Credit Slips

Bring Back Bob the Banker

If you’re over 40 years old and didn’t grow up in the big city, you knew Bob.

Bob was a local banker. He lived in the same town where his bank was. He was a loan officer, probably a Vice President, and worked for the bank for years. Bob married his high school sweetheart, raised four or five kids in the town you lived in, belonged to the local optimist club, and attended a local church every Sunday. Bob showed up at most of the civic events in town. You saw him at many of the weddings, christenings, and funerals in town too. Bob knew everybody who was anybody in your town. He also knew a lot of nobody’s as well, but that didn’t matter to him – anybody or nobody, you were from his town and he was the banker.

Bob viewed himself as the guardian of the bank’s money, and the reputation of the bank in the local community was very important to him. When people needed money, they would come to Bob to apply for a loan. There was paperwork to fill out, but it usually wasn’t very extensive. Bob looked at the paperwork to be sure, but Bob knew you, he knew your parents, he knew where you worked, and he knew how much money you made.  Most importantly, Bob had a pretty good idea what sound financial practices were and he cared about your financial well-being because it was tied to his bank’s reputation.

In Favor of the Consumer Financial Protection Agency (CFPA)

Adam's earlier post started the ball rolling on the CFPA discussion, and I wanted to weigh in (favorably) having now waded through the 153 pages of proposed legislation.  I take the case to be made for sheer regulatory consolidation as surely correct: the crazy quilt of overlapping agencies would make even Sir Humphrey cringe.  But the case in favor rests on much more than that, and of shrewd appeal to both typical bailywicks of the left and right.

Who Loses in Cuomo v. Clearing House?

Adam Levitin already posted on this week's decision in Cuomo v. Clearing House Association where the U.S. Supreme Court struck down a regulation from the Office of the Comptroller of the Currency's (OCC). The regulation preempted state enforcement of consumer protection laws against national banks and grew out of subpoenas issued by the New York attorney general. At first blush, the opinion seems to be a big victory for consumers, and it certainly is a victory. As alluded in the comments to Levitin's post, the opinion might not be as big of a victory as it seems.

Repealing Marquette

Senator Sheldon Whitehouse has introduced, with Senator Dick Durbin, the Empowering States' Right to Protect Consumers Act of 2009 (S. 255). The statute would repeal the thirty-one year old Marquette decision, which was the United States Supreme Court ruling that held federal law preempted state law regulating interest rates. A later decision in 1996 (Smiley v. Citibank) expanded the scope of federal preemption, holding states also lacked the power to regulate the fees charged on credit cards, and the bill would repeal Smiley as well.

Marquette effectively deregulated most consumer interest rates and led to the expansion of consumer borrowing for the past thirty years. After the Smiley decision, bank fees started to climb. Much of the "gotcha" marketing mentality from the credit card industry can be attributed to the freedom Smiley gave banks to exploit credit card fees as a revenue stream.

Some persons think interest rate and fee caps are bad idea. Fair enough. The Whitehouse bill, however, is not an interest rate cap. It merely returns the power to the states to regulate consumer lending to their citizens and harnesses the states as "laboratories of democracy" (as the saying goes). Let the states experiment with interest rate and fee caps, and we will find the right balance between exploitative market practices and overly restrictive government regulation.

Gamble Away the Risk

Bankruptcy is a back-stop for risk management errors. Last week I attended a conference sponsored by the Center for Health, Economic, and Family Security at Berkeley Law on the appropriate level of risk that government, private industry, and individuals should bear for a variety of risks--job loss, illness, changes in family needs, and others. Repeat CreditSlips guestblogger Christian Weller and Amy Helburn presented a paper on family debt and assets that highlighted the $15 trillion in lost household wealth in the 18th month period 6/07 to 12/08. The paper's key point is that our savings rate is too low. That is a pretty easy case to build, and as Weller and Helburn skillfully acknowledge, the trick is figuring how to stimulate savings. Anne Stuhldreher from the New America Foundation had lots of interesting ideas. The most fun one capitalized on the penchant for gambling. She reported that the average American spends $500 in scratch/instant lottery tickets per year. A pilot program in Michigan, Save to Win, gives consumers a chance at a $100,000 grand prize and monthly cash prizes. Each $25 deposit into the savings account is an entry to this lottery for savers. The highest take-up, as well as those depositing the highest percentage of their income, are residents of central Detroit. The program is proving particularly adept at motivating savings even among households with low-incomes or substantial risk of financial hardship. While only one lucky consumer will get rich with the grand prize, all these families reducing their risk of losing in the game of chance that is American household economic security by bolstering their savings.

Finally, Some White House Interest in Credit Card Abuses

The Obama Administration today turned its attention toward abusive credit card practices. After years of presidencies that were at best indifferent or at worst supportive of the credit card industry abuses, to finally have the White House give some attention to these issues is an incredibly welcome development. Specifically, the Obama Administration has indicated it will support H.R. 627, the Credit Cardholders' Bill of Rights Act of 2009. Representatives Carolyn Maloney and Barney Frank have played a leadership role in this legislation, as they have for years with consumer credit issues, and they were able to get the bill through the House Financial Services Committee. The full House is almost certain to pass the bill, but it faces an uncertain future in the Senate.

The Credit Cardholders' Bill of Rights would end retroactive interest rate hikes and hikes without notice, put an end to double cycle billing, and limit fees and penalties. It is legislation that needs to be adopted. Not surprisingly, the bill is facing tough opposition from the financial services industry which is trotting out the usual arguments about credit restrictions and price hikes. These canards, although I know some will disagree with me about that characterization, are used every time consumer lenders face legislation that might make them play fairly. I'll let that debate play out in the comments, as it undoubtedly will.

There is one particular industry argument, however, that strikes me as particularly disingenuous. The New York Times reports that the industry is arguing the federal legislation is unnecessary because it largely duplicates recently adopted Federal Reserve rules. It is true that the legislation does have some overlap with the rules, but that is still no reason for the legislation not to go forward. First, the legislation is not identical with the Fed rules, meaning the legislation would fix some problems the Fed rules will not. Second, to point out the overlap is to beg the question of which action is the redundancy. Why aren't the Fed rules now redundant and beside the point? Third, the Fed rules won't take effect until July 1, 2010, and the legislation would take effect three months after adoption (generally speaking). Fourth and perhaps most importantly, I suspect the real reason the financial industry wants to keep the lawmaking at the Federal Reserve level is that the industry has more influence there. Once these new rules become enshrined in legislation, it will be much more difficult for the financial industry to undo them, which is as it should be.

Consumer Overindebtedness Around the World

My plan for the evening is to go in search of a giant sculpted head of Karl Marx. Fortunately, I'm in Chemnitz, Germany, where such a monument is a feature of the town square, a holdover from the days when the city was known as Karl-Marx-Stadt. Dr. Wolfram Backart has organized a wonderful conference at the Technische Universtät Chemnitz. The conference is entitled "Overindebtedness: Everyday Risk in Modern Societies? Theoretical Aspects and Empirical Findings in International Perspective" and has brought together scholars from Germany, China, Portugal, Japan, Sweden, South Africa, Finland, Canada, the United States, the United Kingdom, and Austria. Two themes have been emerging

How to Start to Get Trillions in Lost Wealth Back

The fact that wealth is rapidly declining deserves public policy attention. Wealth serves critical functions in the U.S. economy that relies heavily on individual initiative. It is primarily an insurance against a range of economic risks. The more such insurance exists for the typical family, the less a family has to worry about their basic necessities and the more they can focus on longer-term economic growth. A family that has the basics covered can take more chances by sending their kids to college and letting them choose a degree that suits their abilities. Also, family members can more easily switch jobs to match their particular skills. And, a family with enough wealth is in a better position to let their creative side take hold and start a business. The entire economy wins from letting people gain more skills and apply those skills most effectively in their job or by starting a business.

Recommending what the government should and should not do about rebuilding family wealth has become as ubiquitous as real estate ads in the mid-2000s and dot-com IPO discussions in the late 1990s. Here are just a few principles that will likely guide the reform debate.

Rx Contract Abrogation (Use Only As Directed)

Former Credit Slips guest blogger Anna Gelpern has a nice post on AIG and contract abrogation on Nouriel Roubini's RGE Monitor.  Anna argues that there are times when abrogating contracts makes sense, but that AIG just isn't one of them.  Contract abrogation is a powerful tool that should be used sparingly and only to protect macroeconomic welfare, not to express political outrage over the behavior of a single company.  

A Vignette from Champaign

Driving down one of our main thoroughfares yesterday, I drove past one of our local banks that was advertising its CD rates on the electronic sign out front. OK, nothing usual there. What was unusual was the line that appeared at the bottom of the sign "No TARP Funds." I was going to take a picture with my cell phone, but I decided that the attempt to do so while driving at 35 MPH might become the basis for one of my colleague's final exams in Torts or, worse yet, Criminal Law.

We've heard that some banks are wanting to cut ties to the TARP program because of the strings that came with it (NYT article). Out here in the heartland, the lack of a connection to TARP also seems to be perceived as a way to attract customers. This morning, I did notice that the CD rates and the accompanying TARP reference no longer was part of the sign's rotating advertisements.

The Repo Man Cometh.

An AP article by Jay Reeves highlights yet another disturbing consequence of our credit-based recession -- a rise in repo violence. The article details the killing of Jimmy Tanks, a 67-year-old retired railroad worker, who used a rifle to confront a repo crew at 3 in the morning and ended up dead.  The repo man has been arrested for murder. The rise in repo violence probably has a lot to do with the rise in repossessions. Car repos increased by 12 percent in 2008 and are expected to increase another 5 percent in 2009.

But the Uniform Commercial Code has a lot to do with this as well. Under Article 9, a repo is legal as long as the creditor's representatives don't "breach the peace," a test which has led to a body of caselaw that, paradoxically, almost guarantees violence. Basically, if the repo crew can get the automobile away from the debtor without violence occurring (no matter who starts it), the creditor is safe. But if the debtor manages to physically prevent the repo, even by extreme measures such as threats or chaining himself to his car, the creditor's representatives have to leave. This gives repo crews incentive to proceed by stealth, which it turn makes it more likely that debtors will confuse them with car thieves, and it encourages debtors to take extreme measures to defend their cars.

Another disturbing facet of this story is that the debtor had already filed for bankruptcy. The article doesn't mention whether the creditor had managed to get the automatic stay lifted, but if not, then the repo guys had no business whatsoever being there in the first place.

I want to thank my students James Hughes and Beckie Brice for the tip.

Household Income and Debt Trends Since 1980: Quick Picks

The folks who write Credit Slips are among those who have long wondered what the “exit strategy” was for an economy that was predictably on a wobbly course, with about 70% of GDP driven by household spending when many of those households were on kind of shaky ground.  That’s obviously not a sustainable long term strategy for economic growth when, on one hand, the income side of the ledger for a large share of those households was sputtering or stalling, while demands on the expense side from big ticket, basic items like health care and health care financing, education, and housing were growing.  The American household debt burden looks like a more complex problem if you think about the cumulative impact of all of these trends, rather than just thinking “flat screen TV” and stopping there.

In looking at data about these trends, I’ve been struck by the comparisons between the first post-WWII era (roughly the 30-35 years ending in the late 70s – early 80s), and the second one covering the last 30-some years.  Since the current crisis seems likely to serve as the end point to the late 20th century economic era, it’s interesting take a Before and After look at the household account trends.

Income growth:  Through this last period, the income gains have skewed increasingly not just to the top, but to the very tippy-top.  From 1946 – 1976, the average income growth for the “bottom” 90% of households was 92%, compared to 25% for the top 1%.  But from 1976 to 2006, the bottom 90% saw only 10% growth, while for the top 1% it was (wait for it --)  239%. (Sources for this and related figures are cited in the appendix to CRL’s comments to the Fed's then-proposed rules defining unfair and deceptive practices for credit cards.)   For a really cool visual of this uncool trend, take a look at the graphic in Clive Crook’s 2006 Atlantic article called "The Height of Inequality." And while you’re there, the story’s pretty interesting, too.

Savings:  A chart on the "By the Numbers" page on Inequality.org shows that the savings rate roughly doubled from 5% in 1949 to over 11% in 1982.  Since 1982, it looks like a downhill ski slope, and the rate was in negative territory by 2006.

Debt:  The debt-to-disposable income ratio of American households more than doubled from 60% in 1980 to 133% in 2007.  A recent article in the Economist says that household and consumer debt went up from 100% of GDP in 1980 to 173% now.

Sorry I haven't yet collected nice links to specifics on those expense-side demands, except for a recent Washington Post article noting that “college tuition and fees have jumped nearly 440%" since the early 80s, but you get the picture.

Lots of factors went into shaping this picture, not the least of which is just the economic world evolving.  But it wasn’t all out of our hands: we made some public policy decisions that helped. (And yes, personal decisions, including collective decisions that made up private sector policy decisions as well.  Personal responsibility is appropriate for both home and work.)  Now will be a good time to find our way to some better trend lines than these. Yes we can.  You betcha.  (In the spirit of bi-partisanship.)

The Other Underwater Loans: Negative Equity in Auto Finance

On Tuesday Fed Chairman Bernanke announced another installment in the effort to alleviate the  credit crunch in testimony before the House Financial Services Committee. One new tool in the kit is a joint Treasury – Fed facility to lend against “AAA-rated asset-backed securities collateralized by recently originated student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration.” 

This got me to wondering what the recent (pre-crunch) state of affairs was with respect to the practice I used to call in consumer education programs “Drive One, Pay for Two” – burying the cost of refinancing the left-over debt on the trade-in vehicle in the new (or new-to-you used) car loan docs. Here’s how that  works:  The value of the trade-in is $8000; balance on the loan for that trade-in is $10,000. That leaves a $2000 deficit that either a) the dealer eats (unlikely), or b) you have to cover with an extra cash down payment as well as the trade, or c) gets rolled into the new car loan. The last option means that you are  essentially refinancing the remaining debt on the car you just sold back to the dealer, along with the price of the new car and whatever add-ons get added on back in the F&I office.

A lot of prospective buyers might decide to wait on that new purchase if they understood that  their new car loan would include left-over balance on the car they don’t own anymore. So a lot of dealers used to (still??) fudge the numbers on the loan papers so the old loan pay-off disappeared. (Don’t even ask about the Truth in Lending rules and issues.) 

Calling All Article 9 Supernerds--Negative Equity and State Law

What’s a blog for?  For law professors, a key attraction is to float a question you don’t have time to write a law review article about.

As a matter of state (not bankruptcy) law, should a loan be considered all purchase money if the lender makes a consolidation loan for purchase of collateral and also for paying off an old obligation, all secured by the collateral being purchased?  In particular, what are the policy implications for Article 9 purposes of defining purchase money obligation that broadly?

In bankruptcy, the definition of “purchase money security interest” determines the scope of the “hanging paragraph” in chapter 13--specifically, if “negative equity” on an old loan is rolled into a new purchase money loan, whether the whole loan should be treated as a purchase money obligation so that it can’t be crammed down (assuming that is the treatment under the hanging paragraph).

Under state law, the question of the meaning of “purchase money obligation” is not confined to car loans or even consumer loans.  The definition sets the scope of special purchase money provisions in Article 9 that extend to commercial finance for purchase of equipment and inventory.  Should the leap-ahead priority for purchase money obligations apply to rolled in negative equity?   Could this have perverse effects?  In the case of consumer loans for items outside certificate of title laws’ reach (i.e., collateral other than cars and boats), should automatic perfection extend to “negative equity” on some other old loan the balance of which is rolled into a loan for purchase of a washing machine or a diamond ring?

Here Is Your Interest Rate, Except When It Isn't

Credit card companies often make you promises with fine print that nullifies the promise. The Simpsons episodes (maybe the best . . . . show . . . . ever) often will include an advertisement promising some great product with a voiceover that says something like "There is no promise the actual product will be as advertised. Too bad that only one of those is a gag.

A Credit Slips reader e-mailed with a story of how Chase had just decided to change his interest rate from a 3.99% APR to his choice of a 7.99% APR or a $10 monthly service charge and 5% of the minimum balance. This person had a great credit score, no missed payments or job loss, and the loan balance was modest (only about $1,700). Still, Chase had decided it was going to change the deal.

The 3.99% APR is a great rate, of course, and had been a "teaser" rate to get this person's business. To induce him to apply for the card, our reader had been promised a 3.99% APR on all balance transfers "until balance is paid in full." Our reader did the financially responsible thing and transferred his existing balance to this lower-rate card. He dutifully made sure he did not incur any new purchases on the card that would trigger a higher rate. Chase was apparently not making enough money on the deal and decided it was time to change the terms.

A Class on Bailouts

In early 2008, I had to figure out what courses I would teach in the next academic year, and it was decided that I would offer a seminar of some sort in the 2009 spring semester. "Just call it a seminar on consumer credit as a placeholder in the course listing," I said. It seemed likely that such a seminar would be timely. Who knew? By the fall, of course, we were in a full-blown financial crisis, and the seminar became the Bailouts class.

Students looking for me to lecture from the front of the room with answers will be disappointed. I have more questions than answers. Although the seminar became more of a class as enrollment grew, I still intend to conduct the class principally as I would in a seminar with emphasis on reading and discussion.

Whiteboarding Credit

Yes, I meant "whiteboarding." If you're not an expert and are looking for plain English explanations of concepts like asset-backed securities, credit default swaps, and margin calls, check out the Marketplace Whiteboard. It's an effort by Paddy Hirsch, senior editor of American Public Media's Marketplace, to explain complicated financial concepts using everyday analogies that bring home the underlying ideas. The video podcasts are a good way to get educated on these topics.

Tying an Auto Industry Bailout to Health Care

I'm skeptical about a government-sponsored auto industry bailout and think chapter 11 probably provides the best policy tool to deal with the current problem. Although auto industry execs have balked at the idea of a bankruptcy filing, some have promoted the idea of a "prepackaged" chapter 11 as if it offers some sort of risk-free panacea. That is wrong, and I recommend Fred Tung's post over at The Conglomerate where he discusses the pitfalls that even a prepackaged chapter 11 might have. Discussing a prepackaged filing presents similar tough issues as a regular chapter 11. My task with this post, however, is not to take on the question of whether we should bailout the U.S. auto industry but, if we do decide to do it, one way we might do it better.

Former Credit Slips guest blogger and oberlawyer David Yen suggested to me that an auto industry bailout be tied to the industry's health care costs. This is a good idea and deserves some attention in the debate. The idea, as Yen wrote to me, is:

Instead of just giving the Big 3 auto companies money, we should give them tax credits tied to their health care bill. The tax credit would be structured so that if a more comprehensive health plan is ever enacted, there could be a relatively smooth transition. This would be a two fer.

The tax credit would incentivize the auto companies to ensure their workers have adequate health-care coverage, helping to alleviate one of the biggest financial stresses on the American middle class.

Do We Want More Consumer Lending?

Yesterday, Treasury Secretary Paulson announced a major shift in strategy for the federal government's financial rescue plan. Treasury now would make $50 billion available for lending to companies making credit card, automobile, and student loans. The idea is to jump start consumer lending sector, although I am not sure to what end. There is no doubt that the consumer lending sector has frozen up along with the other credit markets. What concerns me is that the Treasury's latest plan seems an attempt to return us to the same policies that got us to where we are today.

Worst Practices: Residual Interest

Professor LoPucki's APR issue might not be two-cycle billing as many of the commentators think. Just as likely, it is residual interest (a/k/a trailing interest), the often ignored, but just as potent cousin of double-cycle billing.

Residual interest has not gotten nearly as much attention as it should (and it is often confused with double-cycle billing). Residual interest is a nasty billing trap that drains away discretionary income (also known as potential savings) from American consumers, and should be at the top of the Congressional hit list for predatory credit card billing practices.

Behaviorally Informed Financial Services Regulation

A new policy paper issued by the New America Foundation and authored by Michael Barr, Sendhil Mullainathan, and Eldar Shafir argues that we need to move toward "behaviorally informed financial services regulation." By this the authors mean that financial services regulation should incorporate the insights of behavioral economics and cognitive psychology, regarding things like default rules, framing of information, and hyperbolic discounting.

This paper comes on the heels of Richard Thaler and Cass Sunstein's book Nudge, the culmination of their work in developing what they call "libertarian paternalism"--a soft-form version of paternalism that instead of mandating outcomes, such as requiring retirements savings, sets default rules and menu choices in a way that encourages them, such as making workers opt-out of retirement savings plans, rather than opt-in.

There's much to commend about this work (Barr et al., as well as Thaler & Sunstein), and the incorporation of behavioral economics into law has been an important development in the last decade or so of legal scholarship. I do not doubt that behaviorally informed financial services regulation would be an improvement over our current model. But I am dubious about its ultimate efficacy for three reasons.

The Moral Hazard of Treasury's "Equity" Injection

Treasury Secretary Paulson is jawboning banks to use the Treasury's capital injection to lend, rather than to just sit on the funds. This is very telling about the way Treasury sees the financial crisis and should concern us because it sets up a moral hazard and papers over the looming problem of the US economy: consumer overleverage.

Regulation Cannot Depend on Irrational Markets

At this point, it is all too clear that financial markets can get things wrong. This is not an isolated phenomenon. No, getting it wrong tends to be the name of the game for financial markets. Understanding that financial markets regularly underestimate or overestimate the risks of investing is crucial to the proper design of financial market regulations.

This is a Financial Crisis like Any Other – Treat it Like One

I wanted to thank Bob Lawless, Elizabeth Warren and Credit Slips to invite me back as guest blogger. It seems an appropriate time to discuss topics in two of my areas of expertise -- financial crises and retirement income security -- as they are directly related to the current financial turmoil.

The markets are crashing. This is a standard financial crisis, as many other countries experienced over the past twenty or so years. In a crisis four risks materialize: default risk, maturity risk, interest rate risk, and exchange rate risk. We are spared from the last one since the dollar dropped well before this crisis. The problem is that we are not adequately addressing the remaining risks.

Is the Crisis Real?

At a Harvard panel discussion yesterday, [correction**] Gregory Mankiw--Harvard economist and Chair of the President's Council of Economic Advisers 2003-2005, made an interesting point: The liquidity crisis isn't real.  Or, to restate it: Any liquidity crisis is caused by the promise of a government bailout. Greg said that his many friends in investment banking said that there is plenty of money to invest in financial services, but right now it is "sitting on the sidelines."  Why?  Because the financial services industry does not want to pay the terms required to get that money back in circulation (e.g., give up equity).  As he put it, why do business with Warren Buffett who will negotiate a tough deal, if you believe that the government will ride in soon with cheaper cash? 

Economics professor Ken Rogoff also talked about the need to shrink the financial services sector. He thinks it is good that the investment banking houses are failing and many people on Wall Street are losing their jobs because, in his view, we have an oversupply in that sector and our economy just can't support it.   

Greg's work with the current administration and Ken's background with the IMF and on the Board of the Federal Reserve add a certain credibility to their assessments of conditions on Wall Street.  If they are right, the $700 bailout is saving some investment bankers' jobs in the short term, but overall it is just making the financial system worse. 

The Bailout -- how do we know we really have a problem?

As the politics of the bailout get more and more heated, my friend and colleague Frank Pasquale, a regular at this blogging stuff who has also been thinking about the proposed bailout, was kind enough to comment on one of my earlier posts.  In essence, he asks how do we know that the credit markets would really collapse if the bailout legislation did not pass?

It is not an easy question to answer, given that the markets are largely anticipating some sort of bailout -- albeit with some doubt thrown into the mix.

I look to three factors:

1.  The interbank LIBOR rate is acting erratically.  This is the rate that banks charge each other for loans.

2.   Non-financial corporations are stockpiling cash in case of a lending market shutdown.

3.  The CDS market (admittedly part of the problem here) is also acting erratically, moving sharply based on the latest news about the government's actions.  The following chart (produced by Markit) tells the story last week with regard to the movement of two leading CDS index measures:

 

The Bailout -- another perspective (part 2)

In my prior post I talked about why the bailout was probably the best, if still unattractive, solution to the current mess, while noting that the Fed and administration have done a pretty lousy job of explaining what is at stake.  In this post I take up the regulatory issues that naturally flow from the present crisis, particularly the issue of credit default swaps, which I've been following for a while.

During the hearings earlier today, Senator Dodd called the current crisis “entirely foreseeable and preventable, not an act of God."  He is right.

The crisis is complex, but there seems to be general agreement that the root problem was a deadly co-dependence between irresponsible borrows and irresponsible lenders.  While I leave the problem of the borrowers to my colleagues that study them, I will state at the outset that if this bailout is our national moment for "moving on," it seems reasonable that that this should apply to the borrows and lenders equally.  In short, I don't buy Secretary Paulson's suggestion that this is "unlreated."

Turning to the lenders, the part of the problem that is within my jurisdiction, I agree with Christopher Cox, the chairman of the Securities and Exchange Commission,who today called for more regulation of the credit derivatives markets.  While I was willing to give this new market some space while it developed, it is clear that the atomistic nature of the market is at odds with the larger economic good.

Stated bluntly, the industry had its chance and blew it.  Time to consider something new.  More after the jump.

The Bailout -- another perspective (part 1)

First, I want to thank Bob Lawless and the rest of the Credit Slips folks for having me back yet again -- I'm getting to be like the guest who would not leave.

Second, while it might make me part of the "establishment," I'm going to say right from that start that I join those who favor the bailout.

I also think we need to avoid a whole lot of knee jerk reactions that are floating around out there -- like the SEC's ban on short selling, which is quickly becoming the Bad Management Protection Act of 2008.  Of course, the notion that the administration can open the door on this issue "just a little" is also equally suspect.

I view the economy and the larger financial system as being at a Titanic like moment:  post iceberg, per submersion.  It is certainly reasonable to disdain those who got us into this situation, but I'm not going to let my feelings for them get in the way of saving as many people as possible.

That said, I understand why there is a good deal of skepticism about the bailout.  In part chapter 11 is to blame -- there has been almost no effort to explain why AIG is different from Enron, United Airlines, or any other really big corporation that has recently failed.  And the financial industry needs to fess up that it blew its chance to self-regulate the credit default swap market -- too many people, even myself to some degree, bought the "trust us, we're experts" line from ISDA and other market players.

No wonder people aren't buying that line in connection with the bailout -- especially when the administration has its own credibility problems in this regard in connection with other big, complex projects in the non-financial area.

More on the chapter 11 issue, and why I think the administration has done a terrible job of selling this but still generally support the bailout, after the jump.  I'll save my thoughts on the CDS market for another post.

Before I Hand Over a $700 Billion Check, How About Some Balances?

When the government bailout of the financial industry was first announced, we were told more details would be forthcoming. The weekend has passed, and we still have few details. We're being told that there is a big threat, things have to happen quickly, and we give the Administration broad powers and trust them to do the right thing. When have we heard that before? Rather than being steamrollered again, Congress should demand some accountability rather than giving Treasury and Hank Paulson unfettered powers.

To the extent we have more information than we did on Friday, the proposal has become vaguer. Instead of mortgage-related securities, Treasury now would be authorized to purchase "any financial instrument." Instead of the buyout being limited to institutions with headquarters in the United States, Treasury could buy "any financial instrument" from an entity with "significant operations in the United States."

Weller on Time to Avoid a Banking Bailout

Former Credit Slips guest blogger Christian Weller wrote me over the weekend to point out that the charge-off rate on credit cards hit an eye-popping 5.47% for the second quarter of 2008. That led to an e-mail conversation about what was happening with the banking sector and how things look like they will get worse. Christian, who is an associate professor at UMass-Boston's Department of Public Policy and Public Affairs and a senior fellow at the Center for American Progress, made some really interesting points and, even more importantly, had some ideas for some actions that needed to be taken to prevent things from getting worse. I asked Christian if he would write up his ideas so they could be posted here, and he was kind enough to do so.

From Christian Weller:

Policymakers at the Federal Reserve and in the administration were slow to admit that they had a mortgage mess on their hands. The solutions have thus been tepid and so far not particularly successful in stemming the tide in foreclosures. Foreclosures are shattering previous records, setting new ones, just to be broken a few months later. The Mortgage Bankers Association reports that the share of mortgages that entered foreclosures in the second quarter of 2008 stood at 1.1% and the share of all mortgages in foreclosure was 2.8%. Since the 1970s, the share of mortgages entering foreclosure never exceeded 0.5% before the end of 2006 and the share of total mortgages in foreclosure never exceeded 1.5% before the second half of 2007.

Why the OCC Can't Be Relied on for Consumer Protection

The OCC is up to its old tricks. It doesn't matter how bad things are out there for consumers--one can always count on the OCC to stand up against any attempt to regulate the consumer lending practices of national banks.

The OCC's latest shande is its opposition to the Federal Reserve's proposed expansion of Regulation AA, which defines and bans certain unfair and deceptive acts and practices (UDAP). The OCC's response, is perhaps the best illustration of its complete regulatory capture--the OCC is objecting to the proposed Regs because it is concerned that they will hurt bank safety-and-soundness, and constrict lending (which it claims is bad for consumers).

Somehow the OCC's parallel agencies--the OTS and NCUA, which regulate federal thrifts and credit unions, haven't been overwhelmed by the same concerns, as they have proposed parallel UDAP regulations to the Fed's. It seems that the OCC doesn't understand that UDAP regulations are about consumer protection, not safety-and-soundness. But, then it is hard to think of a federal agency that is more in the thrall of the entities it "regulates."

The Banks, Private Equity, and the Fate of Consumers

The New York Times has an interesting op-ed about private equity investment in banks. Long story short: banks need money now, and private equity is one of the last remaining sources of capital available. PE investment strategy is to buy a control stake, maximize efficiencies, and resell the company in 5-7 years. Because current bank regulations require that an entity holding beyond a certain threshold of a bank's stock either register as a bank holding company (which subjects it to various regulation, including disclosure requirements) or forgo involvement in the bank's management, PE firms are reluctant to invest in banks. Private equity is about control and lack of transparency. PE smells a great buy in banks, however, so PE shops are pushing federal banking regulators to relax the regulations. Their argument: without us, the banks will fail and/or credit will contract, and this will be on your heads, banking regulators, so beggars can't be choosers.

The Times rightly notes that PE shops shouldn't get special treatment and if banks fail, well let that be a lesson to their investors and creditors to monitor lending practices better in the future. Depositors are largely protected by FDIC insurance.

But there's another worrisome angle left unmentioned in the Times editorial. Because PE shops are simply trying to maximize efficiencies in the short-term in order maximize their return on exit, they aren't concerned about the long-term safety-and-soundness of banks. If the company blows up after the sale, the PE shop doesn't really care. This could spell bad news for consumers. If a PE shop buys a bank and sets out to maximize revenue/cut costs, it will likely start milking the consumer cow much more vigorously. And this means PE shops might be tempted to push all sorts of abusive, but very profitable lending practices. This is quite concerning, and if federal bank regulators do loosen the investment requirements for PE, it should be with very explicit commitments to maintaining best practices vis-a-vis consumers. Of course, once the camel's nose is under the tent, these commitments could start to look a lot like the ones on human rights that China made the International Olympic Committee.

Hearings on Squeezing the American Family

Yesterday, the Joint Economic Committee of the U.S. Congress (JEC) held a hearing on the economic state of the American family. We've got falling real incomes, a mortgage crisis and a housing market in turmoil, record gas prices, and other increases in the costs of living. It's not going well.

Among the witness was Credit Slips's own Elizabeth Warren who started off with this:

From 2000 to 2007, measured in real dollars, incomes declined while basic expenses increased sharply. By the time today’s family makes a few basic purchases—housing, health insurance, food, gas, phone—it has about $5800 less than it had back in 2000.

Warren backs up that statement with numerous charts and statistics that demonstrate how incomes have failed to keep up with the rising cost of living. Her full testimony is here.

Usury Bill

This week Senator Richard Durbin (D-IL) introduced a federal usury bill, S.2387, the Protecting Consumers from Unreasonable Credit Rates Act. I haven't found a copy of the bill yet, but according to Durbin's website, the the bill:

• Establishes a maximum interest rate of 36% on all consumer credit transactions, taking into account all interest, fees, defaults, and other finance charges.
• Clarifies that this cap does not preempt any stricter state laws.
• Applies civil penalties for violations including nullification of excess charges, fines, and prison.
• Empowers attorneys general to take action for up to three years after a violation.

There are four major points to make about this legislation. First, it would restore an important element of democratic political accountability to consumer protection in financial services. Second, it would significantly restore states ability to protect their own citizens. Third, it offers a solution to the problems of financial products being structured so as to avoid APR disclosures and to catch consumers with hidden fees. And fourth, it represents a very important first step in a legislative process of rethinking the model of credit industry regulation.

[Hat tip to Dan Ray for the link to the text.]

Harkness on Changing Credit Card Regulations for the Elderly

Most consumer credit regulation, especially at the federal level, is a disclosure-based system -- disclose the terms to consumers and let them decide. There is a robust debate questioning whether the disclosure-based system works. I doubt that it does, but one demographic segment where it would seem particularly not to work are the elderly.

On that topic, the University of Illinois's Elder Law Journal has just published a piece by Professor Donna Harkness of the University of Memphis: "When Over-the-Limit Is Over the Top: Addressing the Adverse Impact of Unconscionable Consumer Credit Practices on the Elderly." From the abstract:

Predatory lending practices in the credit card industry have created retirement instability for today's elderly population. Many elderly individuals find themselves facing mounting debt, lawsuits, and foreclosure because of the eradication of state usury laws as a limit on interest rates, late fees, and other penalty charges. Existing laws, which focus on disclosure of credit terms to consumers, have done little to address or ameliorate the problems facing the elderly, who are more vulnerable to the negative effects of unconscionable consumer-credit practices. While many feel that the problem lies in the improvident extension of credit, evidence suggests that much of the profit gained by the credit card industry lies in extending credit to people more likely to default, such as the elderly. Professor Harkness advocates for the revision of the federal Truth in Lending Act to add substantive protections that would prohibit the charging of excessive late fees, require creditors to take affirmative steps to mitigate damages, and prohibit assessment of over-the-limit fees when debtors have not actually requested issuance of additional creditor. These revisions would help eliminate the financial incentives encouraging credit card companies to profit from the default and financial ruin of the elderly.

The article is at p. 1 of volume 16 of the Elder Law Journal and available here online. Those interested in elder law issues might want to check out the journal's web site.

Debt Stress and Other Credit Card Gems

On June 9, the Associated Press and AOL released a poll describing an increase in self-reported stress by Americans struggling with debt. According to a Debt Stress Index that compiled the poll results, 43% of respondents scored in the moderate to high range as compared to 32% from a comparable survey at the end of 2004. Blog posts and news stories summarizing the results can be found in many places including here (WebMD), here (AOL), and here (MSNBC, a good summary).

The link between high consumer debt and physical problems has been well known, albeit not as well publicized as it should be. For example, this most recent poll finds 44% of persons reporting high debt stress also reported migraines or other headaches as compared to 15% of the other respondents. Also, persons reporting high debt stress reported heart attacks at double the rate of persons reporting low debt stress.

Older Americans in Bankruptcy--The First Paper Out of the Consumer Bankruptcy Project

Many of us on Credit Slips are part of the Consumer Bankruptcy Project (CBP), a multidisciplinary research initiative. This week, many of you probably saw the press coverage for the first paper published out of the CBP data: Generations of Struggle by Deborah Thorne, Elizabeth Warren, and Teresa A. Sullivan. This paper's reports three key findings. Since 1991--

• Americans age 55 or older have experienced the sharpest increase in bankruptcy filings.
• Americans age 34 or younger have experienced the greatest decrease in bankruptcy filings.
• The influence of Baby Boomers on bankruptcy filings has moderated substantially.

A full copy of the paper is available from the AARP here. The paper shows that older Americans are under greater financial stress than ever before. I am sure we will have more to say about this paper here on Credit Slips.

Because the courts do not collect any basic demographic data about who files bankruptcy, this sort of information would not be available without interdisciplinary research teams like the CBP and the organizations who generously support our research (the AARP, the Robert Wood Johnson Foundation, the Federal Deposit Insurance Corporation, and research funds at the University of Michigan and Harvard University). The data collection for the CBP is complete, and we will keep announcing the availability of new papers here on Credit Slips. What exactly, however, is the CBP?

Countrywide's Politically Connected VIPs

Credit Slips readers will want to take a look at this article in Conde Nast's Portfolio.com. The article describes Countrywide's VIP program, which gave favorable loan terms to politically connected individuals. Beneficiaries of Countrywide's largesse would receive reduced fees on their loans and were allowed a free float down of their interest rate if the market rate went down after the rate was locked in. From the beginning of the article:

Two U.S. senators, two former Cabinet members, and a former ambassador to the United Nations received loans from Countrywide Financial through a little-known program that waived points, lender fees, and company borrowing rules for prominent people.

The New York Times carried a story today about the response of Senator Dodd, one of the senators mentioned in the story.

Hat tip to my ceremonial dagger-wielding colleague for pointing my way to this story.

Senate Rule XXVI and the Consumer

Yesterday, Senator Patrick Leahy caused the Senate Committee on the Judiciary to hold a hearing with the intention of shedding some light on how Supreme Court decisions affect everyday Americans. In the middle of answering my first question, Senator Whitehouse interrupted me to say that, as the presiding officer, he regretted that he had to gavel the hearing to a close. An unnamed Republican senator had invoked Senate Rule XXVI, which requires the hearing to come to a close within two hours after the Senate convenes for the day. Normally, the Senate gives unanimous consent to waive this rule but not yesterday.

On the previous day, a Republican senator had used the same tactic to shut down a hearing about whether coercive interrogation tactics--a polite term for "torture"--were effective. As one of the spectators in the hearing quipped afterwards, you know you have a hit a nerve when the same tactics as were used in the torture debates are being used to silence those who would speak in favor of stronger protections of consumers. Senator Whitehouse was visibly unhappy with having to close the hearing, and Senator Leahy released a statement similarly criticizing the procedural move. What was being said at our hearing that was so awful?

The Supreme Court and the Consumer

Tomorrow, the United States Senate Committee on the Judiciary will hold a hearing entitled "Short-change for Consumers and Short-shrift for Congress? The Supreme Court's Treatment of Laws that Protect Americans' Health, Safety, Jobs and Retirement." The committee will shed light on how seemingly obscure and highly technical regulatory Supreme Court decisions can have dramatic effects on the lives of everyday Americans. As usual, Jon Stewart about summed it up when he was talking about some regulatory development, suddenly stopped, and said, "Yes, it's boring, and that's how they get away with it." That's pretty much the point of tomorrow's hearing. These decisions may seem quite boring, but start paying attention unless you want to expect more of the same.

Most of the hearing will focus on preemption decisions that affect the ability of Americans to recover for wrongful decisions of their health insurers and their employers. I will be there to talk about some of the Supreme Court's decisions in the financial services area, decisions that have removed any effective protections consumers might enjoy from their own states from aggressive and deceptive lending practices. More information can be found on the hearing web page here including, when they become available, the senators' statements and the written testimony.

Obama on Credit Cards and Bankruptcy

This is quick post about Obama's speech on the economy in Raleigh, N.C. He spent two and a half "paragraphs" of it discussing credit cards and bankruptcy. (The link is to the whole speech. I've also excerpted the relevant passage in the "continue reading" part of this post.)  I'm intrigued by his five-star risk rating idea for credit cards because I have a particular interest in meaningful disclosures, ones that can actually help real people make decisions about financial products. But I am a little disappointed by the limited way he discussed bankruptcy reform. Yes, letting people prove medical bankruptcy would be a good start.  But as many of us look more closely at the post-BAPCPA data, I'm becoming more convinced that it's the procedural barriers and the expenses they entail keeping people out of bankruptcy, not the means test itself. If that's correct, a small improvement to the substance of the law might not make much of a difference, especially if it were accompanied by additional procedure (i.e., the process by which people would "demonstrate" that they filed because of medical bills).

Justifying Debt Forgiveness: Information Asymmetry and Risk Allocation

In my last guest blogs before quitting, I want to briefly discuss, and hopefully get a discussion going, about two topics related at the Illinois Debt Symposium. This was a fabulous interdisciplinary event, about which Mechele Dickerson has blogged extensively already.  But a couple of the topics are still stuck in my craw.

Ever since Heidi Hurd’s talk at the Illinois Debt Conference, about why we grant a bankruptcy discharge in our society, I have been unable to stop thinking about it. She attempted to justify debt forgiveness because it is the right things for a just, moral, wealthy society to do. The most interesting thing about topic is that it implicitly challenges what many of us take as a given. Is it necessary to forgive debts for people cannot pay them? On what basis? Many readers of this blog cannot imagine a world without a bankruptcy discharge, but numerous others in our society (and other societies) completely disagree. Professor Hurd (and her coauthor Professor Brubaker) ask us to justify the forgiveness of debts, something we should be able to do.

The Myth of the Non-Bankruptcy Exemptions

How does the saying go, possession (of a lawyer) is 9/10ths of the law? When it comes to exercising ones rights under the state exemption schemes, the adage is true. The common lore is that if a person's assets are worth less than the state's exemptions, they do not need a bankruptcy to protect these assets. But the non-bankruptcy exemptions can be deceptively difficult to take advantage of without a lawyer. And, there is little reason to believe people who have just had a judgment entered against them for non-payment of a debt will have access to lawyer.

The exemptions allow the debtor to keep some necessary assets (house, car, tools of trade) out of the hands of judgment creditors. The reason we do this is not kindness but efficiency and utilitarianism. We want to save creditors the trouble of grabbing assets with little value and keep debtors from become wards of the state, keep them working, living inside, etc.  In theory, state exemption laws allow some people to avoid formal bankruptcy and still keep their assets, because they have no non-exempt assets that can be reached by creditors.

Nice theory, but here is how it works in real life.  Creditor gets a judgment.  Debtor gets notice of the judgment and a large packet of documents in the mail.  Among them is a piece of paper asking the debtor to state whether any of his or her assets are exempt from execution. If this is not done within 10 days (20 in some states), the exemptions are "deemed waived."

When Agencies Get it Wrong, They Reeeeeeeeeeeeeeeeeealy Get it Wrong

We ended the first day of the conference with management professors, Professor Gerry McNamara (Michigan State University) and Professor Paul M. Vaaler (University of Minnesota). They discussed How and Why Credit Assessors "Get It Wrong" when Judging the Risk of Borrowers: Past and Present Evidence at Home and Abroad. Professor Vaaler observed that the subprime meltdown is just one of the latest mistakes the rating agencies have made in recent times (he also points to the S&L crisis, Asian financial crisis). He argues, however, that private, credit rating agencies are at the center of the current housing crisis.

Professor Vaaler stressed that the agencies almost always get it right when assessing the risk posed by individual securities. But, when they get it wrong they get it wrong in a spectacular way.

How did Lenders Get it So Wrong?

An economist, Professor Amir Sufi (University of Chicago), shifted our focus in the afternoon session from debtor, to lender, behavior. In discussing his paper, Lender Incentives, Credit Risk, and Securitization: Evidence from the Subprime Mortgage Crisis, Professor Sufi asks why lenders made such bad decisions when making subprime mortgages. He concludes that securitization reduced lender incentives to scrutinize borrowers, because lenders knew they would sell virtually all the subprime loans they originated and, thus, knew they would shed the credit risk associated with those loans. Professor Sufi argues that this is to be expected, since financial intermediaries overcome information frictions only if they have an incentive to properly screen and monitor borrowers.

The Stimulus that Can't Stimulate

Hanging the worldwide economic recovery on reigniting consumer spending is like investing in used fireworks.  The pizzazz is already gone. 

How are Americans planning to spend their stimulus checks?  According to a new poll, fully 41% say they will use their rebates to pay down debts.  Another 19% are trying to protect themselves by saving it, so that 60% have no spending plans at all.  Only 7% describe new spending.  Debt is blocking a large part of any impact the stimulus package might have had.

Presidential Candidates and Short-Term Fixes

In this morning's New York Times is a story about Senator McCain's position on the mortgage crisis. With the story is a graphic comparing the candidates' positions on short-term and long-term fixes to the credit problems in the United States. Long-term fixes I get, but here is what I would like the candidates to say about the short-term fixes:

If I am elected president, I would not take office for another eleven months. Our current financial crisis will look very different by then. In eleven months, we could be dealing with a housing problem where the issue is simply ensuring that large numbers of people have the shelter they need. In eleven months, the credit problems could have spread even further to areas like the credit card industry or the student loan market. In eleven months, we may have seen a string of bank failures that will require us to prop up the banking system. Maybe things will go in another direction. In eleven months we may have had more positive outcomes with confidence on Main Street and Wall Street increasing and credit again flowing.

Different experts will tell you what they think will happen, but nobody knows for sure. As president, you should want someone who will be nimble enough to deal with the situation as it will be presented to them next January. If you want to know what I would do if I were in office today, I'll tell you, but don't think these ideas necessarily will be the best solutions one year from now.

Yeah, I know, not going to get said.

Loaded for Bear?

Last week, JPMorgan was going to pay $2/share for Bear, Stearns, with any loss absorbed by the Fed (and thus by taxpayers). Now JPMorgan is going to pay $10/share.

This new offer shows what a lowball offer $2/share was. The offer just jumped 500%! This should make one question whether $10/share is still a lowball. Can we expect the current process to produce a fair market price for Bear? Shouldn't we at least have some sort of an auction? Perhaps that already happened informally before the JPM bid came out, but now that the initial panic has subsided, maybe it's time to have a more formal and orderly auction. In light of the apparent drafting snafu in the original offer that has JPM on the hook for all of Bear's trades, regardless of whether the deal is consummated, I have to think the Bear Stearns board might have a duty to shop for other offers. I assume that the Fed would offer its guarantee to anyone who could top the JPM offer.

Regardless of whether JPM pays $2 or $10/share to eat Bear, I'm still puzzled why the Fed didn't guarantee BS directly or buy it out itself? Why would the Fed take the downside risk, but not also the upside? I'm not familiar with the Fed's enabling statute--perhaps there is a legal impediment. But even if not, I doubt that the Fed wants to own BS itself--it's one thing to hold some mortgage backed securities, it's another thing to have a 100% stake in a major investment bank, even for a short period. Still, it's one thing to bail out Bear Stearns. It's another to hand JPM (or anyone else) a windfall that should rightfully be the taxpayers'.

The Future of Consumer Credit...Today

Paige and Jeremy have had some wonderful posts this last week, and although I have not been deputized to be their official host, I want to thank them for really pushing the behavioralist perspective.

I want to take up the final question Paige and Jeremy posed, however. They ask "Will the terms of consumer credit improve (lower interest rates, more frequent flyer miles) or worsen (higher late fees, more invasive collections practices)?"

We already know the answer, because the future is here today.

Asymmetric Paternalism

With the growing evidence on behaviors that deviate from the rational-choice model, a discussion on paternalism is taking center stage. As an economist, I am pretty averse to taking choices away from people, but can we have our cake and eat it too? Enter “asymmetric paternalism.”

“A regulation is asymmetrically paternalistic if it creates large benefits for those who make errors, while imposing little or no harm on those who are fully rational..."