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Credit Card Debt and Subprime Mortgages: Who’s to Blame?

This story is a follow-up to “On Not Owning a Credit Card” and was originally posted on New Deal 2.0.

By Bryce Covert

A few weeks ago I wrote a post about my personal decision to stay away from credit cards and my struggle with a society that is rigged in favor of them. The post didn’t advocate getting rid of credit cards; it advocated getting rid of a credit score system and other incentives that make it difficult not to have one.

The comments section for the post on reddit had a variety of opinions in response, both positive and negative. But many of them used the words “dumb,” “idiot,” “lazy,” “stupid.” They used words such as “responsibility” and “discipline” and “self-control.” The crux of these arguments is that those who get into heavy credit card debt are financially illiterate (or just plain naive). This viewpoint rests the blame of soaring American credit card debt on those who get the cards, rather than the companies who issue them. There is of course a grain of truth in this — many people who have credit card debt spend beyond their means. And there are ways to be savvy about credit cards and not run up a balance.

But that is not what a credit card company wants, and you may in fact find yourself rejected from getting a card if you are that responsible. You are far outside the sweet spot, or what Ronald J. Mann, a professor of law at UT Austin, calls the “sweat box”:  “the spectrum from those who carry balances, to those who routinely make minimum payments, to those who miss payments altogether… [where] the interest rates that borrowers pay…greatly exceed the cost of the lender’s funds.” Mann wrote a paper in 2006, right after Congress passed the Bankruptcy Abuse Prevention and Consumer Protection Act. Proponents of the act relied heavily on a moral argument: that it is shameful Americans could ‘easily’ walk away from their debt by filing for bankruptcy. Those pushing the reforms were concerned that consumers used bankruptcy as a convenient part of financial planning, not as a last resort. Thus the rules for filing had to be tightened.

But Mann smelled something fishy: the credit card companies had lobbied heavily and expensively with this bill. But the bill was unlikely to return enough income through increased bankruptcy payouts to justify the expense of lobbying. In fact, it had none of the effects you might think credit card companies would want: deterring risky borrowing, increasing bankruptcy payouts, or lowing bankruptcy filing rates. So why did they do it? It turns out that the major outcome of this bill, and all that lobbying, was to delay consumers from filing for bankruptcy. The credit card companies weren’t worried about losing money when a customer defaulted; they were worried that too many defaults too early led to lower profits. This is where credit card companies make their money. Not off of customers who are so irresponsible as to default right away, not off of customers who are so responsible that they pay their bills on time. Rather, off of those who are just bad enough to drag out their balances for a long period of time. And that’s where they want to keep you — in the sweat box.

Credit cards have evolved along the same path as mortgages. As Elizabeth Warren, tireless consumer advocate, puts it: “The financial industry has perfected the art of offering mortgages, credit cards, and check-overdrafts laden with hidden terms that obscure price and risk.” Need proof? The average credit card contract has bloated up to 30 pages, from a page and a half in the early 1980s. Issuers advertise a single interest rate and then bury the real details in the contract. (It’s no coincidence that the landmark Marquette Nat. Bank of Minneapolis v. First of Omaha Service Corp. case was decided in 1978, which said that states could no longer regulate interest rates on nationally-chartered banks, leading them to easily find the laxest state laws and regulators.) Similarly, to quote Elizabeth Warren again, “More than half of the families that ended up with high-priced, high-risk subprime mortgages would have qualified for safer, cheaper prime loans.” Wonder why that is. Maybe all those families were interested in high-stakes gambling with their houses? “A recent Federal Trade Commission survey found that many consumers do not understand, or can even indentify, key mortgage terms.” Hmm, maybe not.

The responses to my credit card post mimic the response to the subprime mortgage catastrophe, which placed the blame on homeowners who got mortgages without the adequate funds to pay them back. Again, there is truth in this viewpoint. It is true that many people with little to no income bought houses that they couldn’t afford. But why were so many of these mortgages given out? Who gave them? And what were their motives?

Gary Rivlin may answer some of these questions in the chapter “The Birth of the Predatory Lender” in his book Broke USA. He writes about the early 1990s, when nonbank lenders started to realize that there were profits to be made from low-income neighborhoods. They preyed upon the poor, as “the typical customer…didn’t feel ripped off paying interest rates of 20% or more but instead felt grateful that finally, someone was saying yes.” A lawyer working to help some of these customers climb out of their debt “suspected that the lender was more interested in seizing homes through judgments of default than in accruing steady profits through regular monthly payments.” And indeed, Fleet, one of the first large banks get into the business, “lost $17,000 per home on the 101 homes it sold at a loss, [but] it made an average of $32,000 per home on 194 homes.” Again the story of relaxed regulation in the 80s comes to play: the state caps on interest rates banks could charge on mortgages were barred in 1980. Two years later, Reagan went further and gave lenders the ability to sell creative home loans, including balloon mortgages and adjustable-rate mortgages. A whole new lingo emerged: “packing” a loan, in which a salesperson was able to load it up with points and fees and credit insurance; “flipping,” in which a broker could convince customers to refinance loans again and again, each time adding more points and fees; and all of these practices falling under “equity stripping,” in which banks siphoned off the equity customers had in their homes. The cards were stacked against mortgage customers so that banks could profit. By the turn of this century, “Increasingly, mainstream banks were revving up profits by purchasing or starting a subprime subsidiary,” Rivlin recalls. And we all know how that turned out.

It’s tantalizingly easy to place the blame for huge problems like credit card debt and subprime mortgages on individual consumers. The solution to that is for them to “just man up,” as one of the reddit readers suggested. And as I said above, individual responsibility will always be a factor when it comes to these issues. In Elizabeth Warren’s words: “Nothing will ever replace the role of personal responsibility. The FDA cannot prevent drug overdoses, and the CFPA cannot stop overspending. Instead, creating safer marketplaces is about making certain that the products themselves don’t become the source of trouble.” And therein lies the rub. It is far more difficult to think and talk about the system in which so many of these decisions are taking place.

The flood of comments and reactions to my piece heartens me, however, for two reasons. One is that people who had similar stories to mine came out of the woodworks. Friends, family, coworkers, strangers all started telling me how they either stayed away from credit cards for similar reasons or got into debt early on, found a way out, and then stayed away. The second heartening thing is that clearly this is something that people care about. President Obama just signed sweeping financial regulation into law, and whether or not it’s strong enough to prevent another crisis, the new Consumer Financial Protection Bureau promises to right many of the wrongs listed above. Contracts will become clearer. Regulators will do a better job of regulating these products. Consumers will actually be able to compare credit products, because they will really understand them, and innovation and competition can come back to the market. But none of this will deal with the problem my original post addressed, which is the way our society tethers its people to debt products. If so many people care, so many people wish to be credit card-free, maybe this can change too.

Bryce Covert is Assistant Editor at New Deal 2.0.

Did you get yours?

Your FREE annual credit report.  You eligible by law to get an annual (every 12 months) one but there is ONE legitimate source. It’s not the one that has the funny commercials with the catchy jingle. 

Fair Credit Reporting Act (FCRA), federal law, allows Americans to obtain an annual (every 12 months) credit report free of charge.  This is an excellent way to track your credit particularly to check for identity theft.  And did I mention it was FREE.

We have to be careful though. There are a lot of scam websites that offer free credit reports.  They sound attractive but there is always a hook or catch or phishing for your personal information. But there is only ONE legitimate source for this FREE annual credit report:

AnnualCreditReport.com

Believe me there are a lot of sites that have names very close to the above - so be very careful.  If your not certain about the site please check with the Federal Trade Commission website. 

Good luck.

On Not Owning a Credit Card

This is interesting story and perspective about credit cards was originally posted on New Deal 2.0 website.

By Bryce Covert

Why are we forced to engage with a system rigged to keep us in debt?

Good credit is like a golden key to the city. A good credit score gets you access to apartments, mortgages, and sometimes even jobs. A bad credit score will follow you around like a bad stench that you can’t wash off.

I don’t own a credit card. At age 25, I’ve made the conscious decision to avoid getting one since I was 17, when I opened a student bank account and began receiving credit card offers in the mail. Every time I’m tempted toward one, a distinct memory comes back to haunt me: my parents sitting at the kitchen table, trying to even up with their credit card bills. I remember how my mother turned to me and warned me about how dangerous they are. She carefully taught me not to spend money I don’t have, and I always figured that with a debit card I’m basically constrained to stick to this program. But with a credit card, I open a Pandora’s box of someone else’s money.

I’m not in a majority. Seventy-eight percent of consumers own a credit card, and the average cardholder has 3.5 credit cards. But credit card usage is falling, particularly in this economic crisis, and card companies are reporting drops in customers. Many consumers are now wary of company practices exposed by the financial meltdown — and are looking to simplify finances by paying off (and staying away from) debt.

Yet ever since I opened my first bank account, I’ve been repeatedly told — by the financially dumb and savvy alike — that I have to get a credit card in order to have good credit. And there is an unmistakable undertone to these admonishments that I’m naïve if I don’t. It doesn’t matter that I’ve never missed a payment on anything in my life. I pay rent on the first; I pay my electric bill when it comes in; I make every payment to my student loans ahead of schedule. But when my credit score is stacked up against someone who has 3.5 credit cards, I look less responsible because there is less proof of my ability to meet financial deadlines.

As our colleague Josh Rosner has pointed out, credit cards should really be called debt cards, since that is what you get when you open an account — debt. Any money spent with a credit card is money you immediately owe to someone else. Credit cards are designed to give a false sense of wealth and then hit you with a load of fees. Rosner notes that it all began in the late 1970’s, when consumers moved from charge cards to revolving debt issuance. This changed the consumption patterns of the whole country. Now, the average credit card debt is about $3,700 per adult, or $7,400 per household.

And opening the account is the easiest part. As New Deal 2.0 contributor Elizabeth Warren has repeatedly noted, most people can’t even understand their contracts, and the fees can easily gobble up your savings. Hence Warren’s fight for a Consumer Financial Protection Agency as an essential part of financial reform — it promises to make contracts actually readable, so that people know what they’re getting themselves into. It will also reign in the wild west of deregulation that credit cards now exist in. Warren has been making this argument since way back in 2007, when she pointed out that credit products fall through regulatory cracks (as opposed to toasters and microwaves that could never put consumers at so much risk). With stricter regulation will come better products and innovation in the consumer’s interest. Credit cards will no longer be subject to a patchwork of state regulations, leading to a race to the bottom, but one uniform rule. Interest rates will be regulated. And rules will have real enforcement behind them. With these changes, credit cards could evolve to work for the consumer, rather than functioning as a financial booby trap.

But what if I want to live without debt cards altogether? Because I’ve made the choice to stay away from these dangerous cards and live within my means, I’m blocked from certain activities. Renting and buying houses or apartments is just one of those. There are a number of much smaller things that I’m excluded from — that add up. For instance, some car rental companies don’t let you pay with debit cards; you can only pay with a credit card. The MTA in New York City won’t let me buy a refillable Metrocard without TWO credit cards on file (it’s hard to get your bank to issue you two debit cards). And God help you if you don’t have a Visa or Mastercard logo on your debit card — at that point it’s practically useless. Society is rigged in favor of owning a credit card, and it takes some real maneuvering (or just plain exclusion) to stay away from them. While grassroots campaigns such as Move Your Money are speaking out against predatory credit card policies, I have yet to see a movement to undo the deep connection between consumers and credit cards. (Although if anyone knows of one, I’d love to join it!)

We’ve constructed a world in which the risky choices have been turned into the reasonable ones. While financial reform will hopefully curtail the risks banks took with their own money and put limits on what credit card companies can do, we could use some restructuring of society to decentivize personal risk taking. We shouldn’t reward — nay, expect — people to sign up for credit cards at age 18. We should reward prudent decisions. That would take some serious change.

Bryce Covert is Assistant Editor at New Deal 2.0.

BEWARE - Debt Settlement Arrangements

It’s hard not to come across an advertisement for a debt settlement company.  They are everywhere.  I like the one that implies that there is a government stimulus program that helps us with our credit card debt (there isn’t one).  These debt settlement arrangements are highly susceptible to fraud and may not be all that effective.  Beware.

With many Americans loaded with debt (as high as $20,000 to $30,000) these debt settlement companies have flourished with promises of salvation from credit card debt.  A recently released report by the Center for Responsible Lending provides some evidence that debt settlement services may not be very effective.  This report was released just as the Federal Trade Commission prepares to possibly ban huge upfront fees that debt service companies require. 

The CRL report indicates one major flaw with the debt settlement companies’ business model is the requirement of huge upfront fees and monthly fees that often put the consumer in worst position:

facing increased debt, higher risk of (or actual) bankruptcy, ruined creditworthiness, heightened collections efforts and even lawsuits.

Of course the debt settlement trade group is lobbying for legislation that would allow them to collect huge fees regardless if they deliver results. 

As for the effectiveness of debt settlement services the report stated the following:

An industry study (reported in letter to FTC):

• 65.6% of those enrolled had terminated before completion.
 
• 24.6% of consumers had completed the program (defined as at least 70% of debt settled).
 
• 9.8% of consumers were still actively enrolled.
 
• Settlement savings versus fees shows fees were a hefty 51% of savings (not taking into account increased fees/interest on other accounts, and other harms).

Richard A. Briesch “Study” of one debt settlement company (Aug. 6, 2009):

• 60% of those enrolled (~2,700 consumers) cancelled within two years (higher rate 64.5% for those with the most debt).
 
• These consumers alone paid at least $1.3 million in set-up fees.
 
• For the 40% who did not cancel, detail is provided about the size and frequency of offers and settlements only for those consumers who had at least one settlement or offer of settlement (without disclosing the size of this group, or how many consumers had no settlements or offers at all).       o After one to two years of paying fees, even those consumers who had at least one debt settled still owed money on 48% of the enrolled accounts and still owed 46% of the total debt enrolled     (plus whatever amount that debt had grown to during the interim).

Colorado AG Data (Oct. 15, 2009):

• More than 50% of consumers who had signed up in 2006 or 2007 had already terminated as of Dec. 31, 2008.
 
• Only 7.81% of those who had enrolled 2-3 years earlier (in 2006) had completed the program.
 
• Less than 10% of total enrollees had completed the programs.
 
• Enrollees had already paid an average of $1,666.

Judgment (Court Findings) Against Nationwide Asset Services, Inc.:

• 1,981 consumers were defrauded.
 
• Only 1/3 of 1% of enrollees received promised savings (25-40% debt reduction).
 
• 180 consumers who completed the program paid more in fees and settlements than the amounts they saved.

 
FTC Case Against National Consumer Council, Inc. (2004):
   

• Only 1.4% of consumers enrolled in a debt settlement plan obtained the promised results.

Florida Complaint Against Nationwide Asset Services, Inc. and Others:
 

• Alleged that 227 Floridians had enrolled over six years, but only 30 of those consumers completed the program, which is a completion rate of less than 13.5%.

FTC Case Against Debt Solutions, Inc. (2006):
 

• Alleged that Defendants failed to achieve promised interest rate reductions for 99.5% of sample of accounts and failed to achieve any interest rate reductions in 80.4 percent of the accounts.

First, we must understand all of our options before signing up with a debt settlement company.  This does mean seeking legal advice, if possible, or debt counseling advice.  U.S. Department of Housing and Urban Development (HUD) does have a list of approved counseling agencies - some do provide credit card debt counseling.  Second, if our only option is debt settlement - research, research, research - make sure there are no complaints filed against company by checking with state agencies such as state attorney general office or other consumer protection agencies and the Better Business Bureau.  Third, before signing anything, make sure that you read and understand all documents that debt settlement company wants signed - particularly check for fees and any promises offered are included in the documents.  Please do not sign something if you don’t understand it.

Good luck. 

401(k) Conundrum

I came across two related articles regarding 401(k)s.  One addressed the policy angle regarding 401(k)s: Why It’s Time to Retire the 401(k) and the other addressed investment strategy regarding 401(k)s: A 401(k) is Still the Best Way to Save for Retirement.  Both articles highlight the huge conundrum workers face regarding retirement savings. 

A 401(k) is an employer sponsored retirement plan that has over time replaced the pensions that many of our grandparents and great-grandparents were accustom to.  401(k)s were sold as a way to put people/workers in charge of their retirement and a great way for companies to off-load a cost.  The effect of which has been to shift the risk of retirement savings from employer to the worker. 

The article “Why It’s Time to Retire the 401(k)” was accurate with the assessment of 401(k)s

The ugly truth, though, is that the 401(k) is a lousy idea, a financial flop, a rotten repository for our retirement reserves. In the past two years, that has become all too clear. From the end of 2007 to the end of March 2009, the average 401(k) balance fell 31%, according to Fidelity. The accounts have rebounded, along with the rest of the market, but that’s little help for those who retired — or were forced to — during the recession. In a system in which one year’s gains build on the next, the disaster of 2008 will dent retirement savings long after the recession ends.

That’s a very ugly truth.  The financial crisis and the recession that followed has dug a deep hole for our retirement savings.  But even scarier is that we weren’t really saving that much even before the financial crisis:

The average 401(k) has a balance of $45,519. That’s not retirement. That’s two years of college. Even worse, 46% of all 401(k) accounts have less than $10,000.

Defenders of 401(k) say they haven’t been given enough time to produce significant retirement savings.  Sure, but the problem is that the amount of savings necessary to achieve retirement without a significant drop in standard of living may be too high:

Some people don’t contribute as much as they should — essentially ignoring free money from company matches and tax relief. And, as the original engineers of the 401(k) suspected, the less you earn, the less you are likely or able to contribute. For most employees, the maximum contribution to a 401(k) is $16,000 annually. She found that just 5% of people earning $80,000 to $100,000 maxed out, compared with 30% of those making $100,000 or more.

There are other expenses that families incur, mainly in the form of living expenses, that often crowd-out retirement savings.  Besides, even with more time there is a question whether they will be rewarding

In practice, 401(k)s haven’t been nearly so rewarding. When Boston College’s Munnell looked at the returns 401(k)s have actually produced compared with the projections, the difference was sobering. The average 55-to-64-year-old should have a 401(k) balance of $320,000. In fact, at the end of 2007, the average 401(k) of a near retiree held just $78,000 — and that was before the market meltdown.

The article alludes to some alternatives and other have been offered.  But that doesn’t help us now.  That’s the first conundrum for us.

The second article: “A 401(k) is still the best way to save for retirement” is correct in its general assessment of the situation - mainly that 401(k)s offer the best option (assuming its an option for us) for our retirement savings.  401(k)s use pre-tax income and offer the opportunity (although not guaranteed) for a contribution from our employer. 

But the problem or second conundrum is allocations.  We’ve been told that for younger workers its best to have a good portion of our 401(k) money in stocks.  For example, many financial planners will say younger workers can afford to have 60% stock - 40% bond allocation.  There are significant problems with this notion.  First, with the volatility of the stock market and riskiness of the stock market nothing should be taken for granted.  Second, studies have shown that many us are not good at changing allocations over time - meaning as we get closer to retirement our allocations should be in less risky investments but we fail to make the change. 

Is it best just to keep allocations in less risky investments the entire time?  But that does mean that we would have to save more over time in order to save enough in order to compensate for lower returns.  These are difficult choices that we have to make.  The important thing is that we make an informed choice.

Good luck. 

 

 

 

 

 

 

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