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Usury Bill

posted by Adam Levitin

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.]

1) It's worth remembering that the Supreme Court's 1978 decision in Marquette did not nullify state usury laws--they are still on the books, and the National Bank Act still subjects national banks to usury laws. Marquette merely held that the state usury law that applies to a national bank is that of the state in which the bank is based. It did not hold that usury laws do not apply to national banks, even if that has been the practical effect. While the effect of Marquette was to allow a regulatory arbitrage as banks moved to states with no or very high usury caps, national banks are still subject to any applicable usury law.

The Durbin bill is actually an important measure to restore democratic (small "d") political control over consumer protection. The Durbin bill merely ends a regulatory arbitrage created by a Supreme Court decision that was driven by a reading of 19th century banking law, rather than any considered policy position. The current regulatory arbitrage situation is affirmatively undemocratic and contrary to the principle that people should choose, through their elected officials, the laws that govern them. At present a couple of rogue states can export their lax lending regulations to the rest of the country. If Delaware and South Dakota voters are willing to forgo a mainstay of consumer protection in lending, that's their own business. But why should Delaware or South Dakota voters get to effectively choose the consumer protections for residents of Illinois or Maryland? Making usury regulation a federal matter allows for a fair, democratic debate on whether lenders should be subject to usury limits and, if so, what those limits should be.

2) The bill would put states back in the consumer protection game--a traditional area of state police power. Federal regulators have either been willfully somnolent (OCC, OTS) or without sufficient authority (FTC, FDIC) to engage in meaningful consumer protection in financial services. State attorneys general have lacked authority because of preemption issues post-Marquette, but they do not lack in motivation to enforce consumer protection laws. And, attorneys general do not have the problem of state banking commissioners, the OCC, and OTS, of not wanting to scare away chartering business by engaging in rigorous consumer protection. An interesting question (which will depend on the text of the bill) is whether Marquette would still apply within the 36% cap. If Illinois decided that a 28% cap was more appropriate, would this apply to all national banks lending business in Illinois or just to those based in Illinois (as well as to all non-national banks, assuming away all parity legislation).

3) A major problem with consumer credit regulation has been that credit instruments have become increasingly complicated, so much so that consumers cannot accurately gauge the cost of borrowing. Oren Bar-Gill has noted this problem in the context of subprime mortgages, but it is equally a problem with credit cards. Simply put there are too many price terms (many of which are contingent) for a consumer to easily compare products or even to know in advance the cost of borrowing on any particular product.

The complication of credit instruments has been a very deliberate move by the credit industry, both as a competitive move and to avoid regulation. Creditors know that borrowers place greater emphasis on some price terms than on others. In part this is a function of hyperbolic discounting--consumers undervalue contingent and delayed price points--and in part it is a function of the terms that consumers are used to having emphasized, e.g., APRs. Creditors know that they gain a competitive advantage by shifting the cost of a credit product from the points consumers pay attention to to the ones that they ignore. Thus, if creditor A offers a fixed APR of 20%, while creditor B offers a fixed APR of 12% plus numerous contingent fees (that it knows from actuarial modeling are likely to accrue), creditor B's loan looks cheaper to the consumer who emphasizes the APR, even if it might actually be more expensive. Competitive pressures have forced the credit industry to abandon simply, up front pricing. The up shot of this is that competition in the credit industry is reduced because it is not being driven by total price, but by only a deceptive part of the price picture.

Likewise, the move to complicated pricing has been spurred by a desire to avoid regulatory disclosures. TILA and Reg Z require various disclosures from creditors, the chief of which is the APR. Indeed, the APR is the chief point on which credit is priced and marketed. But not all fees end up in the APR. Creditors thus have an incentive to shift as much of the cost of credit as possible to fees that are not reported in the APR.

The Durbin bill would counteract the competitive and regulatory evasion motivations to engage in complicated pricing. By applying the usury limit to the total cost of credit (and indeed, what other cost is meaningful?), it would reduce the incentive to hide fees and costs from consumers. Creditors with complicated pricing structures would be more likely to miscalculate the cost of credit extensions and thus violate a usury cap. The presence of a cap would discourage price obfuscation.

4) The Durbin bill also represents a very important opening salvo in a legislative process of rethinking regulation of consumer credit. In this regard, there is something remarkable just in the existence of the bill. The entire model of federal credit regulation to date has been disclosure plus limitations on a few of the most egregious unfair and deceptive acts and practices (most notably in the Fed's new mortgage rules and the Fed/OTS/NCUA proposed credit card rules). The regulatory approach is still very much one of "disclose and don't do anything really bad and you are free to do as you please."

But there is no evidence that disclosure is effective (not worth reading, not understandable when read, limited bargaining ability, and signaling doesn't work because of the private nature of the transactions) for complex consumer financial products (Jonathan Zinman & Victor Stango's work addresses only simple financial products, like auto loans and short term installment loans), and problems in the consumer credit market run far deeper than a few bad actors doing a few egregious acts. Much of it is fueled by more fundamental lending issues that regulators still have not addressed, such as unrealistically high debt service requirements and business models based on turning borrowers into evergreen annuities. There is a huge profit incentive for the credit industry to obfuscate price and to invent new abusive practices whenever regulators belatedly nip off the very worst ones. At best, regulators play a slow-mo game of Whack-A-Mole with the credit industry, and at worst, because of regulatory capture problems, they don't even nip off the worst practices until way too late.

The movement from disclosure to "disclosure+" is unlikely to be effective, and, at worst, will provide cover for the credit industry to avoid more meaningful regulation. While the potential problems of usury caps--most notably credit rationing--are issues of which we should be mindful, it's encouraging to see legislators thinking about regulating the core substantive terms of consumer credit, not just fringe practices.

Comments

In case anyone is not familiar...

If/when this bill is officially introduced, you should be able to track it's progress - and the progress of any other House or Senate bill or resolution - at http://www.thomas.gov .

Got an E-mail from my congressman yesterday about the bill. Gave him some positive feedback.

Whoa "Dolly" whooohooo!
Am going to be here all day!

http://www.corpusbeach.com/portacam2.htm

I'm sorry, but 36%? Has our perspective gotten so bad, we accept this as a starting point? Think about it, what's the 10 year Treasury note yielding? THIS is NOT a starting point, this IS usury.

This bill sounds pretty nice. Unfortunately, it also sounds like it's going to go nowhere.

I'm not sure how a lender could calculate the total cost upfront to comply with the statute. For instance, if the interest charge on a small loan was 18% APR, a lender could easily get above 36% total cost if the customer paid late a few times, went over the credit limit, etc. How could a lender possibly gauge how many fees an individual customer would incur ex ante?

Of course the lender could eliminate all contingent fees, but this move would effectively make people who pay on time/don't go over the limit pay more for credit than people who ordinarily incur such fees.

I'd rather see a reasonable cap on contingent fees. This change would also emphasize the true APR because lenders could not increase profits through extra contingent fees.

[I'm sorry, but 36%? Has our perspective gotten so bad, we accept this as a starting point?]

A similiar bill capped it at the lesser of 36% and T+15% (currently around 22%). Capping it too low will cause concerns by banks worried about a return of high inflation. But 21% interest on 30-year treasury bonds implies a time when consumer credit card debt will be dwarfed by other problems.

On the more general point, any bill will face immense resistance and politics is the art of the possible. The only people paying close to 36% today are people who probably shouldn't be getting loans anyway. There's not a lot of political weight in an argument that bottom-feeders need to be able to continue to prey on people in dire circumstances.

But cut it to, e.g., 25% and you're in the territory of people who have screwed up badly but could still have decent rates in 6-12 months after they clean up their act. That's a difficult issue, though, since there's a fundamental difference between somebody locked into that rate for the life of a car loan, for instance, and somebody with a credit card who has triggered penalty rates but can drop them significantly in 6 or 12 months.

The alternative, in the latter, could be worse. E.g., would you rather have temporary penalty rates, or the bank able to demand immediate payment of the full balance (or at least a substantial fraction of it)?

[I'm not sure how a lender could calculate the total cost upfront to comply with the statute.]

I have no idea how the bill does it, but one reasonable approach is to look at the industry statistics and assume it for these purposes. E.g., it's the APR + 2 late payments + 1 over limit per year. Banks would have to disclose the latter, but could also advertise the pure APR for borrowers in good standing.

Hello, Adam, all. I also blogged on the bill, and got Durbin's office to e-mail a copy. You can see the blog item here: http://blogs.creditcards.com/2008/07/senate-bill-to-cap-credit-interest-rates.php
and here is a direct link to the bill:
http://blogs.creditcards.com/Protecting%20Consumers%20from%20Unreasonable%20Credit%20Rates%20Act.pdf

I'm not so sure that 36% is ridiculous, especially for unsecured loans. I suspect that the effective rate paid by many consumers on their credit cards (when fees are amortized into the finance charge) would yield an APR well over 36%. That's kind of a clever thing about the bill--no one except payday lenders can really complain that 36% would put them out of business, unless they are willing to admit that the cost of borrowing from them is actually much higher than TILA APR disclosures show.

I think Jim is worried about the difficulty of disclosures (although maybe his point is about lenders' being able to predict loan returns). The beauty of a usury statute is that the lender doesn’t have to calculate and disclose the costs up front. It’s ex-post policing, not ex-ante disclosure. TILA disclosures would be the same as today, but would also say something like “the total cost of borrower cannot exceed 36%”. Basically, a lender can choose how it wants to allocate costs among price points—interest, fees, etc., but interest and fees would all be aggregated and treated as the finance charge, which could not exceed 36%. So a creditor sending out a bill would have to total up all the charges and then, if necessary, reduce them to whatever a 36% rate would be. This should be a very simple software fix.

I think there might be some questions regarding the calculation of the 36%, but the details of the bill might clarify things. With short-term revolving credit, where each extension is for say 30-days, it is easy to figure out if the interest/fees topped a 36% rate.
Difficulties might arise, though with longer-term extensions of installment credit like car loans, student loans, and mortgages. I would assume the 36% cap applies to the life of the loan, not to any particular installment payment, but that is something that would need clarification. And if it were for the life of the loan, then lenders would have to be careful that fees, etc. at the beginning of the loan wouldn’t add up over 5 or 30 years to top 36%. That could present some compliance challenges especially for loans that are resold multiple times over many years. Also loan refinancing could create issues. If a loan were refinanced in year 3 of a 10 year tenor, would the usury provision be calculated based on the original term of the loan or on the term up until refinancing? That could make a huge difference for whether the cap was violated. And related to this there is a time discounting question--do fees in year 1 of a 30 year loan need to be amortized for time value? For surely a $1000 fee in year 1 is not equivalent to a $1000 fee in year 30.

I suspect that the battle over this bill (if it ever gets to a committee vote, much less a floor vote--but remember that Durbin is the Whip, even if the bill is not being introduced in the Judiciary Committee) will feature arguments about credit rationing and credit substitution (e.g., will borrowers turn to Tony Soprano if they can't get legitimate credit) and a plea by the credit industry that the only way they are staying afloat now is from usurious fees and interest (don't kick us when we're down).

At last! Knock off all the procedural b-s proposals dealing with foreclosures and the umpteenth round of disclosure legislation and self-perpetuating bureaucracies like the "financial product safety commission" and put out a nice clean clear usury law that expresses the sense of the people as to how much lenders can charge and no more. THIS is the way to go. And 36% is way too high. Cut it in half.

And let's be intellectually honest: putting a usury law with real teeth in place will restrict credit to a meaningful segment of consumers and that may affect retail activity in the economy. We have to bite the bullet and accept that. That has to happen to protect the borrowers, and to protect the rest of us from the externalities caused by their inability to manage their financial affairs and the limitless ability of financial institutions to exploit them. That group is just not capable of protecting itself. We have to cut back the credit they can have and the assets they can buy with it.

One solution to the penalty fee problem would be to exclude those fees from the interest rate calculation, but tax them at a very high rate. This keeps the customer's incentive to pay on time, but removes the lender's incentive to extend credit to a customer they expect will default.

What happended to free market?

If Adam Smith could justify selling opium to get others high based on free market principles, surely present day torch bearers of his can justify easy credit and high interest rates?

This bill would also directly address those tax refund loans and paycheck advance loans where the real interest rate is often much higher then 36%. Many of the paycheck advance chains are owned by large banks.

As far as I know, BTK, no banks own payday lenders, but I do think you are right that the bill would address (and wipe out) payday lending. That makes me wonder how we could say the bill puts credit regulation back in the states' hands. States could not allow payday lending, which requires higher rate caps, even if they wanted to under this bill. Right now, they can outlaw it (like New York does, for instance). Perhaps in other areas the bill would give states control that they currently lack, but in terms of payday lending (which Durbin's website focuses on), all the bill would do is eliminate state control.

WILL WE EVER KNOW WHICH LOBBYISTS PRESENTED 170 MILLION DOLLARS TO WHOM WITH REGARD TO FREDDY MAC AND FREDDY MAE?????

I wish I knew how to get thinking people to slow down a minute & think about the long-term societal impact of a lending policies allowing a max rate of 36%. This IS hyper-inflationary folks, it's the stuff that over time rips countries apart. Have we forgotten the extraordinary lengths our Congress went through to reduce our principal measurement of inflation by a whopping one full percentage point (25%), and the fallout we're living through as a result?
Predatory lending is not a service to any borrower, nor does it benefit in any way the society that permits it. Sorry, but I'm at a loss how tenured Professors can rationalize this? To me, it's just plain wrong.

Thirty. Six. Percent?!?!?!?!?!?

Are they out of their minds?

You could never pay this off. It's perpetual debt servitude. Why not just skip all the small stuff and start up debtor's prisons again?

Great post. This part struck me as very poignant when it comes to credit card lending:

[The Durbin bill would counteract the competitive and regulatory evasion motivations to engage in complicated pricing. By applying the usury limit to the total cost of credit (and indeed, what other cost is meaningful?), it would reduce the incentive to hide fees and costs from consumers. Creditors with complicated pricing structures would be more likely to miscalculate the cost of credit extensions and thus violate a usury cap. The presence of a cap would discourage price obfuscation.]

It seems to me that the "total cost of credit" would be difficult to calculate when the APR includes all finance charges and fees that the consumer might incur each billing cycle. For example, a consumer might incur a late fee on a July bill and not on an August bill, meaning the effective APR was higher on July's balance when the late fee ocurred.

With so many fees on credit cards -- late fees, annual fees, over-the-limit fees, balance transfer fees, cash advance fees, etc., etc. -- it seems like the APR would be "bumpy" over time as a consumer incurs the various types of fees. A 36 percent cap might even be too low to capture the plethora of fees that it's possible for a consumer to incur in each billing cycle, especially if revolving a very small balance. Or maybe I'm missing the point that the Durbin bill would force the industry to eliminate (or significantly lower) these "gotcha" fees and return to much, much more simple pricing?

I have long looked at credit regulation on the state level. I am a past legislator and accountant.
Although I am a believer of keepping the government out of our lives. Financial companies and banks have failed to regulate their greed at the expense of the poor. Easy credit is like Crack cocaine, it grabs you quickly very innocently. Once caught , is very hard to get out of.
I have seen many instances where a person has been paying their Credit Cards “on time” (auto pay from bank account), “Greater than the minimum amount”, the outstanding balance is declining, No new loans, AND THEY SUDDENLY RAISE the rate from “actual” example 7.99% to 34.99% another was from 2.99% (until $30,000 transfer was paid in full) to28.99% after 3yrs of on time payments . They said credit rating changed----credit score actually went up on all three agencies---Trans-union went from 714 to 723.
Will credit regulation really hurt the economy? Probably in the short run as credit sources tighten, but not in the long run. All the cash currently being paid for high interest and late fees will be available to purchase REAL goods, services and assets. The “Bank” building boom may end, but the rest of the economy would flourish.
I propose a base rate at no more than prime + 10%,
Late and other fees caped at “no more” than an additional --- greater of $30 or 1% of monthly balance.
YES that would put the Payday Loan Sharks out of business with their up to 1500% interest/fee rates.
Credit Card Companies should also be prevented from issuing Credit Cards to college students with no income or jobs. (The hidden goal is to entrap students into late payments and credit card defaults. Which will lower their credit scores = higher interest rates for future car and home loans after they graduate with good jobs and are much better credit risk.)
So I Fully support any attempt to return STATES POWER back to where it was intended by our for-fathers. Remember the ONLY three powers that where intended for the Federal Government were 1. National Defense, 2. Foreign Trade and 3. Interstate commerce. All other powers were left to the states.

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