Reforming Credit

America's financial crisis and the related recession are not hitting everyone equally. While many well-to-do investors have lost wealth in the plunging stock market, lower-income Americans were the first victims of the calamity, taken in by rapacious sub-prime mortgages and other predatory forms of consumer credit. As many as 10 million families will lose their home before this crisis is resolved. Tens of millions more are finding that their home equity, the fruit of many years of faithful monthly mortgage payments, has shriveled up because of declining housing values.

Meanwhile, other forms of consumer credit are also in disarray. Moderate-income Americans, who faced decades of declining job and income security, found themselves relying on home-equity withdrawals or exorbitantly priced credit-card borrowings as a substitute for adequate income and decent social protections. Tamara Draut has called this the plastic safety net. But with banks tightening credit requirements and home equity plummeting, that personal financial strategy is no longer available; it was always a precarious cloak for shameful levels of inequality and insecurity. So hardship continues, and it is no more equally distributed than anything else in America.

This financial bubble and collapse had a wholesale dimension and a retail one. At the wholesale level, a series of highly speculative, complex, and opaque business strategies by financial giants like Citigroup, Countrywide Financial, Lehman Brothers, Bear Stearns, American International Group (AIG), and others bid the prices of assets up to levels well beyond their sustainable value. These bets were indulged by weak, captive, corrupted, or ideologically compromised regulatory agencies. When the bets went bad, America's largest financial institutions, some of which had quite literally bet the company on these gambles, were revealed to be insolvent. Government had to come to the rescue with a $700 billion bailout package and trillions more in loans and loan guarantees by the Treasury and the Federal Reserve. And the crisis is far from over.

At the retail level, this system depended on a far-flung industry to create those assets, which involved deceptive products like sub-prime loans, hidden credit-card charges, and predatory forms of consumer credit such as payday loans with annual interest rates in excess of 400 percent. The retail abuses were connected to the wholesale collapse most explicitly through the whole sub-prime loan system: Mortgage companies marketed loans to moderate-income consumers on terms that would become unaffordable after a brief period of "teaser" rates. These retail loans were connected to the wholesale part of the system through an elaborate web of overlapping relationships. The mortgage companies were bankrolled by big Wall Street investment banks; the loans were bundled into high-risk securities; packages of those securities were then blessed with triple-A ratings by corrupt rating agencies; big commercial banks bought some of the securities through off-balance-sheet affiliates; and some of these securities were insured by firms like AIG. When the retail loans began going bad, the entire system collapsed, bringing down the giant banks and investment banks whose bets on these loans were very highly leveraged. The sub-prime circuit provides a snapshot of the rot in the entire system.

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While the wholesale dimension of the financial crisis has received the most attention, this Prospect special report is about the retail part of the crisis, as it has affected people of modest means. What were the abuses? What were their connections to the larger crisis? Who got hurt? And what are the remedies? The authors include journalists, experts, and advocates who are fighting these battles on the front lines.

Reform will require a top-to-bottom remaking of American finance, wholesale and retail, based on far more stringent regulation. At the wholesale level, that project will entail assuring that no institution with the capacity to create credit is exempt from regulation. It must include supervision and examination of many financial products that ordinary Americans never encounter. These are arcane inventions such as credit-default swaps and diverse forms of securitized credit that were largely the province of insiders and speculators. But these obscure products contributed to the crash of the entire system in a fashion that reduced the incomes and the security of regular people who had never heard of them, much less invested in them.

At the retail level, we also need a radical overhaul of basic consumer protection. Three decades ago, most financial products came in one flavor--vanilla. The standard mortgage was a 30-year loan with a fixed rate and a down payment. There were no sub-prime loans; variable-rate loans were in their infancy. Usury laws, until overturned by a Supreme Court decision in 1978, provided universal protection against exorbitant interest charges.

Three decades ago, there were of course abuses, but because the system's products were relatively standard, the abuses were fairly easy to remedy as a technical matter. The hard part was the political will. However, from the early 1960s to the late 1970s, until Reaganism intruded, a robust consumer and civil-rights movement persuaded allies in Congress to pass more than a score of reform bills.

The abuses of that era included overt discrimination against women and minorities. Until the 1960s, it was entirely legal to deny a black family a mortgage because they were black, or to refuse to count a wife's income in a mortgage application on the premise that she might become pregnant. The 1968 Fair Housing Act made overt lending discrimination illegal. The 1977 Community Reinvestment Act added an affirmative obligation for lenders to reach out to formerly redlined neighborhoods.

On the consumer-credit front, the Truth in Lending Act of 1968 required the true interest cost of a loan to be stated in simple and transparent terms. The Fair Credit Reporting Act of 1970 allowed consumers access to their credit reports with the ability to correct mistakes. Although the industry kicked and screamed about the costs of these and other protections, the consumer-credit system of that era was well on the way to greater transparency, and access to affordable credit continued to expand. This era of reform demonstrated that when political constituencies are mobilized, pro-consumer regulation is possible.

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After 1980, however, the ļ¬nancial industry responded by making its products and business strategies ever more complex and opaque. The industry did end runs around nearly all of the regulation, creating new gimmicks that regulators declined to track. Some forms of regulation, such as the 1933 Glass-Steagall Act separating commercial banking from investment banking, were explicitly repealed. Others, such as the Home Ownership Equity Protection Act of 1994, which had been opposed by the Federal Reserve, were simply ignored by corrupted regulators. The current financial collapse is the logical result of this pattern of allowing finance to run wild.

Now, we must fight these battles all over again. At the retail level, we have seen modest progress with a credit-card reform bill signed into law by President Barack Obama on May 22. The law prohibits the most extreme predatory abuses such as deceptive rate increases and hidden fees. The president also issued an important executive order, reversing a Bush-era policy of encouraging federal regulatory agencies to preempt stronger consumer protections at the state level. Still to come are battles over such questions as how to modernize the Community Reinvestment Act; how to stop the escalating spiral of home foreclosures; how to expand access to normal financial services for low- and moderate-income communities; and whether to enact a Financial Products Safety Commission.

Wholesale reform of regulation has only begun, and the struggle will be uphill. Wall Street has been disgraced by this crisis but not yet dethroned as a political force. The big banks, hedge funds, and private-equity companies are fiercely resisting efforts to put them back in harness so that they are servants of the real economy rather than masters. But protecting consumers and borrowers will also require building new institutions, rooted in communities and dedicated to the public mission of expanding economic security and opportunity.

This Prospect special report is designed as a guide to these several interrelated issues. It begins with an assessment of how ordinary people fell victim to the abuses of a predatory system and then moves into several takes on regulatory remedies. We thank the Ford Foundation for making our report possible.

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