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Why Is This Legal?

posted by Elizabeth Warren

Are there some deals that are so bad that they shouldn't occur?  Or it is enough to say that people have choices, and if they make bad choices, tough?

I had lunch with a bankruptcy lawyer, who followed up with an email story:

Today I was interviewing one of my clients and she said that one of the loans she that she had should have been illegal.  I asked her what she meant and she said that the loan she received should never have been permissible. Turns out she had a car loan with Volkswagen with an interest rate of about 3% and a loan balance of approximately $23,000.00 Because she had her home mortgage with Wells Fargo (or at least that is what she thinks is the reason) she received an offer from Wells Fargo for an equity loan on her car! (i.e. just like a home equity loan except the collateral is a car instead of a house) I had never heard of such a thing before.  In any event, she agreed to do the deal with Wells Fargo (she needed to money to pay her bills and was much too embarrassed to go to family and friends) so she agreed to the refi and at closing she received $4850 in cash, Wells Fargo received $1300 in fees and the total amount of the  debt went from $23,649 (the amount owed VW on the original car financing) to, hold on to your seats, $48,852!  The interest rate on the new loan was a mere 16.24% (remember the old rate with VW was approximately 3%).  Of course she defaulted and Wells Fargo repossessed the car and is now seeking its deficiency balance.  Amazing to see an equity loan on a rapidly depreciating asset but when she received the loan Wells Fargo told her that she had paid down her car loan so quickly she had accumulated equity and they had a way to get the equity now.

The Wells Fargo loan was made in 2006 – the cost of the new financing was $17,900 – almost as much as the balance (i.e. $23,649) then due on the original note with VW.  Also, the term of the new loan with Wells Fargo – 72 months, on a 2005 VW Passat!

The woman in the story got an immediate benefit ($4850 in cash), and that saved her some serious embarrassment. But these charges are head-snapping. 

What is the best way to think about this? Is it enough to say that the woman is an adult, she received a benefit, she is stuck with the deal?  Or is it enough to say that the company's terms are unconscionable, disclosure was inadequate, and charges at these rates should be banned? 

Or is there a third option that nudges toward a more rational decision, but that leaves open a number of degrees of freedom?  So, for example, should this be permissable, but only if

1) there are very, very aggressive disclosures
2) the consumer seeks out the deal
3) some form of third-party advice is available

In other words, are there other nudges that would maximize consumer benefits and freedom?

OK, so I'm reading Cass Sunstein's and Richard Thayler's new book, Nudge, and it has me thinking about consumer credit.  The current system seems plainly wrong to me. The question is whether nudges can work, or if some deals are bad enough that they should be banned outright. No one can buy an exploding toaster, even if it would be a little cheaper or even if the buyer was warned. But perfect safety is not required, and someone can still start a fire with a toaster. What's the right approach with financial products?

If a regulatory opportunity opens up so that it is possible to get more effective consumer protection, we may have to address the question about right way to go.

Comments

That's a good question. Let me give another analogy. Jewelers and department stores sell diamonds. They advertise on TV, radio, newspaper, Internet, and maybe direct mail. A small piece of stone sometimes sells for thousands or tens of thousands of dollars. People fall for the advertising. They walk into the stores and buy them. Stores make a huge profit. There is not much disclosure or paperwork. Should these expensive stones be made illegal? What's the difference between expensive stones and expensive loans?

Is "too expensive" the only reason we object to the loan in question? In other words if it were not as expensive, would it be OK? My guess is yes because we are not questioning the 3% VW loan. In your toaster example we are regulating safety, not the toaster's price. A $3,000 toaster is not illegal even if it works just the same as a $10 toaster.

I'd like to make sure I understand the money flows in this deal.

The woman got $4,850 in cash at the closing.

Wells Fargo received $1300 in fees, an asset of $48,852 at 16.24% interest, and collateral that need only be greater in actual value than the $3550 Wells is out at the close (see below)

Even if we only look at interest payments (i.e. without amortization), Wells Fargo is due to receive $7,933 per year -- or about $661 of interest per month

Let's take the $1300 and offset it against the cash of $4,850. Wells is out $3,550 at the closing.

It would take them between five to six months to fully recover the cash. And, at that point, they have -- at least on paper -- an attractive loan on their books.

People are not typically desperate when they purchase toasters or diamonds. It's far more likely that such desperation characterizes folks who walk into a loan shark's office.

[" Why Is This Legal? ... Are there some deals that are so bad that they shouldn't occur? Or it is enough to say that people have choices, and if they make bad choices, tough? "]


... so it's fundamentally a 'legal' issue ??

You do seem to favor 3rd-party forcible intervention into voluntary private contracts... thereby substituting the "choices" and values of government politicians/bureaucrats for those of adult citizens. What do you do if those citizens make 'bad' choices in government elections ?

If there is no fraud, coercion, or direct criminality in a private contract -- politicians & bureaucrats have no right to interfere with contract terms, under U.S. constitutional law.

That principle is called liberty... a basic American right.

Freedom & liberty mandate that people can make subjectively "bad" choices, as well as "good" ones. The alternative societal system is tyranny.

I think more consumers should do a little research before signing. I think emotions get involved and professional salespersons hone in on those emotions as selling tools. Blogs like these are great for learning...but unfortunately, many people do not start partipating until after they are burned.

"If there is no fraud, coercion, or direct criminality in a private contract -- politicians & bureaucrats have no right to interfere with contract terms, under U.S. constitutional law."

I think you're confusing Ayn Rand novels with the Constitution.

Anyway, there are a number of reasons why simple, abstract, rule-based systems that work in Libertopia (Libertarian fantasy land) don't work in the real world. First is the fact that there is no obvious, non-arbitrary, non-subjective way of marking off force from non-force and fraud from non-fraud. You're attempting to draw bright lines on two different axes, one of which represents the relative bargaining power of the parties entering into the contract, the other represents the relative amounts of information available to the two parties. There is a continuum along both axes, not a binary step. The second issue stems from the presence of externalities - the two parties entering into the contract are not the only ones that are affected by the contract. Entire neighborhoods can be destroyed by rising foreclosures when abandoned houses begin to decay, copper thieves leave ruins, squatters move in, drug dealers set up shop, etc. People who had nothing to do with the shady loans are then harmed by their results.

Libertarians would very much like to gloss over things like the origin and justification of property rights (particularly in land and unproduced natural resources), the conditions under which contracts should be enforced, and the existence of externalities, since these matters demonstrate libertarian philosophy to be constructed upon a logically incoherent foundation of sand. Those of us who actually live in the real world, as opposed to Libertopia, do not have that luxury.

[You do seem to favor 3rd-party forcible intervention into voluntary private contracts...]

The ironic thing is, YOU favor 3rd-party forcible intervention to enforce contracts. If Wells Fargo wants to sue this consumer, it's going to have to go into a court of law.

The privilege to make a binding contract is something created by the government. Since the government must define the contours of that privilege, it might as well try to do it in a way that is beneficial to society.

Social psychologists today understand the many ways that corporations manipulate people into making decisions they later regret. If the government turns a blind eye to that knowledge, then it is making a conscious choice to let corporations get richer, while individual citizens are harmed.

Fine, if that's what you want. But admit it for what it is.

Andrew Levine - Exactly. Libertarians sometimes forget that enforced property rights and contracts are very much creations of the state, and thus represent state intervention themselves. There's nothing wrong with believing that state actions should be limited to a particular scope of affairs, but it's silly to think that such a condition is somehow "natural" or represents an absence of force or coercion.

I find it hard to believe any rational/competent, informed person will take out one of the loans discussed recently outside of dire circumstances.

If they're irrational/incompetent, the state has long held these contracts unenforceable. E.g., contracts signed while drunk.

If they're in dire circumstances, we're talking about (potentially) predatory circumstances and again the state has held an interest in these situations. It should take a step back vs. the irrational/incompetent, but few people would argue that the suddenly bereaved are at their best when dealing with a funeral home. We might not agree on which situations are covered, but I (hope) we agree that -some- are.

That leaves the ill-informed and ignorant. The solution is straightforward -- ensuring consumers have access to better information. E.g., how long it would take to save the same amount of money, or if it would reasonably limit their choices in the future. They can still make bad choices, but they'll know the real consequences.

Two examples: the person mentioned above should have known that accepting the loan would mean that her monthly "car payments" would have tripled (or more?), and she would essentially lose all ownership interest in the car. E.g., she couldn't trade it in for another car until the second loan is paid off.

Anyone watching an ad I've seen recently the typical loan that flashed by in fine print -- $2400 for 42 months at 99% APR -- would know that with those payments they could save that amount in perhaps 8 months and save -3 years- of additional payments. That's three years when it will be difficult-to-impossible to carry an additional loan, if it became necessary.

People could still decide to take these loans -- having that money -today- has definite utility -- but they would go in with their eyes (more) open.

"Wells Fargo received $1300 in fees, an asset of $48,852 at 16.24% interest, and collateral that need only be greater in actual value than the $3550 Wells is out at the close"

For Wells Fargo to have gotten 1st lien position in order to foreclose/repossess the car, wouldn't the original loan have to have been paid upon refinancing? If this is the case Wells Fargo would have been out $3,500 plus the loan payoff amount.

Isn’t this already illegal? Were one to defend the deficiency action, would Wells Fargo’s complaint survive summary judgment on the affirmative defenses of the Breach of the Obligation of Good Faith and Unconscionablity? And Wells Fargo would have to defend the counterclaim for Consumer fraud seeking treble damages and fees.

The problem is finding a lawyer to make the bet. It is really a question of legislation or common law litigation.

I would like to know how the Bankruptcy Attorney handled the claim if one was filed. To me this is the same ole' story. "Creative" Financing for people in need. Wells Fargo usually has these high lending standards as purported by them. I guess the way they set it up, the loan was more of a "sure thing" than a "bet". The risk in this loan seems all one sided. I wonder if she knew that when it was made. I would have liked to have seen the BK attorney take up a "cram down" valuation in the case. I wonder how 11 U.S.C. 1325 and 506 would play in that situation. Can you cram down the value? Is it purchase money security? Does a Re-Fi count for the purpose of exempting it from the provisions of the "hanging paragraph" in 1325 and subjecting it to 11 U.S.C. 506? Did or could have the Attorney moved for turnover of the property? I know the point is “look at this new species” and “is it legal”. I would love to know how this new “species” meshes with Bankruptcy code though. It is almost similar to these new 30 day car title loans I have been seeing lately. We will have to deal with them eventually in bankruptcy, let’s coordinate our efforts…… any consumer bk attorneys out there? Maybe BK judges?

It sounds like she is not mentally incompetent but financially incompetent. I would not make the loan but I would not hesitate to enforce it. The nation is full of financially incompetent people. There are many ways to solve that. The author as usual proposes detailed government regulation as to who can borrow what kind of loan. Keep in mind that there are already a dozen or more laws on the books addressed at these problems ex ante as well as bankruptcy ex post. If they haven't worked why dodge the question of perpetuating them all; if you propose to consolidate them in a smaller number that is more effective, fine. But I never sense that in Warren's posts. It's just more of what demonstrably has not worked. A far better solution would be to cap the amount of debt a person can have as a function of their income, such debt being readily ascertainable from their credit report; also, back in the day, we had usury laws that had a meaningful suppressing effect on stupid loans. Clear, simple on/off laws are superior to the thirteenth or fourteenth more-paperwork law. But, failing radical repair, this country has too much debt and too many people who are financially incompetent and I would prefer separating them out, Darwin-style, from those who can handle their own affairs, to seeing yet another useless bureacratic effort to compensate for their incompetence.

Some types of contracts that are unenforceable:

"Ipso facto" bankruptcy default clauses.

Contracts for slavery, sale of children or a kidney, or to make a gift.

Contracts to perform a criminal act.

Contracts entered into by persons under 18 years of age.

In many states, contracts associated with gambling debts are unenforceable.

Contracts for restraint of trade, price fixing, and the like are illegal. Overly restrictive employment agreements are unenforceable.

A contract to waive a doctor's or attorney's malpractice liability is generally unenforceable.

Contracts to waive consumer protection laws, employment laws and the like are generally unenforceable.

Contracts for the transfer of property can be voided under fraudulent transfer statutes.

Certain contracts entered into with government entities where required "bidding" hasn't taken place.

Contracts that are required to be reduced to writing (based on the statute of frauds), and are not are unenforceable.

Are all of these examples in violation of the Constitution? I think not.

I am a consumer/small business bankruptcy lawyer from Austin, TX. I can attest to the Wells Fargo auto equity loan offers because I just got my second offer from them. Wells Fargo quit doing home equity loans in Texas because they were having so many problems with them (I've sued them twice), but now they think making equity loans against vehicles makes more sense?!?! By the way, my vehicle is a Ford F-350 Super Cab, long bed, heavy duty tow package and bumpers, 4WD, diesel. (I own a ranch. This is Texas, after all.) With diesel at $4.50 a gallon, my vehicle is depreciating VERY rapidly because nobody is buying them anymore. Wells Fargo knows what I drive because they financed the truck. Why on earth would they want to make that loan? My guess is the answer is really very simple - I have excellent credit and they are making the offer based on my credit score. The value or quality of the collateral has nothing to do with anything.

Wow, I'm here in Copus, I have not seen them yet! I know it wont be long though. What do you thing zekezrski, about the valuation issue in 13s?

Car equity loans are non-purchase money - so there is no 910 vehicle loan problem.

Bifurcate at will.

I’ve read Nudge and do think certain forms of nudges could be applied effectively to consumer credit products. What’s lacking today is that there is no unified system to oversee the numerous and vastly complex credit products that have flooded the marketplace in the last twenty years. That’s why a Financial Product Safety Commission that you champion could be an effective means of providing oversight and consumer guidance. A commission such as this should be the objective system that evaluates consumer credit products and the single source for weighing credit product pros and cons in the marketplace. It could function similar to a Consumer Reports for credit products. What we are also missing is simplified communications on credit products for consumers to help make better decisions on which products are best for their situation. Much of the information available on credit products is often confusing and overwhelming to make informed decisions because there is a lack of uniform standards for how products are compared. Credit products need to foster more transparency in the marketplace and we need an objective system to rate products, so consumers can evaluate risks all things considered depending on their individual situation.

To help nudge consumers to better credit product choices, I would recommend visual representations such as a 1 – 5 risk assessment scale ranking similar products on specified criteria or four quadrants of product categories (e.g., leading, lagging, improving, etc.). Riskier products would be weighted accordingly and best in class products would show through. There are other ways as well. This would allow consumers a quicker, simpler way to evaluate similar products. It would also be helpful when consumers apply for a credit product for three comparable choices based on the consumer’s criteria to be recommended as potential choices, in addition to the product they are considering. Increasing transparency would help consumers balance the emotional reaction with a more rational objective decision making (e.g., weigh the short vs. long term pros and cons) and the implications of credit products.

I like that idea AMC. That would kind of impact the "how much do you want to pay per month" pitch a bit. If say the rating on financing with a $300 car payment had a bad rating, the seller would have to explain that it was because they were financing a used car with a trade-in deficiency rolled in over 60-72 months. Just as an example. Most people who do not know better buy things like cars not on the total amount of debt they are taking on but on how much they are to pay per month. This solution would kick-start financial education I would think because people will start asking why the financing had a bad rating. Do you think it would have to be a federal framework AMC? States usually have different perceptions on what is good and bad and there will be a lot of variables involved. It places the responsibility on the consumer for the choice which I am sure the other side of the isle would like as well. It doesn’t limit the choices but clarifies them. That’s what I like.

Thought so Zekezrski. CRAM DOWN!

I agree that too many people buy based on the monthly payment, and not on total amount to be paid over the life of the loan, or on the "totality of the circumstances" of the loan.

I don't know what the solution to that is - probably some combination of financial education starting about sixth grade, loan disclosures, government regulation, and a flat out prohibition on loan deals that cross the line to crazy. Don't know if even all those approaches in combination are going to work though. An inability to actually do the math, coupled with a "gotta have it" consumer mentality, is a heady kind of opiate.

Patches -

See In Re Sanders from Judge Clark in San Antonio. You can find it on the Western District website txwb.uscourts.gov and click on the "opinions" button. 26 pages detailed analysis of Texas law on the purchase money issue. (Sanders is a rolling the negative equity from a prior car on to a new one, but the same purchase money analysis applies.) He concludes that if it is not all purchase money, it is not purchase money at all. The 910 limits do NOT apply and cram down is available.

Wow that helps. Thank you for that "Z" can I call you Z? I like Clark, is it "Lief"? Right? He is funny. Well, I heard he can be a “cut up” in court. Anyway I have been trying to find that case or procedure. Do you have a case number? I would really like to look at it. This is how far I got:
http://www.txwd.uscourts.gov/opinions

What about this twist? Say you have a Credit Union and they finance a car maybe two. They then offer the debtors an open line of credit but that open line is cross collateralized with the car loan or loans. Two separate loans, one is a purchase money and the other is not obviously. But.... they are crossed up! There is a negative equity there but can we cram down? That is one I have been struggling with for a while especially when it comes to 1325.

Patches -

The website is txwb - you had txwd which is the district court. The case number is 07-50783.

On your question about the credit unions, I think they may have to make a choice. If they insist on the cross-collateralization, I think you get to cram down on both notes. If the lender waives the cross, then they may be able to prevent you from cramming down the pruchase money note. When credit unions here file their poc for both debts as fully secured, we cram it down to the value and don't worry about how much is which loan. So far, they don't seem to have figured out that they may have an option.

THANK YOU "Z"! Thanks for that case # it is going to be very helpful. I like Clark and his Ops. He comes up with some funny stuff sometimes.

We will see how Judge Schmidt rules if we get that far. It seems like these Credit Unions have been getting tricky lately. Most debtors we talk to don't even know the debt is crossed up. The ones who have missed payments do know but most of the time paychecks are directly deposited and funds deducted sometimes on a bi-weekly basis. They NEVER know! I say "never" more like 8 out of 10 don't know.

Patches -

This is always a problem with credit unions. My clients not only don't know that the car is crossed on the credit card and signature loan, they insist it ISN'T until I show them on the loan form. It's one thing for a bank to cross business loans (assuming a business owner is more sophisticated), but putting a cross collateralization provision in a consumer loan without including major disclosure is ripe for abuse.

I agree Z.

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