Over the break I read Harvard Law Professor Elizabeth Warren’s “The Two-Income Trap” which she co-wrote with her daughter Amelia Warren Tyagi. It is a quick and easy read and, I think, an important book asking why personal bankruptcy rates are soaring to unprecedented levels. (If you are a careful reader like my wife, you will notice a hat tip to Nate Oman for “important assistance with the research work” in the acknowledgments section. Such acknowledgments have become jack-in-the-box events for me, popping up where I least expect it and confronting me with my own undistinguished career.) In their book Elizabeth and Amelia argue that the usual explanation for personal bankruptcy, superfluous consumption, is in fact a myth. Instead there are a myriad of contributing factors: the costs of a mortgage far outpacing gains in wages, healthcare costs, stay-at-home mothers moving into the workplace (because she can not bring in fresh income in an emergency) and, most important to this post, deregulation of the lending industry (Marquette National Bank of Minneapolis v. First of Omaha Service Corp) leading to usurious interest rates.
Usury is a value-laden word that no sensible industry wants to be associated with, so in polite conversation today we call it sub-prime lending. “The Two-Income Trap” argues that sub-prime lending is decimating families, freely lending money to those who can least afford to pay and pushing people with precarious finances over the precipice into bankruptcy. Free market advocates usually respond to this argument that sub-prime lenders are doing families a favor, providing much needed liquidity to people that no one else will lend to. I think there are good arguments to be made on both sides. Unfortunately many sub-prime lenders, among their other sins, make a habit of providing sub-prime loans to uneducated consumers who qualify for better rates — thus undermining other arguments as to why they are good for society. Elizabeth and Amelia, for example, cite to a study that at least 40% of those sold ruinous sub-prime mortgages at Citibank would have qualified for prime-rate loans. In an interview with Salon.com, Elizabeth claims that in 2001, when standard mortgage loans were in the 6.5% range, Citibank’s average mortgage rate was 15.6%. Despite higher rates of default on the loans, sub-prime lending is an incredibly lucrative business where fees, penalties and interest pile up quickly. Lenders can earn many times the amount originally borrowed before it is payed back or written off as a result of bankruptcy.
So who ends up in bankruptcy? The biggest predictor that a person will declare bankruptcy is whether or not he has children. Young families are especially vulnerable and single mothers are at even more risk. Elizabeth and Amelia write that single mothers are “more likely than any other group to file for bankruptcy — more likely than the elderly, more likely than divorced men, more likely than minorities and more likely than people living in poor neighborhoods”.
Kids cost a lot of money and it isn’t hard for most of us to imagine where the money is going: Nike shoes, Juicy sweatsuits and Seven jeans. As it turns out, we imagine the wrong things. Familes spend less on everyday consumption than their parents did a generation a go. 22% less on clothing. 21% less on food (including meals out). 44% less on appliances. Looking at the cost of goods relative to 20 years ago can make even a skeptic a believer in globalization. Families are spending more on truly big ticket items mentioned like mortgages and tuition which become fixed costs. The problem with fixed costs is in their name — and for those living on the edge of their incomes a few missed payments can trigger a vicious spiral of fees and penalties added to the payments they already can’t cover.
Are families buying minor mansions then with their outsized mortgages? The Warrens say no. In the early 1970s the average family lived in a house that was 5.7 rooms. Today that has crept up to 6.1 rooms. I’m not sure we are getting the complete story here — a better measure would probably be square feet and luxuries such as Roman bathtubs — but I don’t have any data on this point In any case, Elizabeth and Amelia do an excellent job of making that case that overconsumption is not really at the heart of the bankruptcy epidemic.
It is easier, and comforting, to blame the victims. When families find themselves squeezed financially it is more convenient to attribute their problems on profligate spending rather than confront the possibility that there but for the grace of God go I. It also makes refusing help easier. On this front the Warrens seem to have a special venom for Senator Orrin Hatch whom they quote, referring to the financially distressed, as “run[ning] up huge bills and then expect[ing] society to pay for them” and contending that massive numbers of families filing for bankruptcy are engaged in “fraud and abuse”. Elizabeth and Amelia point out that no one knows how much fraud there is, but that the courts try very hard to prevent it. They also argue that there remains, contrary to popular belief, a massive stigma associated with bankruptcy and most people avoid it at all costs.
In sum, “The Two-Income Trap" makes a strong case that at the heart of bankrupt spending are not Gucci and Prada, but “college degrees, decent medical care and homes in good school districts”. Families are vulnerable because they make long-term commitments to houses and educations.
If Elizabeth and Amelia are right, then it seems we need to reexamine our posture towards a system in which families are particularly vulnerable. One of the easiest and most effective places to start is to promote tighter regulation of the sub-prime lending industry. It doesn’t seem unreasonable to me to require lenders to do much, much more to educate consumers before extending credit. Credit card companies, for example, could make the most important terms of the cards known to consumer — let people know that if they miss a payment on their 7% card the rate automatically increases to 23%. I’m not arguing against sub-prime lending per se — I believe it can be a useful tool, but especially when it comes to money matters, knowledge is power and it wouldn’t hurt to even the playing field. Families will be better off for it.