Volume 43 | Number 2 Spring 2008
C. U.S. Response to Consumer Over-Indebtedness
1. Disclosure and Consumer Education
When the U.S. credit crisis started earlier in 2006, few members of Congress and no one in the current Bush Administration were willing to propose substantive, immediate solutions to the housing crisis. No one wanted to be perceived as arguing for a bailout of either homeowners or hedge funds. Instead, the most common response was to propose either additional homeowner counseling services or to suggest that consumers be given even more disclosures about the terms of their mortgages or credit cards.127 In crafting a response to the problem of consumer over-indebtedness, policymakers in both the United States and in Brazil should avoid adopting a solution that merely increases the amount of information or disclosures that consumers receive before each credit transaction.128 While disclosure information appears to be useful for higher income borrowers, consumer counseling organizations in the United States have generally found that consumers who have received counseling still are prone to succumb to the aggressive marketing and advertising of lending organizations.129 Thus, additional counseling or enhanced disclosures by themselves are not likely to help resolve the problem of consumer over-indebtedness.130
Counseling and additional disclosures are especially unlikely by themselves to help decrease consumer over-indebtedness because of certain cognitive biases people have. That is, people are prone to be overly optimistic about their financial futures and to systematically underestimate the risk that bad things will happen to them, such as an inability to repay their debts. People also tend to discount the harm that may occur to them in the future, such as default, because they tend to place a high value on positive current events: the ability to own their own home or to buy something with a credit card.131 Given this, it is unrealistic to assume that most consumers will consistently control the impulse to over-consume. Since some consumers (like college students) may have reason to believe that their incomes will increase significantly in a few years, providing additional disclosures will likely be meaningless in convincing them to temper their spending.132 Finally, shifting the burden to the consumer to understand the terms of complex credit transactions creates perverse incentives for creditors. That is, if the burden is placed solely on the consumer to comprehend the often complicated credit transaction, creditors have an incentive to provide long, confusing disclosures133 and have an even greater incentive to target vulnerable populations like the elderly or college students who they conclude will not handle credit wisely.
2. Regulation
In response to the meltdown in the U.S. mortgage market, the U.S. Congress has held numerous hearings and has considered legislation designed to respond to the problem of over-indebtedness generally, and the housing crisis specifically. Unlike Brazil, the U.S. has a legal structure, namely the U.S. Bankruptcy Code, which can be used to enact laws that respond to new or existing problems involving consumer over-indebtedness.134 Indeed, many of the bills that recently have been proposed are designed to weaken the protections mortgage lenders have in bankruptcy. For example, one bill would allow consumers aged fifty-five and older to exempt up to $75,000 in any equity they have in their homes.135 Other bills would allow over-indebted consumers to waive the mandatory credit counseling requirement and seek immediate bankruptcy relief if they are filing bankruptcy in order to save their home from foreclosure.136 One proposed bill also would let consumers discharge the entire amount of the mortgage loan if the lender engaged in certain fraudulent acts or violated certain state and federal laws.137
Perhaps the most controversial aspect of the recent proposals is that they would protect consumers who find themselves “upside-down” on their home loans. That is, because of multiple refinancing, no down payments, and other exotic loan features, many homeowners find that they owe more than the home is worth.138 Borrowers whose loans permit them to defer interest or pay significantly lower interest rates than the stated rate in the loan have found that their loan has negatively amortized since their principal loan balances would increase because of their failure to pay all accumulated interest. Proposed legislation would let a borrower who sought relief in Chapter 13 reduce the amount of the lender’s interest in his home to the value of the home, and also would let the consumer modify the terms of the loan to make low initial payments, then a large “balloon” payment in three to five years in anticipation of a loan refinance when interest rates (hopefully) drop.139
Allowing courts to reduce the value of a mortgage holder’s interest to the value of the home would be a dramatic shift in U.S. policy since mortgage holders have always been favored under U.S. bankruptcy laws even if the mortgage debt did not enable the consumer to purchase the home and, instead, was used to repay other debts or to purchase consumer durables. 140 While opponents of the bill have argued that it would make it even harder for borrowers to get mortgages,141 this would at least be one way to give lenders a strong economic incentive to take greater care when approving mortgage loans or buying those loans in the secondary market. Since lenders appear willing to expand credit only if they can be sure that they can repossess the collateral that secures the loan, it is likely that they will take greater care in extending credit if they think that their security will not be protected in an insolvency proceeding.
In addition to these proposed changes to the U.S. Bankruptcy Code, the Office of the Comptroller of the Currency and other federal banking entities142 have proposed agency guidelines to address the homeownership crisis and problems created by exotic loans generally, and the particular issues involving subprime loans.143 These proposed guidelines are designed to ensure that the terms of nontraditional lending products are consistent with prudent lending practices and that these standards help prevent borrowers from experiencing a substantial increase in their monthly loan payments. The guidelines address the need to help borrowers understand the loan terms and to determine whether they can afford the loan at the time and will be able to make loan payments if the loan balance increases because of negative amortization. The guidelines also are designed to help borrowers understand whether they may be placing their homeownership at risk by using one of these products.144 The agencies specifically discourage the use of liar loans and urge mortgage originators to require borrowers to produce employment verification statements (i.e., W-2 statements), pay stubs, or tax returns.145 Regulators also would require that mortgage originators verify the “reasonable ability” of the borrower to pay the principal and interest on the loan, real estate taxes and homeowners insurance; would require lenders to consider the borrower’s ability to pay the loan after the rates reset; would eliminate liar loans; and would deem mortgage brokers to be in a fiduciary relationship with the potential borrower.146 The Federal Reserve Board also has proposed changes to the regulation that governs credit card disclosures, commonly known as Regulation Z. The proposed changes are designed to make credit card disclosures more comprehensible and require issuers to give consumers longer notice of any proposed changes to the credit card terms.147
Lenders opposed not only the housing loan guidelines enacted in response to the U.S. housing crisis and regulations that would impose on them any duty to evaluate a borrower’s ability to repay a housing loan, but also the proposed changes to the U.S. Bankruptcy Code.148 Undeterred by this opposition, the Chairman of the U.S. Federal Reserve has stated that the Federal Reserve is looking closely at some mortgage lending practices, including the appropriateness of evaluating a borrower’s ability to repay a loan at the time the loan was made.149 Moreover, the U.S. Congress continues to hold and to threaten to hold additional hearings to examine the practices of credit card companies. Scrutinized practices include the marketing of credit cards to college students, unilaterally changing the terms of credit card agreements, and treating a consumer who has not missed any payments on Credit Card A to be in default simply because the consumer is in default on Credit Card B, a practice known as universal default.150
Though this has not yet happened, the United States and Brazil should carefully consider the concept of responsible lending, a policy that has been considered but not adopted by European countries,151 and also the notion that the consumer should be guided to “good loan” products.152 Responsible lending suggests that well-functioning credit markets need rules that both make credit available to all people, thus embracing the democratization of credit, and protect the consumer who is vulnerable to exploitative lending practices. Similarly, the concept that the consumer should be guided to “good loans” is based on the belief that all parties involved in the mortgage market should ensure that borrowers have access to a loan that is transparent and fairly priced, provides benefits to the consumer, and does not expose the borrower to unexpected foreclosure or default risks.153 Of course, it is a challenge to craft rules and regulations which ensure both consumer access to credit and that this credit does not overwhelm or confuse the consumer. Yet, the United States and Brazil should nonetheless consider these policies since they are consistent with the economic reality that some amount of legal intervention will be necessary to give creditors an incentive not to take advantage of vulnerable customers or of customers’ behavioral biases.
3. Changing Issuer and Lender Practices
Consumer advocates have urged credit card issuers and mortgage lenders to adopt basic principles that would govern the way they market these products to the vulnerable consumer.154 While this is not in the economic interest of the financial industry, the fear that administrative agencies or Congress will enact new regulations or laws gives lenders an incentive to unilaterally change their practices to avoid additional agency or legislative oversight. This appears to have happened with some of the changes financial institutions have made recently concerning their credit card and mortgage practices.
For example, consumer advocacy groups have applied intense pressure on universities to restrict credit card issuers’ access to their students and at least some states have passed legislation to regulate credit card marketing on campuses.155 In addition, the public outcry about subprime loans in the United States combined with the number of Congressional hearings that have been held over the last few years as well as the fear of additional or more burdensome regulation appears to have caused mortgage lenders to voluntarily change some of their lending practices. U.S. mortgage lenders have agreed to reduce the number of liar loans they will approve and many have stopped offering loan products that had very low interest rates for the first few years, then dramatically higher rates for the remaining years (typically twenty-seven to twenty-eight years).156 In addition, some credit card issuers have voluntarily agreed to abandon the practice of universal default, though it is unclear whether it is a complete abandonment of this practice.157
VI. CONCLUSION
In fashioning relief for unsophisticated over-indebted consumers, the United States and other countries should consider ways to ensure that lenders will not act in ways that are designed to take advantage of vulnerable consumers in credit transactions. Lenders will likely continue to oppose attempts to regulate their lending practices, and likely will argue for increased disclosures, more consumer literacy programs, or other market-based approaches. These approaches have not, by themselves, worked in the past and there is no reason to think that they will work in the future. Given the harm that consumer over-indebtedness and, more specifically, the subprime housing and credit card crises have had on the United States and global capital markets, Congress should enact laws that shift at least some of the burden of conducting responsible credit transactions to the lender and away from the consumer. And, Brazil and other countries that are enacting or revising their consumer insolvency laws should ensure that these laws give both consumers and lenders economic incentives to behave rationally when entering into a consumer credit transaction.
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Footnotes
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