Washington Helped Fuel Our Credit Card Woes

Last week when President Obama signed legislation putting new restrictions on credit card companies, the press hailed the bill as “long overdue” and a “relief” for most consumers. At the worst, stories suggested, the new legislation might pinch some credit-worthy customers whose perks, like rewards programs, would disappear as the new regulations cut fees, and industry profits declined.

What the press coverage reflected was both bad economics and a lack of understanding about how the credit card market evolved in the U.S. That’s troubling because when the real impact of this legislation—which will reduce credit for many lower-income and riskier borrowers—becomes apparent, I suspect that Washington will respond with more market meddling that will have many of us subsidizing credit for those who can no longer get it.

There are many reasons why America went from a nation of savers to debtors, why our personal savings rate dipped from a post-World War II average of about 10 percent in the late 1940s to under one percent annually from 2005 to 2007. But one reason certainly was a policy which emerged in the Great Depression and took hold in the post-war era that expanding access to consumer credit would energize our economy and spread the American dream to more households.

Although installment credit had gained a certain amount of respectability in the U.S. beginning in the late 19th century, starting in the 1930s the government came to see consumer credit as a tool it could use to manage and grow the economy. In that era, “the federal government regarded installment credit as a viable way of expanding mass purchasing power as well as--at times--a regulatory tool in Keynesian efforts of macroeconomic management,” wrote the economic historian Jan Logemann in a 2008 article in the Journal of Social History on credit in America.

The National Housing Act provided loans for home modernization, while the Electric Home and Farm Authority, a New Deal agency, “promoted the purchase of electric household durables on installment credit.” Then in the post-war era, the Federal Housing Administration and the Veterans Administration, building on legislative changes to the home mortgage market instituted during the 1930s, sparked a housing boom with low-cost mortgages, and as mass home ownership grew in the 1950s, so did installment credit as a way that Americans could fill up those homes quickly with appliances and furniture.

True, terms were quite different back then. Although Diners Club started offering a charge card to well-heeled Americans in 1949, by the late 1950s, when financial institutions started pitching cards to middle-income households, the average credit limit was still only $300, or a mere $2,200 in today’s dollars. A preferred customer could get as much as $500 in credit—only $3,600 today.

Credit card debt exploded followed the loosening of underwriting standards in the mortgage industry, and that was no coincidence. Starting in the mid-1970s, advocacy groups and some politicians began complaining that banks were refusing to make mortgages in some lower income neighborhoods, sparking a 20-year effort to loosen underwriting criteria and expand lending, which resulted in a more benign view of debt in general.

In that era banks found that they could satisfy complaints about lending practices registered against them under the Community Reinvestment Act by promising to issue more credit cards in low-income areas. Under pressure, banks also started allowing low income borrowers applying for a mortgage who did not have money for a down payment to borrow the cash via advances on their credit card—even though historically such lending led to greater mortgage defaults. Pushed by regulators like the Federal Reserve Bank of Boston, mortgage lenders also raised their debt ratio, that is, the ratio of income to total debt for low-income mortgage borrowers, in the process allowing a mortgage applicant to carry more credit card debt and still get a mortgage. From an industry average of about 33 percent, the debt to income ratio soared to as high as 50 percent in some special lending programs.

Over time lenders naturally applied these standards, relentlessly championed as ‘safe’ by government regulators and advocacy groups, to most borrowers, not just those in low income neighborhoods, thus sanctioning the rise in debt in America. As mortgage lending grew, so too did credit card debt. Inflation-adjusted total U.S. consumer debt rose nearly three-fold to $2.56 trillion from 1980 through 2008. Of course, the credit card companies extracted a price for this additional debt--since much of it was going to people with risky credit ratings—in the form of higher interest charges and penalties. By 2008, according to a survey of the National Foundation for Credit Counseling, 26 percent of Americans said they couldn’t pay all of their bills on time, and one in six households was making only the minimum payments on their credit card debt.

The meltdown in the home mortgage market has temporarily reversed these trends. As lenders have reinstated historically safer lending patterns, applicants with high levels of credit card debt are finding it harder to get mortgages, and more people are paying down their consumer debt, surveys show. Short on capital, credit card issuers have also been culling risky borrowers from their ranks, trying to head off future problems. Now, the new legislation, passed in reaction to consumer complaints, will make it even more difficult for card companies to profit off risky borrowers by limiting rate increases on existing customers and penalty fees for certain types of late payments.

If you happen to believe that America has gotten drunk on consumer debt, then no doubt all of these developments will please you. But I get the feeling politicians have little idea whose credit will take the biggest hit from this legislation, and I wonder what they will do when they find out. The big losers won’t be people with good credit, but those with marginal credit ratings, who will find their credit lines yanked or sharply reduced. When that happens, some of these folks will undoubtedly turn to less respectable forms of lending. Expect business at payday lenders and pawn shops to increase, for instance. Soon after, expect stories in the press about the burden that borrowers who can’t get credit cards now face in our society. And soon after that expect to hear new proposals from Washington about how to open up access to credit to more Americans.

That’s when the real burden on credit-worthy customers--who have been called on in the past to subsidize lending to riskier borrowers—will become apparent, I fear.

This piece originally appeared in RealClearMarkets

This piece originally appeared in RealClearMarkets