The beauty of this approach is that it would help families get out of debt
without costing taxpayers a dime
. How would it work? By harnessing the energy of the marketplace. Lenders themselves would transform mortgage and credit card practices just by acting in their own best interest. Since they would no longer be allowed to charge exorbitant interest rates to families with marginal credit records, it would become unprofitable for lenders to pursue families in financial trouble. Instead, banks would once again have a reason to screen potential borrowers carefully, making loans only to those who really can afford to repay.
We hear the antiregulation camp clear their throats, ready to explain why regulating the credit industry (or any other industry, for that matter) is a bad idea. On the surface, their logic sounds convincing. A deregulated market reduces costs and provides more choices for home buyers and credit card holders, so consumers should win out—eventually. Besides, as federal judge Edith Jones wrote, “Nobody is holding a gun to consumers’ heads and forcing them to send
in credit card applications.”
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People always have the option of walking away from an overpriced mortgage offer or an outrageous credit card offer.
But this argument rests on one very important supposition—a well-functioning market for credit. Any honest economist will explain that markets work efficiently only when there is a level playing field, when consumers have full information about the costs and risks associated with whatever they are purchasing. The evidence is strong that the lending playing field is anything but level. After all, if the market were working properly, how could Citibank sell 40 percent of its high-priced subprime mortgages to families with good credit who would have qualified for low-cost mortgages? How could the company’s loan officers get away with charging extra fees to anyone who “appeared uneducated”? And why would low-income whites get better terms on their mortgages than high-income African Americans? A perfect market free to operate without government interference certainly sounds good, but it is little more than a fantasy held up to distract policymakers while lenders rake in profits from those who never quite figure out the terms in fine print.
The argument for reregulation of consumer lending is a lot like the argument for regulating any other useful but potentially dangerous product. Consider the toaster. People buy toasters for home use. No one makes them buy toasters, and they could live without toasters. If they understood electrical engineering, they could evaluate the safety of each toaster under every possible scenario. But toasters are regulated. No toaster manufacturer may peddle toasters that have even a 1 percent chance of catching fire. Toaster makers (and conservative economists) could point out that riskier toasters could be made more cheaply, and that permitting their sale would expand the number of toaster owners in the country. Companies might put special disclaimers and instructions on their toasters, telling customers how to extinguish the fires themselves. But as a nation, we have collectively decided that the risks posed by an unregulated toaster industry are not acceptable.
The government regulates the sale of millions of products—everything from children’s pajamas to aspirin to automobiles—to protect consumers from the risks of substantial injury. For most of America’s history, loans to consumers fell squarely within that definition. Interest rates and other terms were carefully limited by state legislatures and patrolled, when necessary, by state attorneys general. Predatory loans may not set houses on fire the way a faulty toaster might, but they steal people’s homes all the same. America has had more than twenty years to observe the effects of a deregulated lending industry, and the evidence is overwhelming. It is time to call the experiment a failure.
Reregulation would help solve a litany of evils. The most important is worth its own headline: Limiting interest rates would halt the rapid rise in home foreclosures. With a lower ceiling on interest rates, lenders would lead the charge to reestablish an appropriate match between family income and mortgage size, which would have the effect of reducing the mass of families that are sucked into mortgages they have no hope of paying. Minority communities would no longer find themselves stripped of wealth by predatory subprime lenders. And homeowners would no longer be suckered into second and third mortgages that promise to lower their monthly bills but that actually rob them of the family home.
Interest rate regulation would also take the ammunition out of the middle-class bidding war, helping to save families from the Two-Income Trap. Competition for the best neighborhoods would continue, but if
no one
could get a mortgage that ate up 40 or 50 percent of the family’s entire income, then home prices would begin to settle down to Earth. To many economists, this is a scandalous notion, involving a reduction in Americans’ “net worth.” But that net worth isn’t worth anything unless a family plans to sell its home and live in a cave, because the next house the family buys would carry a similarly outrageous price tag. Some families with weaker credit histories or more modest incomes might find themselves limited to smaller houses, but they would also be far less likely to end up in a home that drove
them into the bankruptcy courts. Moreover, as housing prices leveled off, more families would be able to afford a home
without
having to resort to a subprime mortgage. Reregulation of interest rates would bring relief to
all
families, not just those already in serious trouble.
Families would also be far less likely to get into trouble with their credit cards. With appropriate limits on interest rates, banks would still be able to issue credit cards profitably, and consumers would still have access to those convenient plastic cards. But banks would have far greater incentive to screen cardholders, offering only as much credit as each family could repay. Moreover, there would be no incentive to single out families in financial trouble, tempting them at the moment when they are most vulnerable with special offers of extra credit at exorbitant rates. Banks would have no reason to scour credit records looking for homeowners in trouble, offering to “solve” their credit problems by putting their homes at risk through second or third mortgages.
Limits on interest rates would reverse another disturbing trend—the transfer of wealth away from lower- and middle-income families. Since 1970, banking profits (inflation-adjusted) have more than tripled, growing by more than
$50 billion
.
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Those profits weren’t the rewards for important innovations. Lenders didn’t invent a faster computer, design a better car, or make a great new movie that everyone wanted to see. (Indeed, many would argue that the quality of banking service actually declined during this period.) No, they sold pretty much the same thing they always had—debt. The difference was that they sold more of it, and they charged higher prices.
A modest example illustrates what is happening to American families. Credit card companies basically have three costs: marketing costs, collection costs, and the cost to borrow the money they will re-lend to consumers. The Federal Reserve lowered interest rates nine times in 2001, which meant that credit card companies’ cost of borrowing fell considerably. Even so, they held steady the rates they charged most of their cardholders. The result? A $10 billion windfall for credit card companies.
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Nothing had changed in the way these
companies did business; their marketing costs stayed the same, their collection costs stayed the same, and their products stayed the same. The only difference was that their already-high profits jumped by an
additional
$10 billion. That $10 billion was paid by families across the country—$10 billion that might have paid for medical bills or college tuition, school shoes or car repairs—or even paid down the balances on outstanding loans. In a single year, 10 billion extra dollars disappeared from families’ wallets and reappeared on the balance sheets of a handful of corporate lenders. Families got nothing in return; they paid out dollars that, if interest rates had been regulated, would have belonged to them.
Regulation would also eliminate the worst abuses of a lending industry run amok. Payday lenders would no longer target minority neighborhoods with short-term loans at interest rates of 100, 500, and even 1,000 percent—rates that would make any mobster drool.
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The more subtle forms of loan sharking would also disappear, so that when families managed to get into trouble with credit card debt, lenders would no longer be able to prey on their desperation by doubling the interest rates and piling on the late fees that turn their debts into financial quicksand.
What about families’ access to credit? Deregulation of the mortgage lending industry was not a right-wing conspiracy; it was actually supported by most Democrats as well.
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Many liberals got behind the move for traditionally liberal reasons: They wanted to defend lower-income families. They had been persuaded that the risks posed by overaggressive lenders might not be as dangerous as once was thought. A deregulated lending market could even prove to be a critical tool to help low-income and disadvantaged groups improve their lot. After all, working-class families needed credit to start businesses, to build homes, and to send their kids to college—things that upper-income families had long had plenty of opportunities to do.
Moreover, there was a growing body of evidence that even though it was illegal, overt discrimination and “redlining”—the practice by which mortgage lenders refused to lend in certain neighborhoods—
was crippling housing markets in minority neighborhoods and denying low- and moderate-income families the chance to build wealth through home ownership. The new solution was to “democratize credit”—make credit available to anyone and everyone, no matter how poor.
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The prediction was for a more perfect world in which home ownership rates would go up, a sluggish economy would begin to boom, and cities would blossom—all thanks to the free flow of credit.
Obviously, that perfect world didn’t come to pass. But politicians may still worry: If America turns back the clock on lending regulation, what will happen to the home-ownership rate? Every time anyone talks about putting restrictions on interest rates, the lending industry puts up one of those heart-warming advertisements that show a family with two kids and a dog moving into their first home. But the hard numbers belie those happy ads. Reregulation of interest rates would have very little effect on home-ownership rates.
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Since the mortgage industry was deregulated in 1980, the proportion of families owning their own homes has increased by less than 3 percentage points.
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Plenty of factors have contributed to these modest overall gains, such as a long-running economic boom, the aging of the population, and a falling inflation rate—and those factors won’t be affected by changes to mortgage regulations. Moreover, since most high-interest subprime mortgages are used for refinancing, not for families trying to buy their first homes, outlawing those mortgages should have little effect on the number of first-time home buyers. In fact, if fewer families were pushed out of their homes by creditors intent on raking in profits through loan-to-own scams and predatory practices, the overall number of homeowners in America might be higher.
What about the “democratization of credit” for which activists fought so hard? If interest rates are regulated once again, will credit become undemocratic, available only to those with realistic prospects for repayment? To answer this, it is time to step back a moment. The original intent of the credit democratization movement was for credit to help more families become financially independent. Credit was not supposed to be an end in itself. But it seems that the original intent
has been forgotten. Consider, for example, the motto of one prominent advocacy group: “Access to credit and capital is a basic civil right.”
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Is it a civil right to pay interest on a credit card balance for the rest of a person’s natural life? A family that finances its home with a subprime mortgage can end up paying twice as much for that home as a family that gets the market rate. Is it really a basic civil right to pay double for a home? And foreclosure rates are skyrocketing. Is it a civil right to lose that home in a sheriff’s auction? The dream of democratization of credit was to use credit as a vehicle to expand home ownership, to launch businesses, and ultimately to help build wealth in neighborhoods that are short on it. The point was not to bombard families with more credit than they could possibly afford or to flood the market with complicated loans that only a CPA could understand.
But the mantra of expanding access to credit has been hard for consumer activists and politicians to abandon. As a result, reform efforts have fragmented into a patchwork of measures intended to curb “predatory” lending practices. The problem is that no one can agree on how to define “predatory” lending.
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As the
Economist
dryly observes: “As with pornography, consumer activists and legislators say they know predatory lending when they see it.”
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The National Housing Institute defines predatory lending as “any unfair credit practice that harms the borrower or supports a credit system that promotes inequality and poverty.”
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But what constitutes “unfair”? And who decides whether a system is promoting inequality or poverty?
Attempting to stamp out “predatory” and “unfair” practices is certainly better than ignoring them, but it puts legislators in the position of trying to uncover the latest shenanigans and redefine abuses, always two steps behind the lenders who keep changing their products to sidestep regulations.
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It also gives far too much room for lenders to circumvent the intent of the law. For example, the New York State Banking Department recently banned “unaffordable loans,” except “under compelling circumstances.”
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We suspect that any crafty loan marketer could dream up some “compelling circumstances” that would permit a lender to sell overpriced loans. The only way to stop
predatory lending once and for all is to go directly to the heart of the loan—the interest rate. Limiting the amount of interest that creditors can charge avoids the hide-and-seek game over what is and what is not “predatory,” offering instead a simple, effective means of regulation.