- "Prohibit lenders from using checks, access to bank accounts and car title pawns as security for obligations. These methods provide undue and coercive pressure on military borrowers and allow lenders more latitude in making loans without proper regard for the Service member's ability to repay. They also place key assets at undue risk."
- "Prohibit provisions in loan contracts that require Service members and family members to waive their rights to take legal action."
Wow. A usury cap for Service members, fees included, at 36%. Not being able to waive rights for legal actions. Proper disclosure of fees into APR. These are incredibly strong measures compared to the CFPA that President Obama is proposing.
So I'm curious if the Republicans who sponsored these measures into law will be supporting President Obama on the CFPA. Representative Geoff Davis (R-KY) proposed most of the reforms in his Military Personnel Financial Services Protection Act and Representative Sam Graves (R MO) introduced the Servicemembers Anti-Predatory Lending Protection Act to handle the Usury cap. Davis' bill passed; Graves bill was later incorporated by Senators Jim Talent (R-MO) and Bill Nelson (D-FL) into the FY 07 DoD Authorization bill. I contacted both congressman's offices to see if they, given that they've legislated pretty hard in this area of consumer financial protection, had any comment on the upcoming CFPA legislation. Rep. Graves's office told me that they want to wait before seeing the final bill before commenting. I look forward to hearing from them -- I'm curious as if their idea of what is necessary and what is sufficient has changed regarding consumer finances in the past 3 years.