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Forgive Us Our Trespasses?
The Rise of Consumer Debt in Modern America

(Released February 2009)

  by Matthew Ruben  


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The Credit Market & Consumer
Decisions to Take on Debt


Deregulation and the Democratization of the Credit Market

Given that household debt has reached historic heights, and given the ample evidence that households are struggling with the burden of debt, it's worth noting that there are supply-side explanations for the changes in the consumer credit market. These provide the backdrop for the increase in consumer debt over the past three decades.

The changes in many of the credit markets, including those of payday lending, mortgages, and credit cards, mirror one another in certain respects. Specifically, recent history has seen growth in these credit markets in part because there have been efforts to deregulate and "democratize" them, and in some cases further securitization of lending.

In the housing markets, the most influential recent developments involved offering more creative loans with sub-prime and adjustable-rate mortgages, opening the market to consumers not traditionally served by the mortgage market, and adopting a generally more relaxed underwriting philosophy. Subprime loans have interest rates that are higher than standard prime mortgages as a direct result of the greater risk associated with holding the debt. An adjustable rate mortgage is a mortgage loan where the interest rate periodically shifts. But these instruments themselves didn't change the landscape of the housing market.

charts about credit cards

The more important factor came in the accompaniment of less selective requirements for lending and a more aggressive marketing of these loans. Adjustable-rate mortgages offered lenders the opportunity to put off big payments until later, seducing borrowers with lower initial payments and low initial interest rates. Further, research shows that subprime loans and adjustable rate mortgages were sold to consumers who are unlikely to be able to repay the loan should interest rates rise. (Garcia 2008, 2) Borrowing became much easier, thanks in part to the belief many lenders had that the growing value of the house would provide adequate collateral.

The negative consequences to these practices became evident in the 2007 market meltdown, as foreclosures became widespread once interest rates became less favorable and housing prices dropped. Historically a person would get behind in his mortgage because of a temporary catastrophic event such as a job loss or health problems. But with adjustable-rate mortgages, people were getting behind simply because mortgages were resetting from their initial teaser rates. Many of these mortgages were doomed to failure simply because of the design of the contract.

The evolution of the credit card market over the same period offers some parallels in that restrictions on lending have disappeared, and markets have subsequently been opened up to segments of the population that at one time would not have qualified for a loan.

subprime mortgages as a house of cards
Graphic illustrates how the subprime mortgage crisis has hurt the overall economy.

For the credit card industry, the most significant development came in a 1978 Supreme Court ruling. Marquette vs. First Omaha Service Corp effectively helped eliminate state anti-usury laws that protected consumers from high fees and interest rates, holding that these laws regulating interest rates cannot be enforced against nationally chartered banks based in other states. Before the ruling, 37 states had usury laws that capped interest rates and fees on credit cards for customers in their state, most at less than 18 percent APR. (Garcia 2007, 14) The court ruling allowed a national bank to charge its credit card customers the highest interest rate permitted in the bank's home state as opposed to the rate in the home state of the customer. Credit card companies followed suit by first convincing South Dakota and Delaware to commit to particularly lax usury laws; the companies then all moved their headquarters (and employment opportunities) to those states. With states powerless to restrict the companies' rates of interest, the federal government chose not to step in with its own restrictions. (Ausubel 58; Garcia 2007, 14)

In other words, the Marquette ruling effectively decided that nationally chartered banks would be subject to the laws of the federal government and the bank's home state, but because the bank could choose a "home" state that would offer few restrictions, effective lending regulations would have to come from the federal government. Meanwhile, financial deregulation has been the predominant trend in Washington since the Marquette ruling.

A related case followed in 1996. Smiley vs. Citibank followed the precedent of Marquette by permitting fees (not just interest rates) to be determined by the bank's home state. Before the decision, late fees averaged $16; by 2007, that figure had risen to about $34. (Garcia 2007, 14)

The greater freedom offered to credit card companies has allowed businesses to lend at higher interest rates to a wider range of the population. In fact, because they are more likely to carry over balances and pay fees, low-income credit card holders are now more profitable to credit card companies than high-income card holders. (Stegman and Faris 2005, 12)

Deregulation has had other consequences. Credit card companies have lowered their minimum payments, allowing borrowers to increase their indebtedness. (Scott 571) And more often than not, credit card issuers reserve the right to change rates of interest on credit card accounts at any time, for any reason. (Wheary and Draut 1)

Credit card companies gave more consumers greater access to credit, but as described in the previous section, these individuals often face interest rates in excess of 20 percent annually in addition to high fees. The incentives credit card companies offer consumers with regard to lines of credit, fees and interest, have made it more likely that families will endure debt over a longer period of time, with little chance of eliminating their debt burden altogether. (Garcia 2007, 14)

Lax regulation at the federal level has also been extended to the payday loan industry. Fees for holding postdated checks are exempted from state usury laws and interest rate caps, and often these fees are substantial. Lax regulation "also allows 'bounce [overdraft] protection' and other assorted bank fees and penalties from which banks profit so handsomely, and these profits discourage mainstream banks from under-pricing payday lenders in a head-to-head competition." (Stegman 185) In other words, banks are less likely to compete with payday loan companies because in order to do so, they would have to forego enjoying their lucrative bank account overdraft fees.

One other development that has proved especially significant for the well being of the economy as a whole has been the rise in securitization of debt. Securitization involves the pooling of financial assets which serve as collateral for new financial assets. Banks could therefore lend money, bundle these loans, split the pool into shares, and sell the shares off. Once shares are sold, the repayment of the loan is no longer a risk to the bank that initially lent the money; the risk had been passed along to the many shareholders of these securities. Consequently, one result of securitization is that repayment of loans takes on less importance to lenders as the asset is sold to investors, but the lender incentives instead are to make the initial loan and enjoy the profits taken from fees. (Morgensen) As long as these securities were in high demand, mortgage brokers had incentives to lend as much money as possible rather than to make low-risk loans.

Evidence suggests that financial innovation through securitization contributed to an expansion in the supply of mortgage credit in the years 2001 to 2005, and subsequent defaults from 2005 to 2007. (Mian and Sufi) In other words, securitization created incentives for lenders in all relevant markets (including mortgages, student loans, and credit cards) to extend services to consumers who would otherwise not be eligible for loans. The consequences for the mortgage market were made evident in 2007 and 2008 as the value of these securities plummeted.

Paved with Good Intentions?

Upon closer examination of the supply side of consumer lending, it becomes evident that many questionable lending practices contributed to the modern rise in consumer debt. What explains the increased demand for debt, especially among consumers who couldn't afford to pay back their loans?

Arguably, people don't ever plan a bankruptcy or foreclosure before it happens, but consumers nonetheless make poor long-term decisions based on an unreasonably optimistic set of beliefs. Studies show that consumers often suffer from other measurable handicaps. Anecdotal evidence abounds with regard to consumers being uninformed or unclear about the complexities of mortgage law. It's less clear how often consumers have a good working understanding about compound interest. But there is evidence that many households don't make informed decisions.

graph of subprime loan troubles

The literature offers a litany of examples, sometimes highlighting consumer ignorance or poor financial management skills. One survey found that "only 27 percent of consumers knew that credit scores measure credit risk, just over half understood that maxing out their credit card would lower their credit scores; and, only 20 percent knew that just making minimum payments on their credit cards will do likewise." (Stegman 186) A different study of Canadian payday loan users found that almost half thought that interest rates charged were not higher than those of other financial institutions or just didn't know. (Saulnier 4) Another found that less experienced consumers tend to use their credit limit in part because they see it as an indication of their earnings potential. (Soman and Cheema 32) Store cards encourage impulse buying. (Erasmus and Lebani 217) Peer acceptance or social pressure regarding debt influences whether or not they accept debt themselves. (Lea et al. 691) But most studies of consumer debt are quick to point out the decisiveness of economic conditions, the cost of living, and personal circumstance (job status, health) when it comes to determining how much debt a household accumulates. Consumers are not generally going into debt in greater numbers as a result of the purchase of luxury items or frivolous spending. (Weller and Douglas 62; Garcia 2007, 11)

Even an informed, rational consumer, facing difficult circumstances such as temporary unemployment or an unexpected health expense, can find himself quickly in debt. If people's incomes are insufficient to cover basic necessities, they will sometimes rely on their credit cards to help them get through a difficult financial period. However, once credit debt is established, high interest rates and fees are often enough to keep people from being able to pay off their debt. (Peterson 175)

This reality, coupled with greater opportunities to borrow and a higher net cost of living, can be explanation enough for greater consumer debt. Undoubtedly, some consumers become debtors because of mismanagement or irresponsible spending, but their likelihood of facing financial adversity is much greater if the cost of living is rising higher than corresponding increases in income. For some segments of the population, these costs have risen. For example, in health care, between 2000 and 2008, the number of Americans that spent more than 10 percent of their income on health care costs rose almost 50 percent, from 42 to 62 million. (Families USA, 1) And consequently, more people are experiencing debt problems as a result of medical expenses. In 2007, 41 percent of adults under age 65 reported medical debt or problems paying their medical bills, up from just 34 percent two years prior. These problems paying medical bills occurred across all income groups, but the problems were understandably more pronounced for families with low or moderate incomes. Half of all families with incomes below $40,000 reported problems paying medical expenses in 2007. (Doty et al. 5)

banners protesting foreclosures and eviction
NORWALK, CA - SEPTEMBER 10: Protesters demonstrate as foreclosed homes are auctioned off under umbrellas in the distance outside the Norwalk Courthouse on September 10, 2008 in Norwalk, California

For much of the population, while expenses have risen, wages have either stagnated or lagged in comparison. One estimate puts the share of family income devoted to "fixed costs" such as housing, child care, health insurance and taxes (i.e., expenses which can hardly be considered frivolous) at 75 percent, up from 53 percent just 20 years ago. (Garcia 2007, 11) The argument, in essence, is that most Americans in debt would have to sacrifice on basic needs in order to pay off some or all outstanding debt. The truth undoubtedly is that some consumers acquire debt from frivolous expenses, some do so because they lack adequate financial literacy, some do so because they are working towards an advanced degree, and some are paying off medical expenses.

What is less arguable is that all Americans work within the same system of laws regarding credit and debt, and all work within the same set of consumer markets. As explained earlier, these markets became more open to more consumers, and borrowing standards became more relaxed, albeit in many cases with higher penalties for debtors. And while sluggish economic growth and rising prices may affect some consumers more than others, the aggregate effect of rising medical expenses and tuition fees and housing prices has certainly led to a rise in total consumer debt.

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