Guest: Todd Zywicki, Professor of Law at George Mason University School of Law and co-author of Consumer Credit and the American Economy.
Not long ago, many businesses competed to extend credit to consumers through unsecured lending, auto loans, home mortgage loans or installment sales. Sadly, true competition is no longer.
In today's consumer lending environment, businesses are nothing other than agencies of federal and, to some degree, state governments acting under the veneer of a private business. They have an unholy alliance with government.
The industry promised, "We will do your political bidding. We will give you political cover, so you can carry out the social policies you wish. In exchange, Mr. Government, you will make sure we never lose any money."
That pact has been honored by both parties to the detriment of us – naive consumers.
Todd Zywicki helps us understand how we got here, where we go from here, and how to spot it when it happens.
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Redlining (a libertarian perspective from Neal McCluskey)
Bob Zadek: Consumer credit is a huge element of our domestic economy. Listeners have a personal self-interest as consumers of credit in the form of home mortgage loans, auto loans, payday loans, unsecured credit card debt, and so on.
Our economy would be in the dumpster the additional buying power given to consumers, because they can spend more than what they are earning in the past week or in the past month.
How important is the extension of consumer credit is in our economy?
Todd Zywicki: That's really the theme of our book that you mentioned, Consumer Credit and the American Economy.
In many ways, the history of America in the past century is the history of consumer credit. Most people don't appreciate that the great migration to the suburbs after World War II was fueled by consumer credit. When people left their apartments in the city and moved out to Levittown, they took out a mortgage, and they needed a car and furniture. That was all funded by car dealers, department stores, furniture stores, and appliance companies. People weren't paying cash for that three-bedroom house with the new Buick in the driveway.
That has continued since then. Consumer credit is a powerful vehicle for consumers to be able to acquire goods and then use them. Think about something as humble as a washing machine. That may be the best investment you ever make in your life.
“[T]he great migration to the suburbs after World War II was fueled by consumer credit.”
The alternative to buying a washing machine is schlep into the laundry mat every weekend with a pocket full of quarters – sitting there waiting for your clothes to wash.
We don't appreciate that these are capital goods – whether cars, houses, or student –that it makes sense for consumers to buy on credit as a form of an investment as well a form of savings as an alternative to renting, etc.
It fuels the economy and it really empowers consumers to make their lives better.
A Brief Primer on Consumer Credit
Bob Zadek: We could break down the consumer credit economy into three classes of the providers of credit:
The businesses, remember them, and then,
As we all know from the student loan crisis, government is the 8-billion-pound gorilla in the area of consumer credit – both directly and as a lender. When they're not the lender, the government is the board of directors of all the lenders, telling them how to do it. They are there one way or the other.
So, we have government butting into private lending, and we have the loan sharks, since the demand for consumer credit will always be there. If that demand is not met by A) businesses or B) government, it will be met by the street. One way or another, consumers will of necessity – not of choice – find a way to get the money they need to go about with their lives.
We start with the past – private lenders – even though those days are over.
Tell us how far away from the activities of a private lender we are today.
The activities of being a private lender and making a profit are easy. You're making loans. That's the product.
I have a lifetime of lending and representing lenders. As I learned when I first ventured into lending, you don't have to be that smart to make a loan – you don't have to be a genius to get a total stranger to take your money. Getting paid back is a bit trickier. You’ve got to know what you're doing. If you're a private lender, you're in the business of making loans to people who will pay it back, and in the ideal world of the marketplace, if you price your product higher than one of your competitors, you will not have any business. A lender has to price the product in a way that they make a profit or else they will fail.
“[Y]ou don't have to be that smart to make a loan… Getting paid back is a bit trickier.”
Profit = Income - Expenses. One of the business expenses of a lender is bad debts, because if somebody doesn't pay you back, that becomes an expense. A lender, in running the business, must manage the expense of bad loans.
Lenders make loans to people who will pay it back at a price that's lower than the competition. Pretty straightforward stuff. But that doesn't happen anymore.
The Distortion of Consumer Credit by Government
How far from that idyllic main street model are we today with consumer lending and why has government chosen to become as involved as they are in a consumer service?
Todd Zywicki: That's a great question – why does the government put their hands so much on finance when they don't design cars?
They don't design blue jeans, but they feel perfectly comfortable designing a lot of the terms and conditions of loans.
We understand why consumers use consumer credit. The demand side of the equation is to acquire what we can think of as capital goods. It makes sense to have a mortgage on a house, for example. It doesn't make any sense to save up for a house, pay rent while you're doing it, and then buy a house in cash.
Same with the car. People don't appreciate this, but one of the main reasons why General Motors overtook Ford as the largest auto dealer, was not just because of the superiority of their cars, but in the 1920s, General Motors rolled out the “GMAC plan” which allowed people to drive the car while they were paying for it. Otherwise, you could save up for the car but in the meantime, you had to take the bus.
The other reason people use credit is to deal with emergency, short-term fluctuations between income and expenses. That's the demand side.
The supply side basically consists of two things: the first thing is bad debt. If you have more bad debt, then you would lose money. The other thing is just the cost of lending.
A lot of the cost of lending is unrelated to the size of the loan. So, for example, it doesn't cost a hundred times more to make a $30,000 car loan as opposed to a $300 payday loan. You've got overhead. You've got operating expenses, employees, electricity, all that stuff. This is why small dollar loans just are more expensive than say a credit card loan – they're smaller, and they have high loss rates. It all makes sense from an economic perspective, but people just switch off their economic thinking about this.
Over time we've seen that a lot of this has migrated away from traditional sorts of credit to financial institutions. Back when we had usury regulations, that kept ordinary consumers from getting access to a lot of good credit – whether it was car loans or credit cards or whatever.
For example, Arkansas in the 1970s had very strict usury ceilings. Consumers, basically, couldn't get a credit card in Arkansas. It was also the pawn shop capital of America. Pawn shops were three times more prevalent in Arkansas, because people have a demand for credit but not a supply. You can't wish away a need for credit. If consumers can't get credit through organized competitive markets, they still need credit.
Tony Soprano isn't just a myth. In the 1960s, for example, there was a Senate report 1968 that said that loan sharking was the second largest revenue source of the mafia. It was estimated around 1970 by an FBI agent that there was about $10 billion a year in illegal loan sharking which is in today's dollars is about $69 billion. The entire payday loan industry in America today – online and brick-and-mortar – is about half that: $34 billion.
That's what we had with strict usury regulations that stifled competition and consumer choice. We learned in the past that whenever the government got involved by imposing these usury regulations, or imposing price controls, would get a black market. The loan sharks would take over.
Eventually, they moved away from usury regulations, but what they've done in many ways is worse – they have gotten their tentacles into the supply side of lending in a much more intensive way to try to control the other terms and conditions even if they leave the prices alone.
The Folly of Prohibition & Usury Laws
Bob Zadek: You mentioned Arkansas and pawn shops. Pawn shops are, of course, lenders. That's what they do. It's dressed up as you are selling something, with a right to buy it back at a higher price. The higher price is the interest. So, it's a loan secured by a guitar.
The pawn shop rates were somewhere around 128% per annum, although they don't lend itself to a precise calculation. So the Arkansas politicians back in the day could proudly boast, "We are protecting our consumers from paying too much interest," but the consumers were simply sent to 128% per annum transaction, because it was illegal to lend them the same money at 42%, which was usury. Go figure.
Of course, the reference to organized crime or even disorganized crime loan sharking is a common story. We all know that. Prohibition – whether narcotics, opioids, gambling – whenever government prohibits an activity that people are determined to do, the people will always do it, except they do it underground, which means the cost of doing it underground is higher.
There is no such thing as prohibiting an activity people want to do. You cannot legislate morality. If you regulate the price of something or ban its purchase and sale, and people want to do it, they will find a way to do it. Government will only succeed in only converting people into criminals just because they want to do something that doesn't hurt anybody else.
If you're a private business, you are torn. You want to make as many loans as you can. But more importantly than making a loan, is getting it back. Therefore, you want to manage all your expenses, including the expense of not getting it back, the bad debt expense.
Which means if you're a lender, you are determined to lend money to as many people as you can so long as they can pay it back. Therefore, you set the interest rate as high as you possibly can, but the market dictates that if you're making too much money you will draw competitors which will cause the price to come down. So, the marketplace puts the brakes on how much you could charge.
Give us some examples of how government has mandated to a lender that they increase their bad debt expense because that accomplishes a social goal. What happens to the marketplace for lending?
Todd Zywicki: They can pass all the laws they want, but they can't repeal the law of supply and demand and they can't repeal the law of unintended consequences. There's a supply and demand. There's a market here just like there is for anything else. You start fiddling with the pricing in that market and you're going to end up drying up the market – meaning people won't be able to get access to credit or some people, or you're going to get the products repriced.
For example, every credit card basically used to have annual fee on it. Now, why was that? It was because you couldn't charge a market rate of interest. Lenders would compensate by just charging you a fee in order to have a card– $40 or whatever. People who paid off their bills every month were subsidizing those who didn’t.
Most people would be familiar with the example of the Community Reinvestment Act during the financial crisis, and the requirement that banks do a certain amount of political lending to favored groups by the government. We know that those loans had a higher loss rate and that those loans end up washing through the system.
The Community Reinvestment Act: A Case Study in Market Distortion
Bob Zadek: The Community Reinvestment Act started in Chicago as an experiment. It was the first big example of requiring regulated lenders, aka banks, to make loans that a bank might not otherwise make. Tell us the effect of that legislation.
Todd Zywicki: It has become the model for subsequent political interventions into the financial system. The Community Reinvestment Act is intended to solve a prior problem the government caused, which is the problem of redlining. Redlining was the idea that there were certain neighborhoods that banks wouldn't lend to, which were predominantly minority neighborhoods. Now, where were the so called red lined neighborhoods? Where did that come from? It came from the federal government's housing agencies basically identifying certain neighborhoods as being high-risk neighborhoods, which were basically defined by their racial demographics.
In a competitive market you don't get that – regulating banks telling them where they can lend. We ended up with decades of federal government discriminatory housing policy that created disparities in the market. The way they decided to make up for that was basically to tell banks that they had to start making loans in a lot of those neighborhoods without applying the same underwriting standards that they apply to other customers. Government policy that creates red lighting and creates a racial discriminatory market followed up by another government policy that is designed to rectify the prior government policy by now turning those into favored neighborhoods where people are subsidized and then you end up with these issues of bad debt.
Bob Zadek: Banks are required to go to Washington and seek favors all the time. A bank wants to acquire another bank. They need approval. The approving agency will say, "Not so fast to Ms. Bank. Before we give you a consent that you want to make more money, let's see how you're doing on making loans to our politically favored groups. If you have a low rating for CRA, then we just may say no."
So, there's a lot of coercion because of regulation. banks have no choice but to make loans to borrowers they otherwise wouldn't make a loan to for credit reasons, not for racial discrimination. Or, they would make a loan, but they would charge a higher rate than the government permits them to make, which means the bank expenses go up.
Well, if the bank's expenses go up and the bank is determined to make a profit, what must they do? They must raise their rates, which means all you listeners are now paying a quarter of a point more for your home mortgage to cover the increased bad debt expense, which a bank incurs because they are ordered to do so. So, notice what has happened: It's been a wealth transfer. By dint of CRA type legislation, consumers who pay their loans promptly are paying a higher rate of interest to underwrite and subsidize the cost of consumers who don't. It's insidious, but it's profound.
But CRA in that dynamic is not alone, is it?
Todd Zywicki: No, not at all. This has become increasingly common by the federal government. A good example of this was during the financial crisis. The government basically took over Ally Financial – they had a majority stake in Ally Financial, the former General Motors financing arm. Ally wanted to become a bank holding company and it needed approval from the Federal Reserve. Basically, the CFPB held it up and extorted a settlement out of the company for discrimination with very questionable evidence to support it. The company has said subsequently that they were basically bullied into it. They used this leverage of discrimination.
We're now seeing that in the wake of everything that happened with George Floyd, this is spreading.
The idea is to conscript private banks to carry out this social policy and use this idea of wealth redistribution through the financial system. They use banks as a piggybank to accomplish things that the government doesn't want spend money on or take credit for directly.
Bob Zadek: Government decides to take money from one group to give it to another group. They know how to do that by direct legislation and call it “The 2023 Wealth Transfer Act”, but that's politically uncomfortable. The government is far too insidious to do it directly.
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A New Target: Credit Rating Agencies
You have called attention to another aspect of consumer lending which is becoming socialized: the credit rating agencies. I dare say the perception is that there's some objective evaluation of how you have behaved as a debtor. But it's far darker than that and getting much worse. What is happening in the area of this boring area of credit ratings?
Todd Zywicki: This is an under the radar issue that people really need to know about. Now, why do I say that? Because it turns out our modern credit reporting system in this country and credit rating agencies is a miracle. I'm not understating it when I say it is a miracle. We talked about the migration to the suburbs, we talked about the American dream. What really fueled that was the adoption of these modern credit rating agencies – these ways of collecting information.
Prior to the widespread use of credit reports and credit ratings, you could get a loan if you played golf with the bank manager. But the Ordinary Joe – the immigrant, the new guy – who was a good reliable person who worked hard and could pay their bills but weren't connected had no way of proving their credit worthy status. Credit ratings enabled the ordinary person to prove that they were creditworthy.
In fact, the great growth in the use of credit rating agencies came about with the passage Equal Credit Opportunity Act. Women were the ones who primarily lobbied for greater use of credit reporting. The accuracy of credit reporting is most important to people who are on the periphery. The young people, who don't have connections; people who don't have experience; people who can't to be able to show that they can be trusted to get a mortgage, to get a car loan etc. We're seeing more of these political assaults on credit rating agencies designed to politicize them to redistribute wealth. But in the long run, it ends up undermining the accuracy and the value of those systems which ends up interfering and harming those who supposedly are being helped the most by this.
Bob Zadek: The credit rating agencies only have their service purchased if it is proven to be accurate. Large consumer credit granters have a way of relating bad debt losses to credit ratings. There are a few credit rating agencies. If you find that one agency's rating produces a higher loss ratio than another's, you will determine the credit agency has a bad algorithm. Their methodology is wrong. So, the proof is in the pudding. Now, governments once again have discovered that credit rating agencies can be used to give credit – which means money – to recipients who might not deserve it so long as the method of rating the borrower can be manipulated.
Todd Zywicki: There is this irony, which is that they want to say that banks are these greedy guys, yet at the same time, they don't want to make loans to valuable customers because of discrimination. One of the persistent issues is that there are chronic differences in the credit scores between whites and minority borrowers.
Or more precisely, Asians have better credit scores on average than whites, and blacks and Hispanics have credit scores that are not as good. A lot of people said, "Well, that's just evidence of systemic racism," and that we need to manipulate the credit scores so they all come out to be the same. That basically means taking what are these electronic systems, these algorithms that are designed specifically to identify what variables will best predict whether somebody will pay their loans and reconfigure them, so that they make it possible for racial redistribution within the system.
One other example that people haven't focused on is a desire to fiddle with the reporting of medical debt. This is part of a long-term effort to move to a single payer healthcare system by basically making it really difficult to bill and collect medical debt over time. If we want to have a debate over single payer health care, let's do that, but let's not do it through the back door by basically making doctors and healthcare practitioners unable to collect debt for services.
Bob Zadek: You could just as well have been talking about admissions policies in major universities. It's the same conversation. It's the objective examination which doesn't let enough of a politically favored group. Therefore, the problem must be in the selection process. Now, of course, university admissions systems are far from objective. There's a lot to be criticized in admissions policy. This is not a love song towards admissions policies, but it's the same process: You start with the result. We need to change the result.
How do we change the result?
We fiddle with the criteria.
But when you fiddle with the criteria of who can pay back a debt, that's nothing other than saying the credit rating policy discriminates against people who don't pay their debts. Well, yes, that's the purpose. So, that's what's going on in credit ratings.
Explain to our listeners why they should care how it will adversely affect somebody who gets sufficient credit and goes about their business life, their commercial life borrowing what they need at whatever rate the market will charge. Why should they care about the government fiddling in underground garages, if you will?
Todd Zywicki: Let me make clear, first, that like many other areas of our history, there was racial discrimination in the financial system. But the important point to recognize is that discrimination was a by-product of government regulation that came about because of government policies by housing authorities that pushed for redlining. That came about as a result of things like usury regulations that made it impossible for lower income people generally, but specifically minorities to be able to get access to credit. That came about because of usury regulations that made it impossible for personal finance companies to be able to operate in cities.
But the answer is not to create more government regulation. The answer to that has always been the private market. It has always been banks, it has always been private lenders looking to identify untapped markets of credit worthy borrowers to whom they could lend money and get paid back.
Why does it matter? Because when some people don't pay their loans, the rest of us have to pay for it. In order to make a loan, you need to either be able to price the risk effectively or you need to reduce your risk of loss. That means either you raise interest rate or other cost, or you have to just not lend to some people. And in particular, who loses? People who have the weakest credit reports – people who have the weakest credit rating are the ones who end up losing. As a result, they are the ones who end up in hand of the loan sharks.
Operation Choke Point
Bob Zadek: Banks used to be truly private businesses, operated as a private business. The government has learned from none other than Lenin and Marx that all you need to do as a government is control the financial system and you control the entire country. That's all you need. You don't need a lot of armed weapons and you don't need a force.
That process started with reducing the number of banks. It's easier to control a smaller number of banks than a larger number of banks. Of course, the banking system used to have perhaps 15,000 or 16,000 banks. Now, we're down to less than half of that. Many people believe, including me, that's not an accident or just mere consolidation. That's a matter of policy, because it's easier to control a few large banks than a zillion small banks.
On top of that, the government, which now ensures the deposits, has a stake in the solvency of the banks. The governments have a tool which is they require banks to behave in a way that doesn't threaten them. The usual tool government uses is they determine that an activity of the bank jeopardizes their reputation and in doing so, it threatens their solvency.
All of that, Todd, is an introduction to Operation Choke Point, which we thought had gone away, but it has not.
Todd Zywicki: We live in a different world here. Those of us who consider ourselves libertarians have always thought in terms of this binary that goes back for centuries, which is that you've got private business on one hand, you've got public government on the other, and that the threat to liberty in some sense comes from the government and not from the private sector.
But now, in the world of the administrative state, that binary distinction doesn't really hold anymore. Banking is in many ways the apotheosis of the regulatory state. Banking is so intertwined with the government – starting with deposit insurance and that becomes the lever for everything that comes after – that it gives the government the ability to exercise all these informal tools over the government.
They particularly use a power called supervision, which is basically the government can go in, and inspect your books and records, and basically determine whether or not you're running the bank in what they consider to be a safe and sound manner. That has been expanded over time now to include things like ESG that many people are aware of.
What many people are less aware of was the Operation Choke Point. Operation Choke Point was an initiative during the Obama administration, where the banking regulators without any authorization from Congress, ended up basically telling banks they should not lend to these legal businesses. These were payday lenders, firearms dealers, etc. These were fundamentally just businesses that were unpopular with the Obama administration.
Bob Zadek: It included dating services.
Todd Zywicki: They weren't just controversial. They weren't dating services. But notably, it didn't include say, abortion clinics. A lot of organizations that could be thought of as controversial, but they just didn't think of it. What they used was this idea called reputation risk. Our friend, John Allison, who was, of course, the President of BB&T Bank for a long time and later president of the Cato Institute refers to it as “regulation by raised eyebrow,” which is the banks look at you and say, "Do you really need to have that particular client in your bank?” whether it's a payday lender or a firearms dealer or whatever.
Most of the time, the banks just knuckle under, and most people don't even know about it, and all of a sudden, people have their bank accounts cancelled. Well, that eventually got out.
Cancel Culture in Banking
Bob Zadek: It got outed and then the FDIC or the OCC denied doing it. I did a show last week on the Dear Guidance letter from the Department of Education. It's the same thing. "No, we didn't tell banks what to do. We just casually express an opinion. We're not crazy about bank accounts for gun dealers," even though it's a lawful activity and bankers got the hit.
You and I thought was dead, but you have pointed out it surfaced again. Government using bank accounts as a weapon to attack citizens who are not breaking any law is not limited to the US. There are examples in Nigeria, China, and Iran. Tell us about what's going on internationally about weaponizing a deposit account.
Todd Zywicki: I call it cancel culture comes to banking. Banks are now depriving private citizens, churches, and non-profit organizations of bank accounts. The Alliance Defending Freedom, for example, a number of religious liberties organization has had a number of their clients lose their bank accounts over time. Mike Lindell, the My Pillow guy, lost his bank account for being too controversial on various issues. But this is increasingly becoming a weapon used by authoritarian governments to prevent dissent.
In Canada, for example, people may recall that Justin Trudeau used this power to stop the Canadian truckers from protesting against vaccine mandates, which is he froze their bank accounts – frozen to the extent that people couldn't even use their own bank accounts to post-bail.
A judge let this one person have bail, but she couldn't access her bank account to actually pay for it. You could easily see how this could lead to de facto taking away constitutional rights, if you have a right to a lawyer but you can't pay for it. The Chinese have done this. Iran right now has announced that women who protest the mandatory hijab rules will get two warnings and after two warnings, they're going to get their bank accounts frozen if they continue to persist in not covering their face in public. Why did they call it Operation Choke Point? Because they know they can choke off the air you need to breathe. And that's why they're leveraging bank accounts.
Bob Zadek: This is Bob Zadek thanking Todd Zywicki for sharing with us his thoughts, as set forth in his book, Consumer Credit and the American Economy. It is scary how our government has weaponized something as benign and ordinary as consumer credit and access to banking. It scares the heck out of me, because it's insidious. Nobody knows about it if somebody knocks on your door in a SWAT uniform. But when your banker is performing the same function as a SWAT team surreptitiously, that makes me fear for our country.
Todd, thank you so much for sharing your thoughts with us.