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ABA Section of Business Law

Business Law Today

Regulating the Subprime Market
Finding the Right Balance
By Michael C. Tomkies
Technology and innovation have permitted a great expansion of credit in the last couple of decades. More people have access to more credit in a greater variety of forms than ever before. Much of this expansion has occurred in the burgeoning "subprime" market. To say that this is a "new" market is somewhat misleading, as some measure of credit and credit-like products have always been available to consumers of lower affluence, to those with blemished credit records, and to those otherwise new to credit. For instance, retailers have long offered open accounts, revolving accounts, retail credit cards, club and layaway plans, and installment credit. Finance companies, licensed small loan lenders, and pawnbrokers have offered secured and unsecured installment loans and the like, not to mention various unregulated sources of credit. However, the amount and scope of credit that have been made available more recently and the entry of subprime lending into the mainstream of banking and consumer finance are relatively new developments. Empirical evidence suggests that the subprime market exhibits characteristics that differentiate it from the more commoditized prime market. These differences have revealed perceived weaknesses in existing regulation. The challenge in developing new regulation will be to find the right balance between establishing effective regulation and allowing further positive market development.

The General Impact of Technology

Technology has contributed greatly to the diversity of the consumer financial ser-vices market, promoting speed, automation, and efficiency. No longer does a consumer need to find a local lender, visit a brick-and-mortar office, wait weeks for a loan decision, or be concerned with currency acceptance issues. Offers of credit conveniently arrive by mail, telephone, and Internet from lenders across town, across the state, or across the country. Credit decisions can be made and presented in a matter of seconds, and a variety of access devices can make cash or credit available instantaneously almost anywhere, even abroad and in cyberspace.

Technology has permitted the unbundling and specialization of functions that are traditionally part of the lending process. Lead generators and brokers interact with consumers. Credit-reporting agencies collect and process credit history data. Marketing partners develop targeted solicitation campaigns. Third-party mail houses, data processors, telemarketers, and lockbox operators print and mail offers, receive responses, process applications, and receive payments for lenders. Lenders make decisions but engage third-party servicers, collectors, and outsourced customer service operations to provide day-to-day customer support and assist in recoveries.

Technology has also expanded the geographic reach of creditors, streamlined the underwriting process, and enabled lenders and investors to more effectively quantify, evaluate, monitor, and manage risk. The combination of technology, credit scoring, other metrics and analytics, and various funding vehicles has facilitated the diversification of investment that has fed further expansion of credit availability to a greater variety of consumers. Credit scoring, coupled with risk-based pricing, has lowered the cost of credit for many consumers while permitting the expansion of traditional credit products to consumers with higher-risk credit profiles who might not even have been considered potentially eligible for such credit a few short decades ago. Increased access has not necessarily brought increased success. Many subprime borrowers still struggle to handle credit.

A Different Market

Empirical data suggest that the subprime market is different, exhibiting risks not just higher, but of a fundamentally greater variety and complexity, than the more commoditized prime market. The subprime market is not homogenous, however. The "typical" subprime borrower almost defies categorization. These borrowers can be of any age, background, educational attainment, income level, ethnicity, or level of financial sophistication, although common groupings can be identified within the broader subprime market. Their only common characteristic is their inability, for one reason or another, to qualify for "prime" credit.

Blemished credit records evidence a higher likelihood of delinquency, but mere scores do not tell the whole story. Many subprime borrowers have unpredictable or seasonal earnings that increase repayment risk. The upward mobility of other borrowers like recent graduates, divorcees, and those recovering from economic hardships or illness can produce higher loan repayment risks and a lack of loyalty that must be accounted for by lenders. Lesser affluence can limit some subprime borrowers' ability to use assets as a buffer against temporary financial difficulties. Some subprime borrowers can lack options for dealing with variances in income or credit needs by, for example, temporarily shifting balances between different accounts like using a home equity line of credit to pay down a credit card balance or using a credit card in lieu of temporarily scarce cash assets to buy groceries. Thus, basic credit risk is generally higher but can also be quite variable.

Subprime loans are generally more expensive to service, perhaps as much as doubly so by some accounts. Transactions are generally smaller, increasing transaction costs relative to the credit extended. Some borrowers may be less organized, less able to understand forms, or simply more comfortable dealing with lender representatives over the telephone or face-to-face. Customer service in the subprime market therefore tends to be more labor intensive. Subprime borrowers generally are more likely to ask for extra copies of documents and more basic account assistance. The greater likelihood of delinquency and default leads to greater collection and recovery expenses and write-offs. These additional costs are reflected in the higher pricing of subprime credit.

Finally, subprime lenders face greater economic, liquidity, and other market risks. Subprime borrowers, for a variety of reasons like those mentioned above, can face significantly greater financial pressures in less favorable economic circumstances. Variability in funding, too, must be considered in pricing subprime loans.

Studies suggest the costs and risk factors explain much of the disparity in pricing between the subprime and prime markets. Nonetheless, many observers remain concerned that subprime lenders may reap outsized rewards in terms of so-called economic rents. Economic rents are not necessarily negative from an economic perspective. Such rents can draw new competition, new ideas, and innovations to the market, resulting in better products and lower costs for borrowers in the end. The complexity of the subprime market makes analysis more difficult, however. Striking the right balance between managing any such rents in the short term and not stifling long-term innovation may be important to preserving consumer access to credit.

More Than Just Credit

The human side of the equation is that subprime lending is not about market economics. Many argue that credit is important, even critical, for economic advancement. Mortgages make owner-occupied housing affordable to those with little accumulated capital. Auto loans provide access to essential transportation for jobs, health, and safety. Installment loans provide funds for education and start-up working capital for small business enterprises. Credit cards provide convenience as well as a measure of practical insurance against emergencies, economic difficulties, and temporary hardships. Payday loans bridge gaps between paychecks and provide emergency funds in a pinch. Credit enables growth.

As beneficial as credit can be, however, there are borrowers who would misuse credit, exercise poor judgment, engage in risk-taking behavior, or give in to unbridled desire, and persons who would take unfair advantage of borrowers. These are not exclusively "subprime" concerns, although they can seem more compelling in the subprime market by degree for the same reasons that the market exhibits heightened risks and complexities, less affluence, fewer options, greater financial pressures, variable employment, less sophistication, inexperience, and the like.

The Problem of Complexity

Credit products have become increasingly complex. Just a few decades ago, standard offers of 21 percent annual percentage rates (APR) cards, with annual fees of $20 to $50, were made across the industry, but only to a relatively narrow band of consumers. Today, "no annual fee" cards are readily available with periodic interest rates from "teaser" rates of zero percent APR to over 30 percent and a variety of features such as variable rates, different rates for purchases and cash advances, balance transfers, promotional rates, and delinquency rates. No longer is the 30-year mortgage with 20 percent down the industry standard offer, itself an innovation over earlier 10- and 15-year mortgages. Products designed for the subprime market tend to be even more complex than those found in the prime market because of the heightened risks and diversity of the subprime market. Greater costs have resulted in not only larger but a greater number of fees.

The Federal Truth in Lending Act, 12 U.S.C. §§ 1601 et seq., and similar state disclosure laws are premised upon the principle that information about the cost of credit, presented in a standardized format, will assist borrowers in comparing costs among competing products, making better decisions, and identifying and avoiding unscrupulous actors. However, as products have become increasingly complex, the usefulness of such disclosure has increasingly become subject to criticism from all sides. Some claim that current disclosures reveal too little while others complain of information overload.

"New consumers"—the inexperienced immigrants, college students, newly divorced, and other consumers who may previously have been unbanked, underbanked, or otherwise deemed unqualified in the past—may be particularly poorly equipped to understand, appreciate, or take appropriate advantage of the many new options and opportunities available to them. They also may fail fully to appreciate the personal and market risks inherent in products like low documentation mortgages, adjustable rate mortgages (ARMs), or unsecured higher-cost credit cards, products of value and great utility to many consumers in many circumstances, but not to all consumers or in all circumstances.

Payday Lending: A Simple Example

Short-term payday loans, a relatively simple product, provide an example of some of the difficulties of regulation in the subprime market. For a fixed fee, a borrower receives a short-term loan on the promise that the borrower will repay the loan on his or her next pay date, generally in 14 to 33 days. Disclosed APRs are often several hundred percent because of the inclusion of fixed transaction costs (fees) in the finance charge calculation over short terms and smaller balances. The product is not difficult to understand and disclosures showing higher annualized rates do not appear to deter borrowers.

As a short-term answer to temporary credit needs, the model works. Situations can be identified where such loans (although arguably high in cost as a proportion of the amount of credit extended) make rational economic sense and save borrowers money. For example, an employee who cannot afford to miss a day of work may prefer to obtain a payday loan to provide emergency daycare funds when a regular daycare giver unexpectedly falls ill. A borrower also may prefer to obtain a loan rather than delay the purchase of much-needed medication. A depositor may prefer to avoid one or more returned check fees when such fee(s) exceed the cost of the payday loan.

Consumer advocates have expressed a number of concerns about payday loans. Some have claimed that the model is hopelessly flawed, particularly to the extent that borrowers are permitted (or encouraged) to take out repeated loans and compound high fixed transaction costs (fees). Others have expressed concern about the amount of fees, suggesting that economic rents are being taken and that other forms of credit at lower costs are or can be made available to such borrowers to address their credit needs as conveniently and comfortably for the borrower as a payday loan.

Payday lenders, on the other hand, claim that the relatively high cost of payday loans largely reflects the inherent risks and costs of the product and its short-term nature. A recent study by professors at the Vanderbilt University Law School and University of Oxford also supports this claim.

The role of the borrower in selecting a short-term loan or the role of unfortunate circumstances, which forces a delay in anticipated repayment, should not be discounted in analyzing these issues. Unlike credit offers like credit cards that may arrive on a borrower's doorstep, borrowers typically must choose to go to a payday lender's physical location to obtain a loan and select the payday loan product. The reason that a borrower might select a short-term loan product to address what may in fact be a longer-term credit need will vary from borrower to borrower, whether from lack of financial education, poor judgment, misjudgment, vulnerability, or otherwise. Again, temporary hardship, illness, and variability in income are common issues in the subprime market.

The Ohio General Assembly recently passed the strictest payday lending bill in the nation. The bill (Ohio Sub. H.B. No. 545) repealed Ohio's former payday loan law that was enacted just 12 years ago and enacted new provisions for "short-term lender" loans. The bill caps APRs on payday loans at 28 percent, inclusive of all fees or charges paid by the borrower. Under the bill, short-term lender loans may not exceed $500 and may not have a term of less than 31 days. The loan amount may not exceed 25 percent of the borrower's gross monthly income. The bill imposes new debt collection requirements on short-term lenders similar to those found in the federal Fair Debt Collection Practices Act and prohibits short-term lender loans made over the Internet. The bill makes Ohio's Consumer Sales Practices Act applicable to short-term lenders and requires the Ohio superintendent of financial institutions to create a statewide database of loans made by short-term lenders. The number of such loans to any borrower is limited to four per year. The 28 percent APR was taken from the Ohio Small Loan Act but without the fixed transaction fees permitted by that statute.

The bill addresses consumer concerns regarding cost, frequency, term, and size. The industry has replied that the bill fails to recognize the economics of small personal loans that are entered into individually in face-to-face transactions and exhibit high loan loss rates. State loan laws commonly recognize the basic fixed costs of entering into loan transactions by allowing for fixed up-front loan charges in the form of application fees, origination fees, credit investigation fees, and the like. The Ohio bill permits none of these. Fees of just $4.24 on four $100 payday loans do not provide adequate compensation for the risks taken by lenders and the costs of making and servicing such loans, the industry argues, effectively precluding short-term lender loans.

Approaches to Regulation

Industry participants are variously chartered, licensed, examined, supervised, and targeted for enforcement at every level of government. More disclosure requirements and more restrictions apply than ever before. However, existing regulation was largely developed before the relatively recent expansion of access to credit and the emergence of subprime lending as we know it today that has been brought about by recent strides in technology and innovation. Addressing the myriad concerns, interests, and factors of the still-developing subprime market is challenging. The market is complex, the products tend to be higher cost, and the borrower population is more diverse. A simple, flexible, workable system of regulation is needed.

Some have called for enhanced regulation, including a return to usury limits for certain types of loans or loan products like military-related loans and payday loans. While simple and relatively easily applied, setting appropriate usury limits to strike a balance between desired access, economic realities, and the elimination of undesirable results may prove problematic in the diverse subprime market in which events are likely to conspire to produce undesirable results for at least some population of borrowers. The value of usury limits continues to be hotly debated as the regulation of rates and fees curtails access, limits choices, and/or shifts costs to innocent borrowers as lenders and investors adjust for risk. Policy judgments about the "right" amount of credit are required and may be difficult to agree upon. The current trend is to identify specific products and situations for regulation.

Outsourcing has produced a fragmentation of the market and weakened the effectiveness of current regulation. Thorough supervision can restore a measure of discipline. To address these issues, federal bank regulatory agencies have effectively imposed supervisory responsibility over third-party service providers onto lenders, requiring lenders to hold their providers to the same high standards that banks are required to meet. Whether lenders are adequately equipped for this role is uncertain since they lack the powers, authority, and perspective of federal and state regulators. The cost of developing new audit, control, and risk management systems for internal and external compliance has increased significantly in recent years and can be expected to continue to rise. These costs will, of necessity, be passed on to borrowers.

Much has been said about the contributions of state-regulated actors to the current crisis, and states too have taken steps to improve regulation through new legislation, expanded licensing and supervision, and better cooperation among state regulators. A number of states have enacted recent legislation to provide more comprehensive mortgage regulation, expand loan officer registration, address mortgage fraud, delay foreclosure actions, and prohibit foreclosure rescue transactions. To address the realities of a diverse national market, states have developed the Nationwide Mortgage Licensing System, and groups of states, like New York, New Jersey, and Pennsylvania, are entering into bank supervision agreements to simplify and unify the regulation of multistate banking operations under a single regulator. Some of these ideas have been around for some time, but the recent mortgage crisis has provided the catalyst for action.

A general shift from prescriptive requirements to guidance-based supervision by the federal banking agencies has provided a measure of regulatory flexibility at the federal level to deal with innovations in a more dynamic way. Principle-based guidance that is reasonably specific can be helpful to the extent that its application can be appropriately tailored to the diversity of the marketplace. Consistent application is important. Overly broad guidance that only identifies areas of concern and suggests potential standards can leave institutions to develop suitable policies and procedures on their own. If such policies and procedures are later challenged and found "inadequate" under broad concepts of "safety and soundness" or "unfair or deceptive acts and practices," institutions may be exposed to significant regulatory and litigation risk when market circumstances change. A mechanism for obtaining guidance that protects against future regulatory and litigation risk would be helpful.

Another approach actively being pursued by federal regulators and considered by Congress is enhanced disclosure. Clearly, if borrowers are to evaluate the products and options available to them critically, so that they may select the products and options that are (or that they think are) best to promote their individual financial goals and meet their individual financial needs, consumers need to have easy access to relevant information in a timely manner. The credit card solicitation disclosure box is a good example of the attempt to pull together pieces of information in a graphic format that is more easily accessible to consumers than the prose of contracts. New disclosures that pull together pieces of information helpful to consumers in a principled way are needed to address the variety of information that may be of particular value to different groups of consumers with respect to the same product or class of products. Deciding precisely what pieces of information are or are not truly essential or material to making particular kinds of decisions, given the variety of credit terms available and the diversity of personal needs, may be difficult. The need for simplicity and flexibility may require imperfect disclosures.

Financial Literacy

Notwithstanding the benefits of enhanced regulation and disclosure, improved financial literacy is essential, especially if consumers are expected to rely on simplified disclosures to make decisions. Consumers need to be able to understand what they are reading, what questions they should be asking, and what may be missing from what they are given. Only then can they assess the relevance of information to their personal circumstances and make full sense of whatever disclosures they receive. Education works, but reaching those in need and convincing them of the merits of education can be problematic. Fortunately, technology is helping to make education more available and more engaging, and a number of web-based resources and electronic literacy programs are now available from federal banking regulators and private groups, including the American Bar Association.

Technology and Innovation

Technology and innovation have contributed to the current circumstances and may provide new solutions to perceived problems in the future. At least one observer has suggested the development of "self-directed" products, empowering and enabling consumers to customize products to match consumers' individual economic needs and priorities. See Angela Littwin, Beyond Usury: A Study of Credit Card Use and Preference Among Low-Income Consumers, 86 TEX. L. REV. 451 (2008). Such products might have consumer-selected, built-in fail-safe protections to automatically reduce credit limits or limit further authorizations (such as eliminating over-limit authorizations) so that consumers can more effectively manage, maintain, and retain accounts. Card issuers already allow consumers to select certain features of credit cards, like rewards, annual fees, and, to a certain extent, rates, which impact the costs of such products to consumers. Technology may one day permit tailored disclosures that highlight for consumers loan terms that are (or should be) of greater importance to them in their financial decision making.

The subprime market that we recognize today is relatively new and made possible by still-developing technology and market innovations. Regardless of the regulatory tools used and the products allowed or disallowed, there will be some consumers, at all levels of credit worthiness and sophistication, who will misjudge their needs and abilities or suffer unforeseen life events that impair their best-laid financial plans. Care must be taken to protect consumers from abusive third parties, or personal inability to use credit wisely, without choking off access to credit for the many who can benefit. Finding the right balance in regulatory policy to correct perceived inadequacies in a diverse market and encourage responsible lending, without unduly impairing credit availability and innovation or unduly increasing the costs of serving the subprime market, will be a challenge.

Sample financial literacy and consumer protection resources

Tomkies is a partner with Dreher Langer & Tomkies L.L.P., in Columbus, Ohio, a firm that focuses on the banking and consumer financial services industry. His e-mail is mtomkies@dltlaw.com.

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