- How credit card debt fueled the subprime mortgage crisis
- How the most vulnerable customers subsidize the market
- The downside of "democratizing" credit
- How the credit card industry is exacerbating foreclosure rates
Eakes is the co-founder and CEO of the Self-Help Credit Union in North Carolina, an organization that caters to individuals and families underserved by traditional financial institutions. He is also the CEO of the Center for Responsible Lending, a research and policy organization with the goal of stopping predatory lending practices. This is the edited transcript of interviews conducted on June 23 and Aug. 19, 2009.
The president recently signed an unprecedented bill [Credit Card Accountability and Responsibility Disclosure Act of 2009] where Congress almost unanimously enacted restrictions on the credit card industry. Are you satisfied? Surprised?
Well, I feel like the bill really was a good step forward, but it's still nowhere near enough. For instance, one of the abuses that I think continues -- and really just is troubling -- is that the current legislation would allow a credit card company to impose a penalty interest rate. So for a customer, their card rate would jump from 9 percent to 29 percent if they ever were 60 days late on a payment on that credit card. And the problem with that is that during this time of unprecedented unemployment, everybody who's unemployed is going to be 60 days behind on their credit card bill. So what sense does it make when a person is unemployed and down to let them all of a sudden be stomped on by having an interest rate triple for them? ... And even under this bill that would still be permitted. ...
Now, that said, the bill that was signed does some very important things. It prescribes that when a borrower pays their payment, the payment is applied to the interest rate balances that are the highest instead of the lowest. Most people thought that's what their payments would be applied to. It eliminates what's called universal default, which is that if you had a problem with another bill unrelated to your credit card account, or you had a change in your credit score that you had no knowledge about, the credit card company previously was able to increase your interest rate from 9 percent to 29 percent. So I do feel like this bill vindicates the American public. It's a great step forward, but it was a compromise bill that only got about a third of the way, I think.
Well, let me understand this. The bill stops universal default, right?
It does stop universal default.
They can no longer do it at all.
And they would come back and say, "Well, that just means that we're going to make credit less available to people, because we only did universal default because we were concerned that somebody was going to be using their credit card while they were actually in financial trouble. And we're the ones who are at risk when we lend that money."
If I had a dollar for every time I've had a banker or an industry person tell me that any reform would eliminate access to credit, we wouldn't need credit anymore, I could personally give gifts to every person who ever wanted to borrow, and it would solve the problem. You hear that line with anything good that is proposed. And in almost every case -- 99 percent of the time -- it's just an outright fabrication.
As you know, we did a program five years ago. At that time, it looked like credit card debt was leveling off. It had reached very high levels -- $7,000 per household -- and then all of a sudden it took off again. What happened?
Well, it's interesting that we all are focused on the current economic crisis as primarily a foreclosure and mortgage crisis. But what most people don't realize is during 2003, 2004, when subprime lending was really taking off, it was largely a mortgage product to refinance credit card debt. Eighty percent of all subprime mortgages in 2003 and in 2004 were refinanced loans. It wasn't for borrowers who were trying to buy a new home.
... In fact, that was the premise for subprime brokers who were marketing their product. They would come to a customer and tell them you could lower your monthly payment dramatically by refinancing with this higher-interest rate mortgage. ... So really the mechanics of credit card debt was what helped fuel the initial burst into subprime lending.
And by subprime lending you mean to people who really couldn't afford the loans?
Well, "subprime lending" can be defined one of two ways. Often it's defined by saying that the borrower had credit blemishes on his or her credit report. But in truth, 50 percent of the borrowers who got higher-cost credit had perfect credit. So the way we now define "subprime" is simply the interest rate on a mortgage loan.
If you're getting a rate that was much higher than what the normal mortgage loan would be, you were considered a subprime loan or borrower. But the really irritating truth is that 50 percent of those customers deserved to have a regular, standard-price loan and just simply got sold something that was not appropriate for them.
So 50 percent of the people who took out these loans, they might have had great credit, but they just bought a product that was much more expensive than what they could have gotten?
The customers were sold products, because if you're a mortgage broker who is selling a mortgage to a customer, and you get paid three times as much for a loan that puts a customer in a 10 percent interest rate than in a 6 percent interest rate, what are you going to do? What they did was they sold the higher interest rate even to people who qualified for a lower rate.
Most families who are buying a first home or even refinancing, they think that their mortgage professionals were looking out for them and helping them get the lowest rate. But it was never the case. In almost every case, the intermediaries who delivered mortgage loans were paid a higher fee by the lender and by the customer if they got an exotic product or they got a higher interest rate. There just was more money in the mortgage, and it got kicked back to the person who was selling it.
So what you're saying is that 80 percent of these subprime or expensive loans -- they're refinancing primarily, right? -- were used to wipe out your credit card balance so you could start borrowing again on your credit card.
Right. Well, so to be precise, 80 percent of the subprime mortgage loans -- the higher-priced mortgage loans -- were refinanced loans. And the vast majority -- not all 80 percent -- were to refinance credit card debt.
The short-term value that we promoted over and over of "spend your way into prosperity," which is really a fundamental flaw in the American value system currently, was promoted through credit cards. Credit cards were the way of making short-term "spend, spend, spend" decisions. And the end result was that people had credit card debt they couldn't afford, and the outlet was to refinance that debt into a subprime mortgage.
Now, one of the things that used to drive me crazy about subprime mortgages is that the up-front costs to the borrower were often not understood. So the very first customer that I ever encountered [who] was a subprime borrower came into my office with a loan that he had gotten 10 years earlier. It was a $29,000 loan, if you can imagine. And when he refinanced it, the finance company had charged him $15,000 of up-front fees to refinance the $29,000 loan. When this man signed his X -- because he couldn't read -- he walked out of that closing with a $44,000 loan instead of the $29,000 loan that he thought he was getting.
So the beautiful thing from a finance company point of view is that you can add fees on the front end of a mortgage, spread it out over 30 years, and oftentimes the borrowers just simply don't understand. So one of the solutions that people put forth is to have more disclosure. Let's figure out a way to have families who are getting mortgage loans or credit card loans get more disclosure of the actual terms of the loan.
And there's a statistic from the Department of Education that 24 percent of adult Americans are illiterate. So you can't do disclosure for the 24 percent who can't read and have to sign an X for their contract. They have to be able to rely on some trusted intermediary. And the basic breakdown we had over the last 15 years is that the intermediaries were really not trustworthy. They had their own incentives.
In fact, in North Carolina, when we passed legislation to stop some of the abuses in subprime mortgage lending, one of the representatives for the mortgage broker industry said to me, "We are not a fiduciary for borrowers. Our goal is just like a used car salesman. We're trying to make as much money as an intermediary, and we're doing whatever is in our best interest." And I asked him, "Would you please come to the General Assembly of North Carolina and just repeat that statement? I think it might help us get the legislation passed."
One of the aspects of the new regulations related to credit cards is more disclosure. But some people in the industry have told us: "Fine. Disclose all you want. It won't mean anything."
Disclosure basically does not work at all. Maybe there can be a redesigned disclosure that is very simple that focuses on only one or two facts. But as a lawyer who used to do real estate closings and has advised customers on credit card contracts, nobody can read all the fine print and understand it. Nobody. I mean, I'm a lawyer; I'm trained to read this junk. You can't possibly read the documents for mortgages or for credit cards and have a clue of what you're really getting into. It just doesn't work.
So Truth in Lending is a sham?
Truth in Lending needs to be simplified down to the bare essentials. And often at this point, I mean, it's like having water. You can have enough water to live on, but if you drink a whole ocean, you're dead; you drown. Disclosure has to be very simple. It has to be balanced. And if you have too little or too much, you end up with nothing at all.
So what's the answer then?
The answer is to have very smart regulations. And I know that's asking a lot. But if you use the example of a soccer game, if you had a soccer game that had no rules whatsoever, the team that was able to bring guns and knives on the field would win every time. On the other hand, if you had so many referees on the field that you couldn't run up and down the field, the game would be no fun. So in designing a market, we need to have boundary rules that enable vendors of financial products to compete within that playing field.
And what we've had over the last 15 years is essentially no boundaries whatsoever. And so the rules that have been passed in the new credit card bill is essential because it puts some of the boundary rules in place and says, "Here are how the good actors have to compete against each other to deliver credit cards to the American public."
... What is risk pricing? How would you describe that to the general public? It's one of those phrases that people throw around in this discussion, and we're trying to figure out a way of explaining it. Maybe you could help.
Well, the term "risk-based pricing" generally means that a borrower with a low credit score gets a higher price and with a higher credit score gets a lower price so that in theory, those customers who have greater risk would have a higher price that they pay for their credit. In theory, that term is used to hide a multitude of sins. Risk-based pricing was used to justify universal default on credit cards where being late on a rent payment or another bill payment could generate a tripling of your credit card interest rate.
There's no proof, no connection whatsoever between the riskiness of that borrower and that otherwise unrelated event, and the risk on that particular credit card default and loss for the creditor. So it's a term that has some validity, but it's used in contexts that take away its total meaning. It's a smoke screen to enable many lenders to charge whatever they want to charge.
... Once upon a time, the idea was that you gave people loans -- consumer loans, for example -- with the idea that [they] were going to pay them off. Is what happened here that that basic ethic, that basic rule changed, and it became much more profitable to give loans that, in a sense, never got paid off?
Well, I recently read an article that defined a predatory loan as a loan that the lender never wanted to be paid off. And so in a credit card setting, many creditors -- particularly if the interest rate is at 29 percent -- they don't want you to pay off that debt. They want you to pay the interest. They would like for you to be late every so often, because there's a late fee.
But the real money in consumer lending over the last 15 years has been in what are called penalty fees. So whether it's payday lending, whether it's credit cards or whether it's overdraft loans on a checking account or a debit card, the real money has been the penalties that have been imposed on consumers that don't realize that they're going to be charged. It's not something they agreed to; it's not something they understood.
So the breakdown in the overall finance system over the last 15 years is that we have so much complex fees charged to customers that the customers don't understand when they're going to be charged and when they aren't. ...
... So in a credit card, one of the most profitable segments of credit card revenues is what's called over-the-limit fees. So many credit cards that have a $500 balance or $1,000 balance, every time you go over that limit by $5 or $10 or $30, you might think that the credit card company would simply deny the charge and not let you make that charge, and then you would put that credit card back in your wallet and pull out a different card or a different debit card. But that's not what happens now.
What happens is that the credit card company authorizes that payment, you go $2 over your limit, and you're charged a $35 fee. And that puts you further over your limit, so that when you use it again, you have another $35 fee. And that cascading of charges is what really has made the American public so upset. They feel like the basic structure of a credit card agreement is just unfair. They get trapped into fees that they didn't anticipate having to pay.
And are those answered by the recent legislation?
... What this new bill does is it says you can still be charged the penalty interest rate -- which I think is unfair -- but you can only be charged that rate if you have a 60-day late payment on that particular credit card account. So that's a significant improvement. It's not enough, but it's at least a good start.
It also says for the over-the-limit fees that the customer has to opt in. So that's a technical legal term that says that the customer has to actually authorize the credit card provider to charge the over-the-limit fee when the person exceeds their authorization limit on the credit card, so it can't just be automatically signed up without your permission. The customer has to "opt in."
The problem with opt in is that if that happens at the opening of an account, it can still just be buried in the boilerplate of a long credit card agreement, and the customer may or may not know that they've even opted in to this fee structure. So much of that will be determined by rules that will be set forth by the Federal Reserve system, and those rules have not yet been issued.
Yes. The customers who pay the most fees -- allegedly because they're the most risk -- generate the most revenues net of losses of any customer for the credit card market.
Do they subsidize the rest of the market?
I mean, one of the things that is surprising -- let's take checking accounts and debit cards, because it's even clearer there. Many banks advertise that we have "totally free checking." Well, the only reason that they can have totally free checking is because the 10 percent of the customers at the very bottom who live paycheck to paycheck are paying as much as $1,000 a year for their checking account.
So 70 percent of all the overdraft fees on a checking account are paid by those account holders who pay that fee more than 30 times per year. So the vast majority are people who get caught over and over and over. Well, a little simple math: Thirty times $35 is over $1,000 for that account holder. So the 10 percent of account holders who are living payday to payday are basically subsidizing and paying the entire cost of checking accounts for all of Americans, and it's just not fair.
So it's true this 10 percent is ... subsidizing the profits of so-called free checking accounts for the banks? This 10 percent is, in a sense, making life cheaper for people who already have money.
That's exactly right. It seems unlikely, because our system of values is that everyone should pay their fair share. But those who have the least are paying the most, not just in percentage terms. They are paying the most in out-of-pocket dollars. This 10 percent who are living paycheck to paycheck are really just getting clobbered by the financial services industry.
It's almost as if 15 years ago, the industry discovered that you could make money off of the most vulnerable people in America over and over, and that would be the business model for the next 15 years. I know it sounds funny to put it in moral terms, but it's really morally wrong. The financial services industry has lost its ethical moorings -- not everyone, but a vast majority.
Overdraft [fees] for checking accounts, credit card accounts that have these penalty gotcha fees, and payday lenders which charge this exorbitant 400 percent interest rate for short-term $300 loans over and over and over again, it's all the same. It's trying to find the group that is the most vulnerable, target them, and have them pay the entire costs of the infrastructure of the financial services industry. And it's just morally bankrupt.
The payday lenders say: "We're not so bad. What are you talking about? We're an essential part of the community for people who don't have money. We can give them short-term loans. The really bad guys are the banks. Their overdraft fees dwarf our interest rates."
Well, in some ways the payday lenders are right. They charge 400 percent interest rate, and 90 percent of their revenues come from those customers who get caught paying payday loans five or more times per year. So it's a model that is built on a debt trap. ... But the payday lenders are right in one regard: that the overdraft fees are just as bad as 400 percent interest rate lending by the payday lenders.
My response to them is that one person who steals with a knife cannot justify their actions by citing someone else who steals with a gun. You know, that is not sufficient to say that, "Well, these other guys are just as bad as I am."
We need to go back to the reforms that were put in place during the Depression and which served us well for 50 to 60 years, that said consumer small loans need to have an interest rate ceiling, need to have a usury limit. And we had that in place for 60 years since the 1930s.
And then we started to deregulate, saying: "Well, the market can solve all problems. Let's just have no rules whatsoever about interest charged." And the market fell apart. It can't survive without boundary rules that keep people and keep competition on a single playing field. ...
Staffers in Congress who were involved in this legislation say that two, three years from now, the industry is going to figure out loopholes in these regulations. They'll find a way to make money around all this. You think so?
Well, there is a history of having industry adapt to the first round of regulations, and then you have to close some of those loopholes. ... But it's really hard for them to get a bill through the U.S. Senate that can get 60 votes when the industry is pouring money into Washington. As Sen. [Dick] Durbin [D-Ill.] from Chicago recently said, "The banks, even as unpopular as they are right now in this crisis, still own this place." They provide three times as much money as any other industry to campaigns. And it costs a lot of money to run.
So it's a very difficult environment to have a reform bill passed. In the last 10 years, before this credit card bill, there had been only one bill that passed dealing with reform of financial lending practices, and that was in 2006, the military protection bill [Talent Amendment] that dealt with payday lending for military soldiers. And what that bill did -- which was bipartisan in an election year -- was prohibit payday lending for military members and their families, because the generals and admirals were stating that they had a hard time having their soldiers be able to pass security clearance with all of the loans that they had that were compromising them.
You mean members of the military were considered to be at risk from a security point of view because of their payday loans?
Their payday loans were keeping military members from being able to pass the security clearance because they felt like someone who was facing the stress of immediate debt collections would be a security risk. And so it was this odd coalition of consumer groups and civil rights groups and the Department of Defense that supported passing the one bill that had been able to pass over the last 10 years, which is a strange coalition. ...
But this credit card bill doesn't regulate interest rates.
No, this credit card bill does not regulate interest rates, but it does try to regulate the practices and abuses of the financial services, particularly the credit card industry. I'm just saying it's very hard to use Congress as the vehicle for passing reforms. It just takes a very long time. The public is outraged, and so the time has come where the sort of public anger about credit cards, about debit cards, I think will boil over to a consensus that has laws actually get passed and implemented.
But for the last 10 years -- I mean, I testified 10 times in front of Congress asking that the mortgage laws be improved so that we wouldn't have precisely the meltdown that all of us in the housing industry knew would occur. And we just couldn't get it done. We went to the Federal Reserve, and they were mandated by Congress in 1994 to pass rules prohibiting abuses in the mortgage marketplace. And the Federal Reserve didn't take one step to do so until the middle of 2008, almost 10 years after they were first asked to take a look at the abuses. So we had a failure of system, a failure of laws that allowed this crisis to get to the level it now is. ...
Didn't the Federal Reserve have an officer in charge of consumer protection?
The Federal Reserve has a whole department. It's very well staffed with very good people. But the dominant ideology on the Federal Reserve until 2008 was that markets will self-regulate; competition will take care of all problems. There's no way that abuses in the marketplace can actually become widespread. I mean, [former Federal Reserve Chairman] Alan Greenspan has said that's what he believed, and yes, he was proven wrong. He has acknowledged that.
Ben Bernanke, the current chairman, he's really a decent person, but he's got a lot of other things on his plate in addition to the functioning of the consumer marketplace for financial services. So yes, there have been actions that have been half steps by the Federal Reserve in the last year, but for 14 years they didn't do anything at all.
And the half steps that the Federal Reserve has done now are nowhere near sufficient to handle the abuses that are still occurring. I mean, we still have overdraft fees that collect $17 to $20 billion per year from low- and middle-income families every year that are just penalty fees they shouldn't be charged at all -- $20 billion of wealth stripped away from the very families that we're trying to assist to become re-employed and to survive this crisis, paying stimulus dollars out. And it's just being stripped away by bad practices that continue to exist in the financial services industry to this day.
The critics of this regulation say you're just going to make it much more difficult for people who need their credit cards, need their credit limit, need that payday loan to pay for vital things -- food, clothing, whatever. You're making it much harder for them to get over this period of the recession.
Nobody needs a payday loan at 400 percent interest rate. If the family was not able to make ends meet at zero percent interest, they're not going to be able to make ends meet at 400 percent interest. So it's a false illusion to think that credit or debt can substitute for income or spending discipline. The truth is, some families shouldn't get credit.
I mean, it's a hard thing. It sounds bad. But if you can't afford to pay back a debt, you shouldn't get that debt. And a system that says, "We want to provide debt to everyone regardless of whether they can pay it back" --
[They] want to democratize credit?
You know, the words all sound so good, but what you're really saying when you say that is that we want to provide debt to people we know cannot pay it back. And if that is what you're doing, and you sort of peel the shades off, you see it for what it is. It's a fraud. You're therefore keeping people in debt forever because they can't pay it off by definition.
Or they go bankrupt.
Or they go bankrupt.
What's the matter with that? ...
Oh, I have no problem if people need to get a second chance. But the American public hates bankruptcy. The image that there are people wanting to run up their debts and then jump into bankruptcy is just an illusion. The people that we deal with and we've actually polled, they hate the thought of going into bankruptcy. They won't do it. They don't believe that they should ever be forgiven for their debts.
American citizens, 80 to 90 percent, are very strongly in favor of paying their debts back. The problem is they just can't do it. It doesn't matter how willing they are to try. They simply cannot pay back the level of debt that has grown over the last 30 years. I mean, we have households now that have three times the level of household debt compared to the real income that they have, compared to 1980 -- three times.
Well, it's not that we magically decided how to handle debt with a fixed amount of income. It's that people got into a level of debt they cannot afford. And so we're having bankruptcies now in record numbers. Even though people despise the thought and despise themselves often for filing bankruptcy, they have no choice. They're literally at the end of their rope and cannot survive.
But they bought into this. This is the American way.
Well, there's a fundamental values question in the American society today. We do fundamentally believe that we can spend our way into prosperity -- spend, spend, spend. And for the most part, we think that it should be done with debt. But debt over a long period of time cannot solve a lack of income for a family.
If you don't have the basic ability to live within your budget, you're not going to solve it by borrowing more money, because that doesn't enable you to pay it off. You know, it's a funny story. When we had the stimulus bill in late 2008, one of the chief complaints was that people were taking the tax rebates that they received and were saving it and using it to pay down their debt instead of going out to buy a big-screen TV. Well, on most levels, that's exactly what we would think people should do. ...
We have a belief in this country that consumption and spending will solve all problems, and we think that we can spend enough to solve all the world's problems. But we have now a debt crisis, and you can't solve a debt crisis by adding more and more debt. You've got to reduce the debt. ... You know, it doesn't take a rocket scientist to figure out that if you keep borrowing and borrowing in order to consume now, eventually you crash and burn.
... So when I hear from the industry, "Oh, you're going to remove access to credit," I sort of shake my head and say, "Yes, that's exactly what's needed." There needs to be less debt in this system, and it needs to be tailored like it was 15 years ago or 20 years ago. It needs to be underwritten or approved by lenders based on whether a borrower can pay it back. Getting a debt that you cannot pay back is in nobody's best interest.
But isn't that what the federal government is doing itself?
Sure, the federal government is doing it.
President Obama is --
I'm telling you that's not in the best interest. Yes, we may have to have a very temporary stimulus. But if we don't understand that the fundamental value that we have been living on in this country for the last 30 years -- that we can basically consume by adding more and more debt -- that is a false premise, and it will collapse. And it will collapse for the government if we don't soon start to understand that you can't keep adding more and more debt. You cannot solve a debt crisis by adding more and more debt.
You believe that interest rates need to be capped. That goes against everything that's been going on over the last 30 years.
Well, let's talk about interest rates and caps. In the 1930s, we placed interest rate ceilings on small loans because we had payday lending even in the late 1920s. But during the hardship of the Depression, we put in place in every state in the United States usury limits, interest rate ceilings, and it worked extremely well for 50 to 60 years.
And then we started deregulating, and we got payday lenders showing up on every street corner. So we now have more payday lending outlets than we do McDonald's and Wendy's and Burger Kings all combined all across this country. And it won't work.
If you talk to people in the faith community, they would tell you that usury limits have been one of the oldest premises of every religion in the world -- that there is something special about debt. Debt is one of those few products that gets a consumer deeper and deeper in a hole just with the passage of time. With nothing else, you can get trapped and become enslaved with debt.
So most people would say what we've done in the last 20 years is not just repeal the laws from the Depression that served us so well -- a usury limit, a cap on interest rates -- but we basically have repealed a principle and a truth that is as old as religion itself. Every single major religion in the world has a prescription against charging usurious interest.
And we seem to have forgotten that as if, well, we just invented the whole world, [that] there were no loans before 1980, and that everything is going to work out right. Well, if we had a little more sense of history or a little bit more memory of what happened in years gone by, we would know that the current ideology of no limits whatsoever on interest rates is ludicrous. It's stupid. It's immoral.
But a study by people affiliated with the Federal Reserve says that since you were able to put a cap, in a sense, on interest rates related to payday lending in North Carolina, where we are today, it's more difficult for people to get loans. It's made life harder for them, and they're bouncing more checks.
Yeah. I mean, this was a silly study. I mean, to even call it a study is more dignity than it deserves. It wasn't by the Federal Reserve. It was a researcher who was affiliated with the Federal Reserve, and what he said was, "We looked at the Charlotte office of the Federal Reserve and looked at its check clearing and bounced checks." Well, the Charlotte office serves five different states, one of which was North Carolina.
It happened to be located in North Carolina, but it didn't serve exclusively North Carolina. And he takes this very limited data set and says, "Well, we have more bounced check fees because there is a prohibition on payday lending in North Carolina." The North Carolina legislation, the banking commissioner, the folks who regulate small loans, they've had no complaints whatsoever -- none -- from consumers that they can't get access to credit.
And in fact, I never thought I would be the defender of finance companies, but in the years following 2001, when North Carolina prohibited payday lenders and sent them away, we had a doubling of small loans by finance companies who were charging 25 percent interest rates. But at least at 25 percent, that's not 400 percent. And the customers were still able to get a loan. Every single consumer who needs a loan can get a loan at this point. To say that the American public is underserviced with debt is almost ridiculous in today's environment.
... But in California, a payday lending company was bought by a credit union and integrated into their operations. And the idea was this is where people go who really don't have any money, or working people living paycheck to paycheck, and it's a way to attract them, to get into more responsible ways of handling their finances using the payday lending operation as a way to get people into the financial system itself.
Any credit union that continues a 400 percent annual interest rate on small loans is betraying the values of credit unions. And the credit union in California that is continuing to do payday lending is, in my mind, an embarrassment to credit unions nationwide.
Some would say the payday lending system is a way to, in a sense, put real loan sharks out of business and give people a way of at least getting some cash up front when they need it, and then -- in the case of this credit union -- then educating them about how they should start savings accounts and how they should get involved in the actual financial system.
Real loan sharks would blush at the interest rates charged by payday lenders. They're so high.
Now, the military seems to agree with you. ... The military is a socialist organization, right? It's owned by the state. Everyone gets the same uniform, they get free medical care, and they have controls over interest rates. Is that the model that you're looking for?
Well, I think the principle that our service members who are putting themselves in harm's way should be protected against the worst ravages of the payday lenders is a principle I agree with. I think it's just unfair to send people into harm's way and have them come home to bankruptcy because of payday loans. Where I would take it a step further is to say if it's right to protect our military service members, why is it not also right to protect our teachers, our policemen, our firemen, our other first responders and really the other citizens of America? ...
Based on your description, it sounds like the payday lender depends upon not the "Come on, here's some easy money. You need it right now. Make it a one-time loan," but [rather upon] making sure people never pay that loan off; they keep refinancing that loan.
Well, payday lenders actually market their product in the same way that drug dealers do. When they compete with each other, they don't lower their interest rate. What they do is they say, "We'll give you your first loan for free. We're going to give you your first hit for free," because they know once they get you on this debt treadmill that most families will not be able to get off.
And literally 90 percent of all of the loans made by payday lenders are made to people who are trapped and not using it on an ad hoc emergency basis. And so 90 percent of all of the fees are to customers who get stuck in this product five or more times per year.
But the payday lender would come back to you and say: "Well, what's the difference with the credit card companies and the banks? Zero percent. And we'll give you some reward points, too."
Oh, I'd be the first to admit that the credit card practices as they were and the overdraft, over-the-limit fees for debit cards as they are now as just as bad as payday loans. I would concede that point right off the bat that all three of those products -- credit card over-the-limit fees, checking account debit card overdraft fees and payday lending fees -- are all a trapping mechanism that charges $1,000 a year for the 10 percent of customers that are living paycheck to paycheck in America. And unfortunately, there are more than 10 percent now, so presumably this will be a booming period.
... My prediction right now is that the fees that were being charged on credit cards, if this new law is as effective as we hope it will be, will be transferred to debit cards so that you will see more and more hidden fees -- and there are already a lot on checking accounts, debit cards. We will need before the end of this year to address the abuses of debit cards, because that one is still left completely wide open.
The bill doesn't touch debit cards at all.
The bill doesn't touch debit cards at all, and that I think is a real challenge. I mean, one of the things for me, for 20 years I've run a financial institution, a small credit union. I want to get people who are left out of the system to become part of the system.
But I can't in good faith right now ask a person, a family, to join the banking system or the credit union system if they're going to bleed to death on overdraft fees. It will kill them, so that the people who are unbanked in America today, they're unbanked for a really good reason. They can't afford the hidden fees that bounce up on their monthly statement each month.
... You were talking before about values and debt. You know, obviously there is a positive function to plastic money, whether it's a credit card or a debit card, right? You would agree?
Well, I think credit cards and debit cards are one of the great inventions of the last 25 years, 30 years.
Are you saying that they've been operating sort of in a free-for-all marketplace where [you can] charge whatever you can get and that they should be brought under control? Or are they really something that should be a public function?
Well, I think great technologies need to have boundary rules within which different companies compete. I mean, we love competition in this country, and competition is really the essence of a market system. But competition does not occur by itself. You have to define a playing field and define the rules to have real competition. So I don't know whether credit cards should be a public good. I just don't know. ...
What do you consider to be a good credit card or a good debit card? Something done by a credit union? Is that what you mean? A co-op? Something like you have?
Well, it might be good if it's done by a co-op, but that's no guarantee. There are no silver bullets. What I think is a good credit card is one that is very simple. It has no over-the-limit charges; it has no penalty interest rates; it has an interest rate that you sign up for; and you use it, and you pay it. And the interest rate has built into it an expectation of a certain level of losses that get covered.
There's no reason in the credit card market or in the payday lending market or any other consumer loan market a penalty rate is imposed only when a person gets into trouble. That just is nonsense, because it drives people into bankruptcy, and it says, "We're going to make this last extraction from someone that pushes them over the edge of the cliff." It's not good business.
So you don't believe in variable interest rates?
Well, I think variable interest rates can make sense. But it needs to be a simple formula and be presented right up front. In the mortgage industry, now variable interest rates have gotten a bad name when it's not the variable interest that should deserve the bad name. It's that subprime mortgages offered a formula that started borrowers off not at a low rate but at 8.5 percent. And if interest rates went down, the rate stayed at 8.5 percent forever. If interest rates stayed the same, in two years the interest rate would jump to 12 percent, and the borrowers couldn't pay that. So it was a neutron bomb. It destroyed the borrowers. It was designed to fail after two years because the mortgage providers wanted to refinance that loan at the end of the two-year period.
Do you believe with a credit card someone should have a minimum monthly payment they can choose to make?
I think for a credit card they need to have a minimum payment, and it needs to be significant enough that people don't end up in perpetual debt. So, you know, the 2 percent standard monthly payment doesn't work. It will take 20 years or more. It takes forever to pay off a balance on a credit card if you pay the minimum payment.
That hasn't been fixed by this legislation.
No, it hasn't been fixed by the legislation.
It just tells you how long it will take you to pay it off.
Right. I mean, this legislation did some good things, but it did not finish the job. Most people think of the Federal Reserve as our money-issuing and monetary policy entity, and they also regulate very large bank-holding companies. But they also right now are the primary rule writer for American financial markets, and they've done an incredibly poor job of doing that over the last 15 years.
... The [proposed] federal Consumer [Financial] Protection Agency [CFPA], some people say it's just adding on another agency. You've already got the Office of the Comptroller of the Currency, the Federal Reserve; we've got FTC [Federal Trade Commission]. We've got an alphabet soup of agencies that are supposed to regulate this marketplace.
Actually, the only entity that has been charged by law to write rules to protect consumers is the Federal Reserve currently. So what the Obama administration's new proposal would do would be to take the rule writing from the Federal Reserve and place it in an independent agency. So it's not creating any new jobs necessarily. It's simply making that function independent of the bank supervision structure.
I mean, if you're the Office of the Comptroller of [the] Currency, which supervises national banks, and you get $50 million of revenue per year from each of the large banks that you supervise, how hard will you be on them? They are paying your bills, paying your staff, paying your agency's budget. There's just an inherent conflict of interest.
Even the best of people -- and in some of those agencies we haven't had the best of people -- they end up compromised and friends and unable to strike a balance where consumers and the American public are protected. They just don't do a good job of it.
... There was an attempt in Congress to give bankruptcy officials the ability to lower the value of a mortgage -- basically the value of a house or the property -- in the bankruptcy proceeding itself, so it would be more in line with the actual loan. Is that correct?
Right. So the bankruptcy proposal that was in Congress -- and all of the national consumer groups and all of the national civil rights groups supported this bill -- what it would do was allow a bankruptcy judge to modify a home loan just like they do day in and day out for every other loan type in America. So if you have a second home or an RV or a boat or a business property, and a loan against that property is causing you to fail, you can go to a bankruptcy court and ask not to get it wiped out but to have the balance on that loan reduced to the current value of the property that's securing it.
It's a key part of bankruptcy reorganization for individuals, for businesses, for all different types of entities. But the only loan product that cannot be modified in bankruptcy is a loan against your personal residence. So one of the jokes was you can get a fix for your second house or your third house or your fourth house or your fifth house, but you cannot get any kind of relief for your primary home. ...
But the fight was not just about the mortgage loans. It was the fear on the part of the large banks who own mortgage loans, but also who own credit card portfolios, the belief that any borrower who went into a bankruptcy court and had the incentive or the option to fix their mortgage loan would thereby -- as part of the process ancillary to it -- would also get their credit card debt written off, because the credit card debt has no security and is often one of the places that needs to be reduced for a bankrupt family to get back on their feet.
So the mortgage crisis, which left a lot of people underwater -- loans that were higher than the now lower market value of their house -- those people would be more likely to go into bankruptcy if the bankruptcy judge could lower that mortgage to the actual value of the house, and then they could continue to try to pay it off in Chapter 13, as it's called, one of the two main areas of bankruptcy. ... More people would then be encouraged to go into bankruptcy, so it would readjust what they had to pay off on their houses. And at the same time, because they were in bankruptcy and because credit card debt is not secured, they might be able to wipe out that credit card balance. And so the banks, the credit card companies, feared that.
That's exactly correct.
And the credit card balances, as I understand it, have been the profit center for most major banking institutions in the United States for a long time.
The credit card business line has been a major profit center, as have the checking account overdraft fees, which are very similar. They have been the two dominant profit lines because they are premised on penalty fees. What makes something a penalty versus a cost-based charge is that the penalty rate or the penalty is way in excess of what the cost is. So if you can collect penalties and you have virtually no cost associated with the penalty, it's really a great business line if you think that it's sustainable. The problem is that if you ultimately abuse your customers, the customers die off. They end up in bankruptcy, and they can't stay your customer for long.
... And you're saying that the foreclosure crisis has been extended in many ways -- exacerbated -- because the banks are afraid that any reform of the monies owed on mortgages, where the bankruptcy judge could reduce that liability, at the same time that consumer could get rid of their credit card debt.
That's exactly right.
So in some ways they would like to figure out a system for getting people to continue to pay on their houses and stay in them. They're ordinary people who don't really want to harm anybody. But if they did that, they would lose their real cash cow.
That's right. The bankruptcy reform could not really cause losses to the lenders directly, because it only would apply to loans that would otherwise have been foreclosed. And if you go to foreclosure, the loss is greater than the loss is of reinstituting the loan at a sustainable level that's still equal to the value of the house. When you sell a house in foreclosure, the sale price is lower than the market value because it's selling at distress. ...
Now the credit card companies say -- the banks that own them -- that their default rate goes up as unemployment goes up. And unemployment looks like it's going up. Are they really at risk?
Oh, I'm sure that losses on credit card debt -- both because the advances have been nuts in the last five years and because we have rising unemployment -- will be at levels higher than any time in the last 25 years. So typically credit card losses equal about 4 percent of the outstanding balances on credit cards. So if you have a 19 percent credit card loan, 4 percent of that will go for losses, and then that leaves 15 percent to go for administrative costs and earnings for the lender.
I would bet that in this environment, the losses on credit cards will go to 10 or 11 percent. So it's a very high rate compared to historical norms because the economy is in such bad shape.
... The challenge will be the business model of the past is now broken. They can't do the same practices that got us into this problem because of the new law, which will at least curb half of the abuses or more. And they're going to be very gun-shy about making loans to people that they know might default quickly. If you default slowly, then you earn that 10 percent. Even at a 10 percent loss rate, if the borrowers default over three years, you've earned so much money in the spread that it doesn't really matter to you.
So what you're saying is there will continue to be a credit card business; it just won't be as profitable. And they'll be much more careful about who they give a credit card to.
That's right. So the credit card industry will continue. It will prosper. It will do quite well. But they will do what most of us think is good, commonsense banking, which is to assess whether or not the borrower can pay the loan back, pay the credit card back. What's wrong with that?
... Some would say it interferes with the American way of consumption, of giving people an equal opportunity to make it and to have what they need to live their lives.
If the great American economic value is translated to say, "We must provide debt to people who can't pay it back," then the great American way has lost its way.
... Small businesses were not included in this bill. ... Do you know why?
I think that there is the assumption that businesses can take care of themselves. The same happened with the mortgage modification proposals, that it didn't include investors or businesspeople. So it was just, you know, when they targeted the legislation, they targeted what they thought they could pass, ... although actually I would bet one of the things we've learned over the last 10 years is having a rule in one place often spreads to the other because they don't want to have two sets of rules.
... Rick Lake of California Check Cashing says that they have millions of customers, and it's a service people want. And he says: "This is America, right? We have a choice."
Well, abusive lenders have cloaked their bad practices in the rhetoric of choice for years and years. In the last 10 years, if I had a nickel for every time that an abusive lender told me that "We just want to give a consumer a choice," I would be a rich man right now. And yes, we do want to promote choice, but that shouldn't be a cover for outright stealing from people.
Often we've seen documents and forms where the borrowers were deceived into signing something. And later in litigation, the lender said, "Well, look, they chose this; they signed it; they put their initial." But the consumer had no understanding of what they were getting into.
You've asked for clear disclosure. And we went into some payday lending stores in California, and you can't get much clearer than a big poster on the wall [that] the customer can see. It's not a trap. There can't be any more up-front disclosure than a big poster on the wall.
Yeah. Disclosure does not really work in this setting. If someone gets a loan that essentially traps them for the duration of the year, it doesn't matter what disclosure you gave them on a piece of paper. You know, 25 percent of adult Americans can't read. So you can have all the disclosure you want, but if the fundamental structure of the loan is unfair -- it's destined to be unfair -- disclosure simply will not be enough.
[Lake] says the word "trap" implies that people didn't know what they were getting themselves into, but people do know if it's on the wall.
So a family that's barely making it payday to payday is not going to make it better when you take out $55 every two weeks for the fee on this loan. The Center for Responsible Lending has just done a study that showed that 75 percent of all payday loan transactions are a renewable or a repeat, a payoff of a previous loan.
Once you get into a loan and you're paying 400 percent interest rate, you just simply can't get out. It is a hole; it is a trap. It doesn't matter what you thought you understood at the beginning. You didn't understand that you were going to be stuck in a hole. ...
... [Lake] said that he believes that overdraft fees and check-bounce fees have gone up in the military since payday lending was banned to servicemen.
... There is no evidence that military personnel are worse off after the ban on payday lending to military families. In fact, the people we've talked to within the military say that it is dramatically improved. So there is simply no evidence. I think that's a made-up fact. And maybe we'll look at the evidence a couple years from now when we can actually tell, but there's no data or evidence to suggest that payday lending helps anyone.
Tell us a little bit of the history about your work with the military and where the motivation came from to ban payday lending to the military.
... So military personnel were not prohibited from getting short-term loans; they were prohibited from being charged more than 36 percent interest rate. Most of the criticism that I receive for that bill is that we allowed the rate to be so high for small loans. Most people think that 10 to 15 percent interest on a loan is outrageous, and 36 percent is an abundantly plenty interest that any lender should charge.
Any business that cannot survive charging 36 percent interest rate does not deserve to exist in the lending business. Every religion in the world has said that a usury, indebtedness that keeps people indebted and enslaved for life, is a very bad thing both for the people and for the community where they live.
... The payday lenders say, "It's not an interest rate; it's a fee." If you charge for clothes, you take a percentage. Yet if you charge for cash, everyone is on your case.
The payday lenders and other lenders have been arguing for decades that their fee is not a finance charge, is not really interest. And every single court in America has looked at that issue and definitively said that a fee in a finance product for a loan is an interest rate. It counts as interest. So that argument has been raised and shot down every single time that it's been looked at. It's just simply a distortion.
... The major problem in the financial services marketplace is that bad practices tend to propagate, and they force good practices out of the market. So if one entity can charge over and over overdraft fees that then enable them to advertise, and we have free checking for everyone, even though that's deceptive, no other credit union or bank can compete with that institution without also offering free checking.
So the bad practices have a way of driving out the good. And that's the reason that the oversight by the Federal Reserve, which is the primary consumer oversight agency, is so important. Unfortunately, the Federal Reserve has failed miserably time after time over the last 20 years to even offer a modest amount of protection to consumers in this country.
The Federal Reserve has come out against [the] Consumer Financial Protection Agency.
Well, the Federal Reserve has said they want to keep their authority as the rule maker for consumer protection. There's not an agency in Washington that voluntarily gives up its turf.
So the current proposal to put a Consumer Financial Protection Agency in place that would be independent of any of the banks and any of the regulators who are basically concerned with safety [and soundness] of banks, not with protecting the citizens, it's a natural opposition for the Federal Reserve to want to keep its own turf. ...
Over 80 percent of the American people favor a new agency that would protect consumers against unfair financial practices, but almost 100 percent of financial professionals oppose this agency in its current form. So it's very difficult to tell whether it can be enacted. But our hope is that it will be.
And if the Consumer Financial Protection Agency is put in place, it will stop the practices that created the financial meltdown that we have today. We wouldn't have the foreclosure crisis in America if the Federal Reserve had done its job, which it simply can't do because it's so closely connected to banks in its current form. ...
... The payday lenders say that it's not [fair to calculate the interest rate on their products]; it's not apples to apples. This is a fee.
... In order to compare different financial products, you have to have a common frame of language. In this country, we use the APR, the annual percentage rate, to compare short-term loans and long-term loans and all kinds of different loans. So it's important to cover all of the charges that a lender would have in calculating what the annual percentage rate actually is, or else you can't compare apples to apples.
Many lenders who charge a lot of money want to exclude their fees and other charges from being counted in the interest rate. And it's deceptive, and every court in America has ruled that that's not the way to compare apples to oranges and apples to apples. You must include all of the charges in order to get an effective comparison between different loan products.
I'd like you to tell me ... whether you support "plain vanilla" products.
... One of the proposals in the new Consumer Financial Protection Agency legislation is to define a plain vanilla product that every financial provider would have to put forth, and I'm actually not in favor of that. I think that partly it's that I've worked with small businesses my whole life, and not every small business can offer every product. So I want there to be competition within the financial services marketplace and for people to be able to come up with better ideas.
The goal is to set broad boundaries that prohibit unfair practices. And if we get to defining what is the only acceptable product, I think we will err on the side of being too intrusive in the marketplace. So that is probably not the most popular position among the consumer advocates. But I don't think that that proposal ultimately is a wise one, and I don't think that it will survive the legislative process in Washington. ...
Trying to define what is a plain vanilla product is going to vary depending on who is tasting the vanilla. I think that it is too intrusive to try to define what is the only acceptable product in a marketplace. There could be dozens that are perfectly safe that look very different from each other.