How to fix: Credit woes

America's middle class is facing a debt crisis. To solve it, the US needs to rein in credit card companies and home lenders.

By Richard Conniff, MSN Money

The numbers coming out of the credit crisis are astonishingly ugly: The average American household now spends 14% of its disposable income just paying interest charges on mortgage and consumer debt; some sources estimate that up to 2 million families will lose their homes through foreclosure over the next two years.

Where have we seen trouble like this before? Oh, right -- during the Great Depression.

This time around, things started back in 2001, when the middle class went on a credit binge, borrowing against the rising equity in their homes as if it were a third household income (because even two incomes no longer seemed like enough).

Predatory lenders encouraged the trend, often pushing families to refinance into mortgages with deceptively low teaser rates. Now the real cost of those loans is becoming crushingly evident as the teaser rates expire and real-estate values decline.
So how do we get out of this mess? And how do we keep it from happening next time? Here are some of the reforms that have been proposed recently:

Ban "universal default." Credit card companies say it's not enough to pay your credit card bill promptly; you have to pay all your other bills on time, too. (If you didn't hear them say it, that's because it was buried in the 30 or 40 pages of fine print in your contract.) Even if you're just a month behind with the phone company, for instance, your credit card issuer can automatically jack up your interest rate as high as 32.5%. Critics say some companies actually target borrowers who are likely to get in trouble, because that's where the profit is.

Credit card companies say they're just protecting themselves by charging more for people whose changing financial circumstances make them riskier bets. They also say they're invoking this type of treatment, called "universal default," less often these days. But the language still appears in about 45% of credit contracts, according to Joe Ridout of the advocacy group Consumer Action, and it remains an "underhanded and fundamentally unfair" way to take advantage of people "who believe they are playing by the rules."

A proposed reform would allow the penalty interest rate but would require that it be based solely on a borrower's experience with the credit company.

Mandate strong underwriting standards. Legislation now before Congress would limit no-document loans. These quickie loans were originally meant to help real-estate investors, the self-employed and other short-term borrowers who were willing to pay a little more in order to minimize the paperwork hassle of a full loan

application. But they became a tool for selling pricey loans to unqualified borrowers -- typically with 2 or 3 points tacked onto the interest rate.

Proposed legislation would also require lenders to make sure borrowers are qualified to pay not just the short-term teaser rate, but also the potential maximum interest rate.

Make brokers pay for predatory loans. Under another proposed reform, all mortgage brokers would be required to post a surety bond of $50,000 -- like the guy who trims the tree or fixes the plumbing -- and to provide proof of $500,000 in individual net worth. That way, brokers who sell predatory loans could be held individually liable for a borrower's excess costs if unfair terms cause the deal to go sour. Video: When a child gets sick

Other legislation would make it easier for borrowers to sue deceptive lenders. Right now, mandatory binding arbitration, a standard part of almost all credit agreements, forces borrowers into private arbitration forums that can function, says Linda Sherry of Consumer Action, as "kangaroo courts."

If these proposed reforms sound promising, Elizabeth Warren warns not to get your hopes up. Warren, a Harvard law professor specializing in credit and bankruptcy issues, says the likelihood of the House, Senate and White House all signing off on significant reform is "probably near zero" -- because the lending industry "can make lots of political contributions and hire all the lobbyists in the world." Besides, Warren says, the legislative process is too cumbersome and erratic. She believes it takes independent regulators to develop the expertise necessary to respond quickly to changes in the marketplace. Which brings us to her big idea:

Create a Credit Product Safety Commission. A regulatory agency for the credit industry would function, says Warren, like the Consumer Product Safety Commission -- the federal agency that alerts us when lead paint turns up in toys from China or when a crib poses a choking hazard for toddlers.

But is the credit issue important enough to warrant the creation of a new bureaucracy?

"Whoa!" says Warren. "I'll tell you how important it is. It's consumer credit that is bringing the middle-class American family to its knees. It's the tricks-and-traps pricing model that offers an extraordinary amount of credit to every American family, and then -- for every family that does not handle it with the care and precision of a surgeon -- jerks the legs out from underneath that family and leaves them in enormous trouble.

"Consumer credit is as much a product as car seats

and children's toys, and it's a product that affects a family's well-being. You cannot buy a toaster in America today that has a one-in-10 chance of exploding and burning down your house. But you can buy a mortgage today that has a one-in-10 chance of exploding and costing a family their home."

Moreover, Warren says, the lender often knows on signing that the borrower faces that kind of risk -- and doesn't have to disclose the knowledge.

"In my view, it's just a safety issue," says Warren. American consumers should not have to "walk into the marketplace saying, 'Gee, this is a place where I could forfeit my entire economic security because of tricks and traps that even a specialist lawyer would have a hard time understanding.'"

John Hall, of the American Bankers Association, argues that banks are already thoroughly regulated by the Federal Reserve, the Office of Thrift Supervision and the Office of the Comptroller of the Currency, among others. But Warren replies that those agencies focus on the soundness and profitability of lenders, rather than on the safety of consumers.

Bypass the credit industry with social lending. If reform proves impossible, the free market offers an intriguing alternative: Consumers wary of doing business with traditional lenders could do business directly with one another instead.

"Social lending" Web sites like Prosper, LendingClub, Zopa, Fundable and Kiva -- still a minuscule part of the credit business -- facilitate peer-to-peer (or P2P) loans by cutting out the middleman and sometimes offering more-attractive rates to the principals in a transaction.

Of course it's smart to proceed cautiously with any new approach. Potential lenders should note that different sites have different rules for diversifying your investment and minimizing risk; some emphasize the social good you can accomplish, while others are more business-minded.

But it's worth noting that the investors in these sites include some of the same smart people who helped launch Skype, eBay, PayPal and Google. So social lending could yet become a major force in middle-class lives.