The Economics of Consumer Lending Todd J. Zywicki Professor of Law George Mason University School of Law Research Fellow, James Buchanan Center Program on Politics, Philosophy, and Economics

Overview Substantive Regulation of Consumer Credit Substantive Regulation of Consumer Credit Alternatives to Substantive Regulation Alternatives to Substantive Regulation Consumer Credit Issues in the United States Consumer Credit Issues in the United States Macroeconomic Effects of Consumer Credit Macroeconomic Effects of Consumer Credit

Substantive Regulation Effect of Regulation: Intended Consequences Effect of Regulation: Intended Consequences Effect of Regulation: Unintended Consequences Effect of Regulation: Unintended Consequences Term Substitution/Repricing Term Substitution/Repricing Product Substitution Product Substitution Rationing Rationing Dynamic Effects and Competition Dynamic Effects and Competition

Term Repricing Interest Rate Interest Rate Fixed or Variable Fixed or Variable Annual Fee Annual Fee Quality (Benefits, Hours, Customer Service) Quality (Benefits, Hours, Customer Service) Price of Goods Price of Goods Points Points Term Term Collateral Collateral Costs Costs Insurance Insurance Downpayment Downpayment Balloon Balloon Prepayment Penalty Prepayment Penalty Grace Period Grace Period Default & Foreclosure Default & Foreclosure

Product Substitution

Rationing Historical Evidence Historical Evidence Redistribution Effects Redistribution Effects Empirical Evidence on Effects of State “Anti-Predatory Lending” Laws Empirical Evidence on Effects of State “Anti-Predatory Lending” Laws

Rationing “Predatory Lending Laws Can Cause Headaches,” Parma Sun Post (July 10, 2003): When David Sanderson recently applied to a lender for a second mortgage, he was denied for an unusual reason. Undeterred, he went to another lender and was denied again. Same thing happened at a third institution. In all three cases, he was given the same reason for the denial—the lenders thought he lived in Cleveland and claimed that the city’s anti-predatory lending law prevented them from giving him the loan he needed. *** Since Cleveland’s anti-predatory lending law caps interest charges, some lenders don’t give second mortgages or home-equity loans to Cleveland residents having potential credit risks. But Sanderson lives in Fairview Park, a small, inner-ring suburb west of Cleveland. “When we were applying for loans, the companies would key in our zip code, and Cleveland would come up,” he said.*** Desperate for a solution, Sanderson contacted his suburb’s City Hall. Fairview Park Mayor Eileen Patton wrote a letter on his behalf, verifying he was a resident of the suburb. “Her inquiry into the matter must have accomplished something, because we received a call from one of the companies that initially turned us down, and offered to finance us,” Sanderson said. “Sometimes it pays to the mayor.” Patton said she and City Council have received similar requests from six other residents who encountered the same problem as Sanderson’s.

Dynamic Effects Term Substitution, Nonstandardized Terms, & Competition Term Substitution, Nonstandardized Terms, & Competition Annual Fees & Competition Annual Fees & Competition Retail Market & E-Commerce Retail Market & E-Commerce Wealth Accumulation Wealth Accumulation

Substantive Regulation: Conclusion General Consensus of Economists that substantive regulation Ineffective and Counterproductive in Light of Unintended Consequences

Alternative Regulatory Regimes Disclosure Disclosure Education Education Markets and Common Law Markets and Common Law

Disclosure Regime: Pros Pros Pros Market Failure: Information Costs/Asymmetry Market Failure: Information Costs/Asymmetry Standardization: Comparative Shopping Standardization: Comparative Shopping Better than Substantive Regulation (Usury): Attempts to improve, rather than supplant market process Better than Substantive Regulation (Usury): Attempts to improve, rather than supplant market process Safe Harbor Safe Harbor

Disclosure Regime: Cons Cons Cons Standardization: Inability to Tailor Information to Consumers, One Size Doesn’t Fit All Standardization: Inability to Tailor Information to Consumers, One Size Doesn’t Fit All Clutter/Information Overload Clutter/Information Overload Raises Costs of Finding Information You Want: Benefits, Transactors, Frequent Flyer Cards Raises Costs of Finding Information You Want: Benefits, Transactors, Frequent Flyer Cards Risk of Political/Normative Disclosures: What Consumers Should Care About Risk of Political/Normative Disclosures: What Consumers Should Care About Term Substitution Term Substitution Safe Harbor: Technical Compliance, Lawyerly Disclosures Safe Harbor: Technical Compliance, Lawyerly Disclosures

Typical “Schumer Box” Disclosure (Reg Z, Appendix G) Annual percentage rate (APR) for purchases 2.9% until 11/1/00. After that, 14.9% Other APRs Cash-advance APR: 15.9% Balance-transfer APR: 15.9% Penalty rate: 23.9%. See explanation below.* Variable-Rate Information Your APR for purchase transactions may vary. The rate is determined monthy by adding 5.9% to the Prime Rate** Grace period for repayment of balances of purchases 25 days on average Method of computing the balance for purchases Average daily balance (excluding new purchases) Annual fees None Minimum finance charge $.50 Transaction fee for cash advances: Balance-transfer fee: Late-Payment fee: Over-the-credit-limit fee: 3% of the amount advanced 3% of the amount transferred $25$25 *Explanation of Penalty **The Prime Rate used to determine your APR is the rate published in ___ on the __ day of the prior month

Standardization: Other Disclosures Found in Schumer Box International transactions 3% of the U.S. dollar amount of the transaction, whether originally made in U.S. dollars or converted from a foreign currency. Different rates for bank customers Your APR may vary. Preferred Pricing: 1 For Chase Banking Relationship Accounts - Purchases and Balance Transfers/Balance Transfer Checks: For both outstanding and new purchases and balance transfers the non-introductory rate is determined monthly for accounts with Elite Pricing by adding 3.99% (or 7.99% for accounts with Premium Pricing), to the Prime Rate.3 For all purchases from account opening, and for both outstanding and new balance transfers after 3 months for accounts with Standard Pricing, the rate is determined monthly by adding 14.99% to the Prime Rate. 3 For Chase Credit Card Accounts Only - Purchases and Balance Transfers/Balance Transfer Checks: For both outstanding and new purchases and balance transfers the non-introductory rate is determined monthly for accounts with Elite Pricing by adding 4.99% (or 8.99% for accounts with Premium Pricing), to the Prime Rate.3 For all purchases from account opening, and for both outstanding and new balance transfers after 3 months for accounts with Standard Pricing, the rate is determined monthly by adding 14.99% to the Prime Rate. 3 Cash Advances/Cash Advance Checks for all accounts: The rate is determined monthly by adding 15.99% to the Prime Rate (not less than 19.99% for accounts with Elite and Premium Pricing, or not less than 23.99% for accounts with Standard Pricing). 3 Non-Preferred Pricing/Default APR - For all balances for all accounts: The rate is determined monthly and is up to the Prime Rate plus 23.99%. 3

Education Government Programs: Assessment Government Programs: Assessment Purpose of Education? Purpose of Education? Prevent Fraud Prevent Fraud Make Market Work Better Make Market Work Better North Carolina Experiment North Carolina Experiment

Market and Contract Market is a form of regulation (common law fraud part of market ordering) Market is a form of regulation (common law fraud part of market ordering) 2 Markets: 2 Markets: Credit Credit Information About Credit: Economics of Information Information About Credit: Economics of Information Sources of Information Sources of Information Lenders: Incentives to Provide Relevant Info to Consumers, Advertising v. Disclosures Lenders: Incentives to Provide Relevant Info to Consumers, Advertising v. Disclosures Indirect Information: Klein & Leffler Indirect Information: Klein & Leffler Third-Parties: Consumer Reports, Bankrate.com Third-Parties: Consumer Reports, Bankrate.com Newspapers: ex., International Conversion Fees Newspapers: ex., International Conversion Fees

Behavioral Economics and Substantive Regulation New Justifications for Substantive Regulation: Consumers are Stupid New Justifications for Substantive Regulation: Consumers are Stupid Imperfect Self-Control Imperfect Self-Control Underestimation Hypothesis Underestimation Hypothesis Hyperbolic Discounting Hyperbolic Discounting Overestimation of Repayment Overestimation of Repayment Underestimation of Forgetfulness Underestimation of Forgetfulness Credit Card Issuers Prey on These Biases Credit Card Issuers Prey on These Biases

Irrational Consumers? Are Consumers Really that Stupid? Are Consumers Really that Stupid? Agarwal, Chomsisengphet, Liu, and Souleles Agarwal, Chomsisengphet, Liu, and Souleles Consumers generally choose correctly Consumers generally choose correctly Learning Learning Errors fall as cost of errors rises Errors fall as cost of errors rises Errors smaller than transaction costs and benefits Errors smaller than transaction costs and benefits Revolvers More Likely to Know Interest Rates and Shop on Interest Rates Revolvers More Likely to Know Interest Rates and Shop on Interest Rates Brown & Plache Brown & Plache Revolvers more likely to select higher annual fee/lower interest rate trade-off Revolvers more likely to select higher annual fee/lower interest rate trade-off Nonrevolvers more likely to carry rewards program cards and charge more Nonrevolvers more likely to carry rewards program cards and charge more Revolvers more likely to shift to debit cards (No float benefit) Revolvers more likely to shift to debit cards (No float benefit)

Irrational Consumers?

Macroeconomic Effects Is Greater Access to Credit Causing an Epidemic of “Overindebtedness”? See Todd J. Zywicki, Bankruptcy and Personal Responsibility: Bankruptcy Law and Policy in the Twenty-First Century (Forthcoming 2007, Yale U. Press)

Substitution Effect

Consumer Credit & Mortgages

Growth in Net Wealth

Household Net Wealth

Mean Net Wealth (In Thousands) All <20%

Home Ownership

Change in Homeownership

Causes of Rising Ownership Federal Reserve Bank San Francisco (Nov. 3, 2006): “We find that… it is likely that much of the increase is due to innovations in the mortgage finance industry that may have helped a large number of households buy homes more easily than they could have a decade ago.” Federal Reserve Bank San Francisco (Nov. 3, 2006): “We find that… it is likely that much of the increase is due to innovations in the mortgage finance industry that may have helped a large number of households buy homes more easily than they could have a decade ago.”

Market Failure and Regulation What is the purported market failure? What is the purported market failure? Is Credit Different from Other Goods and Services? Computers, cars, etc. Is Credit Different from Other Goods and Services? Computers, cars, etc. Schizophrenia of Current Approach: Making Market Work Better versus Market Working Too Well Schizophrenia of Current Approach: Making Market Work Better versus Market Working Too Well Disclosure a Back Door for Substantive Regulation, i.e., “If people only knew…” Disclosure a Back Door for Substantive Regulation, i.e., “If people only knew…”

Summing Up Every Form of Regulation has Costs and Benefits Every Form of Regulation has Costs and Benefits No evidence that consumers are “drowning in debt” No evidence that consumers are “drowning in debt” No evidence of systematic consumer irrationality No evidence of systematic consumer irrationality Need a Serious Model of Consumer Behavior and Market Process Need a Serious Model of Consumer Behavior and Market Process