Fringe Banking, Financial Distress, and the Consumer Financial Protection Agency

I'd like to say thanks again for the chance to share some thoughts at Credit Slips.  I've really enjoyed the comments.  I wanted to end with a post about a current issue before Congress. 

One reason it is important to know what financial distress means and to understand the relationship between fringe banking and financial distress is that policy makers consistently use financial distress to justify intervention into fringe markets.  Because financial distress creates externalities, it is a powerful tool to justify regulation.

A speech President Obama made late last year arguing for the Consumer Financial Protection Agency (still working its way through Congress) is a good example of how this works.  To make the case for the CFPA regulating payday lending, the President gave the example of a women who'd taken out a payday loan.  He linked the product to wide-spread financial distress: "Abuses like these don't just jeopardize the financial well-being of individual Americans—they can threaten the stability of the entire economy."  As I have argued, I think this claim is really hard to make out.  Financial distress might justify the CFPA regulating credit cards or mortgages, but I don't think it justifies regulating on the fringe.

Relying on a link between fringe banking and financial distress distracts from the other persuasive arguments for creating the CFPA.  And, in other contexts, it leads to regulation aimed at solving the wrong problems.  People using fringe banking need protection, but we need to rethink regulation aimed at preventing financial distress because it solves a problem that I don't think exists. 

 

Why Don’t People Sue Their Doctors Over Bad Credit Advice?

In my first post, I mentioned how common it is for fertility doctors (and other doctors, as the comments point out) to direct patients to specific third party creditors.  Sometimes doctors direct patients to credit sources that are inferior to other available credit.  This isn’t surprising because doctors face a conflict of interest when recommending creditors – doctors have to pay third party creditors they partner with when patients use loans to pay for treatments.  Different creditor charge doctors different amounts (you can see a run down here), so doctors have an incentive to pick the creditor who offers the best terms to the doctor, not necessarily the one who offers the best terms to the patient.  Other times, patients take out loans with third party lenders believing they are borrowing from their doctor or misunderstanding the terms of the loan.  I was fooled myself looking at fertility clinics' websites.  On a few occasions the website seemed to say the clinic was offering loans, but when I called the clinics, I found out that they merely partnered with third party lenders.

When patients rely on their doctors and get inferior credit or when they take out loans misunderstanding the terms, we might expect some of them to sue.  People who have successful treatments might be disinclined to sue (see pages 133-135 for an analysis of this in another fertility financing arrangement), but we'd expect people with failed treatments and loads of debt to get angry. 

But my question is what legal theories could people use?

Credit Reporting in Fringe Credit Markets

Credit histories are an important part of what separates mainstream credit from fringe credit.  One reason I believe that fringe banking is unlikely to cause financial distress is that fringe credit firms do not use credit histories to evaluate the likelihood a borrower will repay a loan.  Instead, they assume the risk of nonpayment is high, so they structure the transactions to guarantee repayment through other means like collateral.  Or, they limit the likelihood of default by only loaning small amounts.  Credit cards, on the other hand, rely on credit histories and offer high credit limits without any collateral--the recipe for a product causing distress.  Ironically, the better credit you have, the higher likelihood you will take on a credit product that could cause financial distress.

Richard Brooks has argued that people using fringe banking do not get "credit" for positive histories with fringe lenders because fringe lenders do not report this activity to credit bureaus.   

But, maybe both these observations are about to change.

Fringe Banking and Financial Distress

The answers to the question about the definition of financial distress track with my thinking too.  On the one hand, we could define financial distress loosely and almost everything counts (like forgetting your wallet and needing to pay for parking).  Stephen Ware once wrote that financial distress could mean having wants that exceed your ability to pay.  For me, such a loose conception of the term causes it to lose any meaning.  Wants exceeding needs could be the owner of the Yankees wanting to own a NBA team but not having enough money.  This expansive of a definition misses the heart of distress which seems to relate to not meeting basic needs or getting collection calls, etc.  

On the other hand, some definitions are so restrictive that they miss a large group of people we’d commonly think of as in distress.  If we define distress as declaring bankruptcy or even getting sued or called for collection, we miss all the people who are going without basic medications to pay their credit card bills or skipping meals to service other debt.  And, we miss all the people who do not declare bankruptcy but for whom it would be efficient to do so.

The two most common definitions that came up in law review articles were (1) having unmanageable debt; and (2) not being able to have your financial ends meet.  I think the first is a better definition because most measures of financial distress relate to debt (debt to income ratio; negative net worth; debt service ratio, etc).  But, because the concept is indeterminate and people accept both, I use both.

Using these two definitions, I started to think about whether fringe banking products cause financial distress.  Academics and policymakers often assert that they do.  And, the argument makes a lot of sense: Fringe borrowers are on the financial fringe already, and fringe banking products cost ridiculous amounts of money.  It seems likely that using fringe credit would cause distress.  But I don’t think so.

What is Financial Distress?

I’m new to teaching, so a lot of times I encounter new terms.  I started working on a paper last year about the relationship between fringe banking (payday loans, rent-to-own, etc.) and financial distress.  I realized half way into the project that I really didn’t know what financial distress meant.  The concept comes up a lot.  Seriously, I mean really a lot.  But, it is not defined very often.

I’ve looked at the 300 or so times financial distress comes up in law review articles on Lexis, and I still am left without a clear sense of what the word means.  I’ve settled on two definitions for my paper, but I’m curious about what people mean when they say “financial distress.”

The Origins of Medical Debt

I’m very grateful to have the chance to spend some time here at Credit Slips.  I’ve learned a lot from reading this blog for the last few years, so it is fun to be a small part of it.

One of the things that has occupied my attention over the last year is medical debt.  I don’t mean how much medical debt people have or how much medical debt contributes to bankruptcy.  Instead, I started thinking about the mechanics of how people take out medical debt and the role doctors play in that process. 

To see how doctors influence debt, I looked at the websites of every fertility clinic in the US.  Fertility care is the perfect place to think about debt because most insurance doesn’t cover it, and it is really expensive.  People have to pay for it out of pocket, and most people don’t have enough money on hand to do so, so they have to seek credit.

What I found was surprising to me.