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March 24, 2009
S. 257, The Consumer Credit Fairness Act
March 24, 2009
David C. John
Let me make it clear from the start that my purpose today is not to defend in any way abusive credit practices. I find them as abhorrent as those who are testifying in support of this bill, but I have strong reservations about the approach used in S. 257, and believe that it will end up making the situation for low and moderate income workers in need of credit even worse than it is now.
Unfortunately, economic literature on the economic effect that high interest lenders have on their customers is spotty, with many studies as interested in proving a point as in objective research. Activists take it for granted that there is a "debt trap" where customers of high interest lenders find themselves deeper and deeper in debt to the lender as interest rates and fees combine to make it impossible for them to repay their loans. Such a trap may well exist in both specific cases and in general. However, there is research from the New York Federal Reserve Bank which suggests that the debt trap may not exist in all situations, and in fact some consumers may be better off with the presence of high interest lenders than they are without them. This paper looks at Georgia and North Carolina after payday lenders were banned, and found higher incidences of bounced checks, complaints about the collection methods of lenders and bankruptcy filings after the ban than before it. This suggests that high interest lenders meet a definite need, and raises questions that legislation like S. 257 may end up causing more problems than it solves.
The first question is who the affected borrowers would be. While it is clear from many data sources that individuals from any and all socio-economic levels can be customers of high interest lenders due to either sudden income shocks or poor financial management skills, the largest proportion of customers fall into three groups. These are low-to-moderate income workers who have limited access to other credit sources either because of low income, poor credit histories, or the simple fact that few banks and other lenders have branches that are easily accessible to these consumers. Second are first time borrowers who may have high potential to become good credit consumers, but for now have no credit history and no one willing to co-sign their loan application. Finally, there are consumers who have poor credit histories or who may have just emerged from bankruptcy, and are seeking to rebuild their credit records.
Credit products are primarily priced by the risk of the customer. Thus, customers with either poor credit histories or none at all, can expect to pay significantly higher interest rates than those with better credit records. The high interest rates cover significantly higher chance of default along with much higher collection costs. However, these high rates are usually temporary. As new borrowers demonstrate their ability to responsibly handle credit, they qualify for lower and lower interest rates, often by switching lenders. The same is true for borrowers with poor credit records who are seeking to restore their reputations.
Certain other reputable lenders will continue to offer products to these borrowers, and may even lower their fees, but they will increase the requirements to qualify for such loans in a way that will reduce the number of potential customers. The combination of higher credit standards and fewer credit providers will leave high risk borrowers with either no credit available, or force them into the hands of less reputable lenders.
Some less reputable lenders will react to the inability to recover high interest loans in bankruptcy by raising their fees even higher so that they can make their profits faster. Their customers will not find any relief from the passage of this bill. Other even less reputable lenders, who never use the legal system for collections in the first place, will be delighted if the result of this legislation is a rise in the number of consumers forced to use their services.
The sad fact is that changing the interest rates charged for high risk loans is very unlikely to change the demand for them. This is especially true in hard economic times when record numbers of Americans are already losing jobs, having their hours of work reduced, or for other reasons finding it ever harder to meet their financial obligations. At the same time financial institutions are raising credit standards so that fewer and fewer customers qualify for their lowest rate products and raising both fees and interest rates for riskier customers and in many cases cancelling the credit lines of higher risk customers. All of these actions simply serve to increase the demand for higher cost credit products.
These tighter credit standards are likely to last for some time. In addition, recent massive increases in the money supply and federal spending may result in renewed inflationary pressures, which will further increase interest rates. This is where the specific language of S. 257 could cause additional problems.
The bill's definition of "high cost credit consumer transactions" is too broad and could encompass transactions that no one regards as usurious, especially as regards "costs and fees". This would subject more lenders to having their loans disallowed when borrowers file for bankruptcy - perhaps, in some cases, to that lender's great surprise. The bill's definition specifically includes any credit transaction where the combination of interest rate and fees exceeds "at any time while the credit is outstanding" the sum of 15 percent plus the yield on 30-year Treasury bonds.
The bill's definition is even more stringent than that contained in the last Congress' H.R. 3915, the Mortgage Reform and Anti-Predatory Lending Act of 2007, which limited its reach to loans where the rate exceeded a spread over a Treasury bond rate on "the 15th day of the month immediately preceding the month in which the application for the extension of credit is received by the creditor." S. 257's open ended liability places any fixed rate loans made during periods of high inflation at risk of being considered as high cost credit and being inexcusable under bankruptcy.
In conclusion, S. 257 is unlikely to reduce high interest rate lending. All that it is likely to do is to either make it harder for certain populations to find credit at all, or to make it even more expensive for them to do so. The sad fact is that the customers of such lenders only utilize them because those customers have no other choice. The demand for those credit services will be there no matter what the cost. This bill, which is essentially a price cap or attempted prohibition, is not likely to reduce that demand at all.
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1. Donald P. Morgan and Michael R. Strain, "Payday Holiday: How Households Fare after Payday Credit Bans", Federal Reserve Bank of New York Staff Report no. 309, November 2007 revised February 2008, at: