F

O
R
U
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Making Credit Safer

The case for regulation
an epithet in Washington since Ronald Reagans presidency, the
R-word supports a booming market in tangible consumer
chance of bursting into ames and burning down your
goods. Nearly every product sold in America has passed basic
house. But it is possible to renance your home with a
safety regulations well in advance of being put on store
mortgage that has the same one-in-ve chance of putting
shelvesbut credit products are regulated by a tattered patchyour family out on the streetand the mortgage wont
work of federal and state laws that have failed to adapt to changeven carry a disclosure of that fact. Similarly, its impossiing markets. Moreover, thanks to eective regulation, innovation
ble for the seller to change the price on a toaster once you have purin the market for physical products has led to more safety and
chased it. But long after the credit-card slip has been signed, your
cutting-edge featuresbut innovation in nancial products has
credit-card company can triple the price of the credit you used to
produced incomprehensible terms and sharp practices that have
nance your purchase, even if you meet all the credit terms. Why
left families at the mercy of those who write the contracts.
are consumers safe when they purchase tangible products with
Sometimes consumer trust in a creditor is well placed. Credit
cash, but left at the mercy of their creditors when they sign up for
has provided real value for millions of households, permitting the
routine nancial products like mortgages and credit cards?
purchase of homes that can add to famThe dierence between the two markets is regulation. Although considered
by ELIZABETH WARREN ily wealth accumulation and cars that

t is impossible to buy a toaster that has a one-in-ve

I
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May - June 200 8

I l l u s t ra t i o n s b y D a v i d Pl u n k e r t

can expand job opportunities. Credit can also provide a critical

safety net, a chance for a family to borrow against a better tomorrow when they confront layos or medical problems today.
Life insurance and annuities also can greatly enhance a familys
security. Consumers may not spend hours poring over the details
of their credit-card terms or understand every paper they sign at
a real-estate closing, but many of those nancial products are
oered on fair terms that benet both seller and customer.
But for a growing number of families steered into over-priced
credit products and misleading insurance plans, trust in a creditor proves costly. And for families tangled up with truly dangerous nancial products, the result can be wiped-out savings, lost
homes, costlier car insurance, job rejections, troubled marriages,
bleak retirements, and broken lives.
Consumers entering the market to buy nancial products should
enjoy the same protection as those buying household appliances.
Just as the Consumer Product Safety Commission (CPSC) protects
buyers of goods and supports a competitive market, a new regulatory agency is needed to protect consumers who use nancial
products. The time has come to recognize that regulation can often
support and advance ecient and more dynamic markets.
AN EPIDEMIC OF CREDIT PROBLEMS
Americans are drowning in debt. One in every four families reports worries about how to pay credit-card bills this
month. Nearly half of all credit-card holders missed payments in
2006 (the latest year for which data are available), and an additional 2.1 million families missed at least one mortgage payment.
In 2006, a then-record 1.3 million families received foreclosure
notices, followed by another 2.2 million families who were in
foreclosure in 2007.
Families troubles are compounded by substantial changes in
the credit market that have made debt far riskier for consumers
today than a generation ago. The eective deregulation of interest
rates, coupled with innovations in credit chargesincluding
teaser rates, negative amortization, increased use of fees, crossdefault clauses, and penalty interest rateshave turned ordinary
credit transactions into devilishly complex undertakings. Aggressive marketing compounds the diculty, shaping consumer demand in unexpected and costly directions. Yet consumers time
and expertise have not expanded to meet the demands of a
changing credit marketplace. Instead, consumers sign on to credit
products with only a vague understanding of the terms.
Credit cards oer a glimpse at the costs imposed by a rapidly
growing credit industry. In 2006, for example, Americans turned
over $89 billion in fees, interest payments, added costs on purchases, and other charges associated with their credit cards.
That is $89 billion out of the pockets of ordinary middle-class
families, people with jobs, kids in school, and groceries to buy.
That is also $89 billion that didnt go to new cars, new shoes, or
any other goods or services. To be sure, the money kept plenty of
bank employees working full time, and it helped make debt collection one of the fastest-growing occupations in the economy.
Not all costs associated with debt are measured in dollars.
Anxiety and shame have become constant companions for Americans struggling with debt. Since 2000, families have led nearly 10
million petitions for bankruptcy. Today about one in every seven
families is dealing with a debt collector. Mortgage foreclosures
and credit defaults sweep in millions more families. How do they

feel about their inability to pay their bills? In 2005, the National
Opinion Research Council asked families about negative life
events: the death of a child and being forced to live on the street
or in a shelter topped the list, but ling for bankruptcy ranked
close behind, more serious than the death of a close friend or separating from a spouse. Of those who le for bankruptcy, 85 percent struggle to hide the fact from families, friends, or neighbors.
Why do people get into debt in the rst place? People know
that credit cards are dangerous, all the more so if they carry a balance. Any consumer who signed mortgage papers without reading carefully or seeking legal assistance should not be surprised if
terms come to light later that are unfavorable to the consumer.
Payday lenders have a bad reputation for taking advantage of people; no one should expect to be well treated by them. Car lenders,
check-cashing outlets, overdraft protectionthe point can be repeated again and again: Financial products are dangerous, and
any consumer who is not careful is inviting trouble. And yet, dangerous or not, millions of Americans engage in billions of credit
transactions adding up to trillions of dollars every year.
SETTING THE SNARE

Some americans claim that their neighbors are drowning in

debt because they are heedless of the riskand there can be no
doubt that some portion of the credit crisis is the result of foolishness and proigacy. But that is not the whole story. Lenders
have deliberately built tricks and traps into some credit products
so they can ensnare families in a cycle of high-cost debt.
Creating safer marketplaces is about making certain that the
products themselves dont become the source of trouble. This
means that terms hidden in the ne print or obscured with incomprehensible language, reservation of all power to the seller
with nothing left for the buyer, and similar tricks have no place
in a well-functioning market.
How did nancial products get so dangerous? Part of the problem is that disclosure has become a way to obfuscate rather than
to inform. In the early 1980s, the typical credit-card contract was
a page long; by the early 2000s, that contract had grown to more
than 30 pages of incomprehensible text. The additional language
was designed in large part to add unexpectedand unreadable
language that favors the card companies. Mortgage-loan documents, payday-loan papers, car-loan terms, and other lending
products are often equally incomprehensible. And this is not the
subjective claim of consumer advocates. In a recent memo aimed
at bank executives, the vice president of the consulting rm Booz
Allen Hamilton observed that most bank products are too complex for the average consumer to understand.
Creditors sometimes explain away their long contracts with the
claim that they need to protect themselves from litigation. This ignores the fact that creditors have found many other eective ways
to insulate themselves from liability. Arbitration clauses, for example, may look benign to the customer, but their point is often to
permit the lender to escape the reach of class-action lawsuits. This
means the lender can break the law, but if the amounts at stake are
small, few customers would ever bother to sue.
Legal protection is only a small part of the proliferating verbiage. For those willing to wade through terms like LIBOR and
Cash Equivalent Transactions, lenders have built in enough
surprises in some credit contracts that even successful eorts to
understand and assess risk will still be erased. For example, after
Harvard Magazine

35

47 lines of text explaining how interest rates will be calculated,

one prominent credit-card company concludes, We reserve the
right to change the terms at any time for any reason. Evidently,
all that convoluted language was there only to obscure the bottom line: The company will charge whatever it wants. In eect,
lenders wont be bound by any term or price that becomes inconvenient for them, but they will expect their customers to be
bound by whatever terms the lenders want to enforceand to
have the courts back them up.
Even worse, consumers wary of creditor tricks may look for
help, only to rush headlong into the waiting arms of someone
else who will eece themand then hand them over to the creditors for further eecing. For example, consumers may respond
to advertisements for a friend to help you nd the best possible
mortgage, someone on your side, and access to thousands of
mortgages with a single phone calldo all your comparison
shopping here. When they call a mortgage broker, they may believe he or she will provide wise advice to guide them through a
dangerous thicketand some brokers do just that. But consumers are just as likely to encounter brokers who are working
only for themselves, taking what amounts to a bribe from a mortgage company to steer a family into a high-cost teaser-rate mortgage, for example, rather than a 6.5 percent xed-rate, 30-year
mortgagebecause the broker can pocket a fee (a yield service
premium, or YSP) from the company to place the higher-priced
loan. High YSPs helped drive the wild selling that led to the
meltdown in the subprime mortgage market.
Despite the characterization of YSPs by one Fannie Mae Foundation vice president as lender kickbacks, Congress and the
regulatory agencies have generally approved of these fees under
pressure from the mortgage-broker industry. In fact, mortgage
brokers face few regulatory restrictionsa critical problem given
that they originate more than half of all mortgage loans, particularly at the low end of the credit market. (YSPs are present in 85
percent to 90 percent of subprime mortgages, implying that brokers needlessly push clients into more expensive products.) The
costs are staggering: Fannie Mae estimates that fully 50 percent of
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May - June 200 8

those who were sold ruinous subprime mortgages would have qualied
for prime-rate loans. A study by the
Department of Housing and Urban
Development revealed that one in nine
middle-income families (and one in
14 upper-income families) who renanced a mortgage ended up with a
high-fee, high-interest, subprime loan.
Of course, YSPs are not conned to
subprime mortgages. Pushing a family
that qualies for a 6.5 percent loan
into a higher-cost loan and pocketing
the dierence will cost the family tens
of thousands of dollarsbut it will
not show up in anyones statistics on
subprime lending.
Other creditors have their own
techniques for eecing borrowers.
Payday lenders oer consumers a
friendly hand when they are short of
cash. But buried back in a page of disclosures for one lender (rather than on the fee page, where the
customer might expect to see it) was the note that the interest
rate on the loan was 485.450 percent. In transactions recently
documented by the Center on Responsible Lending, a $300 loan
cost one family $2,700, while another borrowed $400, paid back
$3,000, and was being hounded by the payday lender for $1,200
per month when they gave up and led for bankruptcy. In total,
the cost to American families of payday lending is estimated to
be $4.2 billion a year. The Department of Defense identied payday lending as such a serious problem for those in military service that it noted that the industry impaired military readiness. Congress has now banned all companies from charging
military people more than 36 percent interest, while leaving all
other families subject to the same predatory practices.
For some, Shakespeares injunction Neither a borrower nor a
lender be seems to be good policy. But no one advocates that
people who dont want their homes burned down should stay
away from toasters, or that those who dont want their ngers
and toes cut o should give up mowing the lawn. To say that
credit markets should follow a caveat emptor model is to ignore
the success of the consumer-goods marketand the pain inicted by dangerous credit products.
Indeed, the pain imposed by a dangerous credit product is
even more insidious than that inicted by a malfunctioning
kitchen appliance. Wealthy families can ignore the traps associated with credit-card debt: their savings will protect them from
medical expenses that exceed their insurance coverage or the
eects of an unexpected car repair. Working- and middle-class
families are far less insulated. For those closer to the economic
margin, a credit card with an interest rate that unexpectedly escalates to 29.99 percent or misplaced trust in a broker who recommends a high-priced mortgage can trigger a downward economic spiral from which a family may never recover.
INSUFFICIENT REMEDIES
Credit transactions have in fact been regulated by statute
or common law since the founding of the Republic. Traditionally

the most basic eorts are blocked from becoming law. A decade
ago, for example, mortgage-lender abuses were rare. Today, experts estimate that fraud and deception stripped $9.1 billion in
equity from homeowners, particularly from elderly and workingclass families, even before the subprime crisis got into full swing.
A few hardy souls have repeatedly introduced legislation to halt
such practices, but those bills never make it out of committee.
Even after a change in control of Congress in 2006, eorts to rein
in lenders have made little headway.
Beyond Congress, some regulation of nancial products occurs indirectly through the Federal Reserve Board, the Oce of
the Comptroller of the Currency, and the Oce of Thrift Supervisioneach of which has some power to control certain forms
of predatory lending. But their main misToday, experts estimate that fraud and sion is to protect the stability of banks
and other nancial institutions, not to
deception stripped $9.1 billion in equity protect consumers. As a result, they focus
intently on bank protability, and far less
from homeowners even before the subprime on the nancial impact on customers of
many of the products the banks sell.
crisis got into full swing. The regulatory jumble creates another
problem: consumer nancial products are
regulated based principally on the identity of the issuer, not on the
ing federal regulators the power to shut down state eorts to
nature of the product. The subprime-mortgage market provides a
regulate mortgage lenderswithout providing eective federal
stunning example of the resulting fractured oversight. In 2006,
regulation in turn.
for example, 23 percent of such mortgages were issued by reguLocal laws suer from another problem. As lenders have conlated thrifts and banks, and another 25 percent by bank holding
solidated and credit markets have become national, a plethora of
companies (subject to dierent federal oversight)but 52 perstate regulations drives up costs for lenders, forcing them to incent originated with companies with no federal supervision at
clude repetitive disclosures and meaningless exceptions even as it
all, primarily stand-alone mortgage brokers and nance compaalso leaves regulatory gaps. During the 1970s and early 1980s, for
nies. This division also triggers a kind of regulatory arbitrage.
example, Congress moved the regulation of some aspects of conRegulators are acutely aware that if they push nancial institusumer credit from the state to the federal level through a series of
tions too hard, those rms will simply reincorporate in another
landmark bills that included Truth-in-Lending (TIL), Fair Credit
form under the umbrella of a dierent regulatory agencyor
Reporting, and anti-discrimination regulations. These statutes
none at all. Indeed, in recent years a number of credit unions
tend to be highly specic: TIL species the information that must
have dissolved and reincorporated as state or national banks,
be revealed in a credit transaction, including the size of the typeprecisely to t under a regulatory
face that must be used and how interest rates must be stated. But
(please turn to page 94)
the specicity of these laws works
against their eectiveness, inhibiting some benecial innovations (e.g., new ways of informing
consumers) while failing to regulate dangerous innovations (e.g.,
no discussion of negative amortization). Whats more, these generation-old regulations completely miss most of the new
features of credit products such as
universal default (increasing interest rates even when customers
are meeting all the terms of their
credit agreements) and doublecycle billing (charging interest on
money that was repaid).
Any eort to increase or reform
regulation of nancial products is
met by a powerful industry lobby
that is not balanced by an equally
eective consumer lobby, so even
states bore the primary responsibility for protecting their citizens from unscrupulous lenders, imposing usury caps and other
credit regulations on all companies doing business locally. Although states still play some role, particularly in the regulation
of real-estate transactions, their primary toolinterest-rate regulationhas been eectively destroyed by federal legislation.
Today, any lender that gets a federal bank charter can locate its
operations in a state with high usury rates (e.g., South Dakota or
Delaware) and then export that states interest-rate caps (or no
caps at all) to customers located all over the country. As a result,
and with no public debate, interest rates have been eectively
deregulated across the country. In April 2007, the Supreme Court
took another step in the same direction in Watters v. Wachovia, giv-

MAKING CREDIT SAFER

(continued from page 37)

charter that would permit them dierent
options in developing and marketing
nancial products. If the regulated can
choose the regulators they want, it should
be no surprise when they game the rules
in their own favor.
Unfortunately, in a world in which the
nancial-services industry is routinely
one of the top three contributors to national political campaigns, the likelihood
of quick action to respond to specic
problems and to engage in meaningful
oversight is vanishingly slim. This leaves
consumers eectively unprotected in a
world in which a number of merchants of
nancial products have shown themselves very willing to take as much as
they can by any means they can.
A FINANCIAL PRODUCTS
SAFETY COMMISSION

It is time for a new model of nancial

regulation, one focused primarily on consumer safety rather than corporate protability.
The model for such regulation is the U.S.
Consumer Product Safety Commission
(CPSC), an independent agency founded
in 1972 during the Nixon administration.
The CPSCs mission is to protect the public from risks of injury and death from
products used in the home, school, and
recreation. It has the authority to develop
uniform safety standards, order the recall
of unsafe products, and ban products that
pose unreasonable risks. In establishing
the commission, Congress recognized that
the complexities of consumer products
and the diverse nature and abilities of consumers using them frequently result in an
inability of users to anticipate risks and to
safeguard themselves adequately.
The evidence clearly shows that the
CPSC is cost-eective. Since it was established, product-related death and injury
rates in the United States have decreased
substantially. The CPSC estimates that
standards for three products alonecigarette lighters, cribs, and baby walkers
save more than $2 billion annually (more
than the agencys total cumulative budget
since its inception).
So why not create a Financial Product
Safety Commission (FPSC), charged
with responsibility to establish guidelines for consumer disclosure, collect and
report data about the uses of dierent
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May - June 200 8

nancial products, review new products

for safety, and require modication of
dangerous products before they can be
marketed to the public? The agency
could review mortgages, credit cards, car
loans, and so on. It could also exercise jurisdiction over life insurance and annuity
contracts. In eect, the FPSC would evaluate these products to eliminate the hidden tricks that make some of them far

ments on the outstanding loan balance.

With every agency, the fear of capture
by those it regulates is ever-present. But
in a world in which there is little coherent, consumer-oriented regulation of
any kind, an FPSC with power to act is
far better than the available alternatives.
Whether it is housed in a current
agency such as the CPSC or stands
alone, the point is to concentrate the re-

The point is to concentrate the review of

financial products with a focus on the
safety of the products as consumers use them.
more dangerous than others, and ensure
that none pose unacceptable risks to consumers.
An FPSC would promote the benets of
free markets by assuring that consumers
can enter credit markets condent that
the products they purchase meet minimum safety standards. A commission
could collect data about which nancial
products are least understood, what
kinds of disclosures are most eective,
and which products are most likely to result in consumer default. It could develop
nuanced regulatory responses; some
credit terms might be banned altogether,
while others might be permitted only
with clearer disclosure. A commission
could promote uniform disclosures that
make it easier to compare products, and
to discern conicts of interest on the
part of a mortgage broker or seller of
what are now loosely regulated products.
For example, an FPSC might review the
following terms that appear in some
but not allcredit-card agreements: universal default clauses; unlimited and unexplained fees; interest-rate increases
that exceed 10 percentage points; and an
issuers claim that it can change the
terms after money has been borrowed. It
would also promote such market-enhancing practices as a simple, easy-toread paragraph that explains all interest
charges; clear explanations of when fees
will be imposed; a requirement that the
terms of a credit card remain the same
until the card expires; no marketing targeted at college students or minors; and a
statement showing how long it will take
to pay o the balance, as well as how
much interest will be paid if the customer makes the minimum monthly pay-

view of nancial products in a single location, with a focus on the safety of the
products as consumers use them. Companies
that oer good products would have little to fear. Indeed, if they could conduct
business without competing with companies whose business model is to mislead the customer, then the vendors
oering safer products would be more
likely to ourish. Moreover, with an
FPSC, consumer-credit suppliers would
be free to innovate on a level playing
eld within the boundaries of clearly
disclosed terms and open competitionnot hidden terms designed to
mislead consumers.
The consumer nancial services industry has grown to more than $3 trillion in
annual business. Lenders employ thousands of lawyers, marketing agencies,
statisticians, and business strategists to
help them increase prots. In a rapidly
changing market, customers need someone on their side to help make certain
that the products they buy meet minimum safety standards. Personal responsibility will always play a critical role in
dealing with credit cards or other loans,
just as personal responsibility remains a
central feature in the safe use of any other
product, but a Financial Product Safety
Commission would be the consumers
ally. And for every family that avoids a
trap or doesnt get caught by a trick
thats regulation that works.
Elizabeth Warren, RF 02, is Gottlieb professor of
law and faculty director of the Program of Judicial
Education at Harvard Law School. An earlier version of this article appeared in Democracy: A
Journal of Ideas (democracyjournal.org/article.php?ID=6528).