Making credit safer.

• Author: Bar-Gill, Oren

Physical products, from toasters and lawnmowers, to infant car seats and toys, to meat and drugs, are routinely inspected and regulated for safety. Credit products, like mortgage loans and credit cards, on the other hand, are left largely unregulated, even though they can also be unsafe. Because financial products are analyzed through a contract paradigm rather than a products paradigm, consumers have been left with unsafe credit products. These dangerous products can lead to financial distress, bankruptcy, and foreclosure, and, as evidenced by the recent subprime crisis, they can have devastating effects on communities and on the economy. In this Article, we use the physical products analogy to build a case, supported by both theory and data, for comprehensive safety regulation of consumer credit. We then examine the present state of consumer credit regulation, explaining why the current regulatory regime has systematically failed to provide meaningful safety regulations. We propose a fundamental restructuring of this regime, urging the creation of a new federal regulator that will have both the authority and the incentives to police the safety of consumer credit products.

INTRODUCTION I. THE PROBLEM A. The Theory: Why Markets for Consumer Credit Products Are Failing. 1. The Limits of Learning 2. Why Getting Smarter Collectively Does Not Work 3. Why Sellers Do Not Educate Consumers 4. Why the Informed Minority Does Not Drive the Market 5. Who Knows the Most About Me? B. The Evidence: Markets for Consumer Credit Products Are Failing. 1. Survey Evidence 2. Consumer Behavior a. Credit Cards b. Mortgage Loans c. Payday Loans 3. Product Design a. Credit Cards i. Long-Term Interest Rates ii. Penalty Fees and Rates iii. Other Fees iv. Introductory Rates v. Additional Design Features b. Mortgage Loans i. Deferred Costs ii. Proliferation of Fees c. Payday Loans C. The Harm: Implications of Credit Market Failure 1. Harm to Consumers 2. Externalities a. The Cost of Financial Distress b. Market Distortions 3. Distributional Concerns D. Summary: The Markets for Consumer Credit Products Are Failing II. THE SOLUTION A. Existing Responses and Why They Failed 1. Ex Post Judicial Intervention a. Existing Ex Post Solutions b. The Failure of Existing Ex Post Solutions i. Institutional Competence ii. Doctrinal Limitations iii. Procedural Barriers 2. Ex Ante Regulation a. The Erosion of State Power b. Regulatory Agencies, Not Legislators c. Mismatch of Authority and Motivation i. The Banking Agencies: Authority Without Motivation ii. The FTC: Motivation Without Authority B. A New Proposal CONCLUSION INTRODUCTION

Safety regulation is everywhere. Toasters, lawnmowers, infant car seats, toys, meat, drugs, and many other physical products are routinely inspected and regulated for safety. Indeed, regulation of such products has become so firmly woven into the marketplace that it is headline news when regulators fail to prevent a dangerous product from making it into the hands of consumers. No one asks if such items should be regulated; policy discussions center instead on whether such regulation is adequate.

Consumer credit products also pose safety risks for customers. Credit cards, subprime mortgages, and payday loans can lead to financial distress, bankruptcy, and foreclosure. Economic losses can be imposed on innocent third parties, including neighbors of foreclosed property, and widespread economic instability may affect economic growth and job prospects for millions of families that never took on a risky financial instrument. Financial harm is not the same as physical harm, but it can be as real and as painful. Why are consumers protected from dangerous products and sharp business practices when they purchase tangible consumer products, but left at the mercy of their creditors when they sign up for routine financial products like mortgages and credit cards? (1)

The difference between the two markets is regulation. Although the "R-word" is considered an epithet in many circles, regulation supports a booming market in tangible consumer goods. Nearly every product sold in America has passed basic safety regulations well in advance of being stocked on store shelves. (2) Credit products, by comparison, are weakly regulated by a tattered patchwork of federal and state laws that have failed to adapt to changing markets. Thanks to effective regulation, innovation in the market for physical products has led to greater safety and more consumer-friendly features. By comparison, innovation in financial products has produced incomprehensible terms and sharp practices that hurt consumers and reduce social welfare.

Credit has provided substantial value for millions of households, permitting the purchase of homes that help families accumulate wealth and cars that can expand job opportunities. Credit can also provide a critical safety net, permitting families to borrow against a better tomorrow if they suffer job layoffs, medical problems, or family breakups today. Many financial products are offered on fair terms that benefit both seller and customer.

For a growing number of families that are steered into overpriced and misleading credit products, however, credit products benefit only the lenders. For families that get tangled up with truly dangerous financial products, the results can be wiped-out savings, lost homes, higher costs for car insurance, denial of jobs, troubled marriages, bleak retirements, and broken lives. (3)

In this Article we argue for parity of treatment between ordinary physical products and financial products that are sold to consumers. Credit products should be thought of as products, like toasters and lawnmowers, and their sale should meet minimum safety standards. (4) We harness both theory and data to demonstrate that sellers of credit products have learned to exploit the lack of information and cognitive limitations of consumers in ways that put consumers' economic security at risk, turning them into far more dangerous products than they need to be. We argue that consumers are no better equipped to protect themselves from many common credit products than they were from poorly wired toasters or badly designed lawnmowers that started fires or sliced off fingers before the safety of these physical products was regulated. We also argue that the current legal structure, a loose amalgam of common law, statutory prohibitions, and regulatory-agency oversight, is structurally incapable of providing effective protection. We propose the creation of a single regulatory body that will be responsible for evaluating the safety of consumer credit products and policing any features that are designed to trick, trap, or otherwise fool the consumers who use them.

Despite the benefits that it provides, the market for consumer financial products suffers from deficiencies that prevent even intense competition from maximizing both consumer and social welfare. Rhetoric to the contrary notwithstanding, (5) a careful examination of the market for financial products illustrates the need for systemic regulation and suggests how such regulation can support optimal market functioning.

Two clarifications are in order: First, we are not claiming that the current regulation of physical products is perfect, or that regulation of credit products is completely absent. Our claim is that regulation of physical products is more broadly accepted and more effective than the regulation of credit products. Second, we are not claiming that all potentially dangerous physical or credit products should be regulated. Regulatory intervention is necessary only when markets are shown to fail, as elaborated below.

Today, consumers can enter the market to buy physical products, confident that they will not be deceived into buying exploding toasters and other unreasonably dangerous products. They can concentrate their shopping efforts in other directions, helping drive a competitive market that keeps costs low and encourages innovation in convenience, durability, functionality, and style. Consumers entering the market to buy financial products should enjoy the same benefits.

1. THE PROBLEM

   1. The Theory: Why Markets for Consumer Credit Products Are Failing

      Credit products are a species of contract. Conceptually, an agreement to lend money is no different from any other contract. In the ideal prototype, each party agrees to a certain set of terms, creating a wealth-enhancing transfer for both sides. The role of law is thus limited--to enforce the parties' contract, not to meddle with it.

      The freedom-of-contract principle and faith in the value of free markets are premised on a number of assumptions, specifically that the contracting parties are informed and rational. In the area of consumer credit products, not only are these assumptions untested, but in many cases both theory and evidence suggest they are unrealistic or directly contradicted by the available data. (6) When those assumptions are not reliable, then freedom of contract shifts from a system to enhance consumer welfare, and social welfare more generally, to a tool used by more sophisticated parties to take consumers' money without giving value in return.

      We focus on the risk associated with using products. Of course, all products carry risks. A toaster, if not used carefully, can cause serious physical harm. Similarly, a credit card, if not used carefully, can cause serious financial harm. Yet toasters and credit cards are ever present despite the risks that they pose. These products are ubiquitous because they provide substantial benefits alongside the serious risks. If an informed consumer purchases a toaster after accurately concluding that the benefits of the product outweigh the risks, then the transaction is welfare enhancing. (7) Moreover, informed rational consumers will minimize product risk by taking optimal care. And a market populated by informed rational consumers will force...