Financial Services and Education Project: Latest Articles

Too Small To Fail

Cecille Isidro — Tue, 21 Oct 2008 08:46:00 -0400

Last fall, Countrywide Financial, then the nation's largest mortgage lender, had a curious new idea --or, more precisely, an old one. No longer would it slush foreign capital through Wall Street to make subprime loans. Instead, the lender would depend entirely on deposits from savers who would finance one another's mortgages--kind of like that humble thrift institution run by George Bailey in the movie It's a Wonderful Life.

Sadly, Countrywide waited too long to get back to basics and became the first major bank of 2008 to require a desperate rescue. But it is not too late for other financial institutions. Indeed, with the world's system of anonymous high finance in crisis, there is a strong case for fostering many more small-scale, traditional depository institutions like George Bailey's.

So far this year, the failure rate among big banks is eight times greater than among small banks. The latest data from the Federal Deposit Insurance Corp. show banks with less than $1 billion in assets outperforming larger banks on most of the key measures.

According to the theory that brought us bank deregulation, this can't be happening. Large financial institutions are supposed to be more efficient because of their economies of scale and, more important, because of their ability to match lenders and borrowers wherever they might be. Banks with global reach can take capital from wherever it is in large supply (say China or the United Arab Emirates) and direct it to places where it is in short supply, no matter how distant (say Stockton, Calif., or east Cleveland).

Redefining Loyalty

On the strength of the big-is-better theory, global-scale "transactional banking" has been allowed to displace small-scale "relationship banking." Internet mortgage originators such as LendingTree run TV commercials mocking the idea that a consumer should be loyal to any one bank. "When banks compete, you win," goes the LendingTree slogan. The message: Forming a relationship with a small-scale banker --as George Bailey did --is for chumps, transactional banking for the savvy.

But is bigger really better? Today we can see that the new system of global transactional finance invested the world's savings in a spectacularly irrational manner. The savings that poured into underwriting zero-down mortgages on McMansions and tract houses far from jobs could have been more profitably invested in just about anything else, such as for America's conversion to sustainable energy sources or retooling our manufacturing sector.

In contrast, small-scale financial institutions generally avoided subprime lending, concentrated on traditional mortgages and small business loans, and today are in comparatively good shape. Though vulnerable to a downturn in the economy, they are generally resistant to the financial contagion infecting larger institutions.

What's the Moral?

It is now clear that a lack of a relationship of mutual interest between lender and borrower was at the heart of the breakdown in global finance. All the players in the system, from mortgage brokers to investment banks peddling "asset-backed" securities, had little interest in whether consumers could actually afford their debt.

Unlike a traditional community bank, most large banks didn't hold any of the mortgages they wrote and didn't depend on deposits from the same people to whom they made loans. Instead, they made their money mostly on fees.

In small-scale banking, by contrast, there is a mutual interest between borrower and lender. Both are members of the same community and as such are able to judge each other's prospects better than borrowers and lenders on opposite sides of the globe.

Put another way, small-scale banks are rich with what Federal Reserve Chairman Ben Bernanke calls "informational capital," which, he explains, they develop through "gathering relevant information, as well as by maintaining ongoing relationships with customers."

What Next for Small Banks?

George Bailey put it better in his clinching argument to panicked depositors. The residents of Bedford Falls could rest assured that their money was safe because they knew one another: "Well, your money's in Joe's house. That's right next to yours. And in the Kennedy house, and Mrs. Macklin's house, and a hundred others. Why, you're lending them the money to build, and then, they're going to pay it back to you as best they can."

The biggest problem facing small banks today is attracting equity capital from stockholders. Most small banks are privately held, and even for those that are not, interesting the public in bank stocks is not easy. It's a problem that could get worse for small banks if, after all the bailouts, just a few giant financial institutions control most banking.

We are pleased to see the Treasury Department announce it will use some of its $700 billion in rescue money to invest in small-scale banks. For the longer term, however, we need a dedicated tax on the securitized loan transactions of the rest of the financial services industry. The revenue raised could flow to a federal Community Bank Trust fund to ensure that small-scale banks expand in number and market share.

This would support the capital and other needs that enable community banks and credit unions to serve their communities--including minorities, immigrants and those of modest means. In the movie, George Bailey got to see what the world would look like if he weren't in it. Today, a world that largely passed him by looks ugly indeed.

Breaking Asset Poverty

Cecille Isidro — Tue, 16 Sep 2008 08:50:00 -0400

In standard U.S. policy-speak, “poverty” is an income concept. The “poverty line” is an income measure, access to social programs is largely related to income, and when policymakers examine distributional effects of a policy, they turn to income quintiles.

Income, however, provides an incomplete picture of family well-being. Income measures a household’s flow of funds, but that flow can be interrupted. In his recent book High Wire, Peter Gosselin presents disturbing evidence that income volatility in the United States--measured by the percentage of households experiencing a 50-percent decline in income over any two-year period--has increased from 5 percent in the 1970s to 9 percent by 2006. This trend has affected families at all income and education levels.

The volatility trend highlights the need for more than income. Assets, such as equity in a home, a savings account or investments, or a stake in a business provide a cushion that can smooth income, a base to leverage additional assets, wealth to pass on to the next generation. Research into the effect of savings strongly suggests that, even at relatively modest levels, asset ownership creates a future orientation that encourages an individual or family to act to enhance that future, such as by getting more education or saving for a specific goal.

Yet at least a quarter of Americans are asset-poor: They do not have sufficient financial or other liquid assets to live at the poverty level for three months if their stream of income were interrupted. The numbers double in the black and Hispanic populations. Among working families with children who earn up to 200 percent of the federal poverty level, 30 percent have zero or negative net worth and barely half have a bank account—with a median balance of $800.

Traditionally, homeownership has been the path to building assets. In 2004, the median net worth of homeowners was $184,400, compared to only $4,000 for renters. Homeownership has meant financial stability and automatic saving through a self-amortizing fixed-rate mortgage, family stability (generally in a more stable community), and the opportunity of price appreciation. Moreover, because of the leverage involved in buying a home, the benefit of any price appreciation is significantly magnified: 10 percent down on a house whose price appreciates by 10 percent yields a 100-percent return on investment. Few other opportunities for financial leverage have been available to those of modest means.

But there’s also a dark side to homeownership. Financial leverage means that modest price depreciation can wipe out even a sizeable down payment. Adjustable-rate mortgages, with no or negative amortization and big fees, are unstable and can strip rather than build equity. Heavy or unexpected maintenance costs and increases in property taxes or the price of energy can destroy a family budget.

Abandoning homeownership as an asset-building strategy makes no sense. Rather, the next administration needs to pursue three alternative strategies simultaneously: bringing back “good homeownership,” supporting quality affordable rental housing so people who don’t want or are not ready for homeownership aren’t forced into it, and developing other ways to help families of modest means invest for themselves and their future.

We know how to do “good homeownership.” We did it during the 1990s, when we substantially expanded homeownership safely and sensibly. The important elements are quality counseling and fixed-rate self-amortizing mortgages, underwritten based on the borrower’s ability to pay the loan for its full life and with escrows for taxes and insurance.

In this new world of ever-increasing energy prices, good homeownership also requires paying attention to both the energy efficiency and the location of the home near jobs and transportation.

Second, the next administration must reverse the policies of the past 30 years and support quality affordable rental housing. Renting may not sound like asset-building, but good rentals buy people the time and means to save, whether for a down payment on a house or to build other assets.

Third, the next administration needs to promote asset-building policies other than homeownership. There are easy and inexpensive wins, like actively supporting savings bonds. Other policies, like children’s savings accounts, will require more money. Finally, there’s a need for new ideas, such as investment plans for more than retirement, for those of modest income, characterized by easy enrollment and automatic additions, economies of scale and opportunities for diversification, and maybe even some leverage.

For 50 years, we’ve had an effective federal assets policy for the well-off. It’s time for everyone else.

Making a Transaction and Savings Account a Certainty, Just Like Taxes

adminn — Thu, 22 May 2008 15:00:00 -0400

In the Feb. 20 issue of Paybefore Update, my colleague, Melissa Koide, discussed a proposal to use prepaid cards to deliver tax refunds through a unique alliance of government and industry, Viewpoints: A Convergence of Opportunities: Delivering Prepaid Accounts at Tax Time (February 2008). We believe the prepaid sector can and should play a major role in working with government to provide an "assets and transactions account" (ATA), a low-cost, high-value transaction account that facilitates savings for financially underserved consumers. The ATA would be opened when a tax filer's refund is deposited at a regulated financial institution and accessed through a prepaid card, giving the filer access to the mainstream financial system and a host of prepaid card features.

A critical step in the development of an ATA product is to understand the banking needs and product preferences of the 39 million potential users. To that end, we analyzed evidence from surveys, focus groups and pilot programs aimed at lower-income consumers to determine the core functions and features most desired by this segment.

Here are a few common themes:

Convenient and quick access to funds through ATMs and point-of-sale terminals. Research shows a need to get cash through ATMs and to pay for purchases at the point of sale. Empirical data from two samples of prepaid cardholder transactions show that consumers actively access funds through both point-of-sale purchases and ATM withdrawals. And, anecdotal evidence in the prepaid space suggests that consumers move toward transactions at the POS over ATMs as they become more familiar and comfortable with the card product.

Automatic savings capabilities. Conjoint analysis and focus groups show that lower-income households prefer prepaid cards with automatic savings features to those without. Furthermore, adding a savings capability creates a "stickiness" that leads to longer term use, delayed funds spend-down and increased take-up of other savings programs.

Ability to receive additional deposits such as wages and salary. Lower-income households strongly prefer to add funds from more than one revenue source (e.g., wages and government benefits) and through a variety of channels (e.g., cash loading at a teller or kiosk and Internet reloads). Consumers value the ability to make direct deposits into their accounts and actually may save more with direct deposit. With respect to network branded prepaid cards, the financial services industry, in particular, asserts that direct deposit is important for facilitating use of the card and sees it as critical to driving interchange revenue, thus helping to make the product viable over the long term.

Savings linked to tax time, automatic transfers to savings and financial incentives. Lower-income tax filers desire savings products to support savings goals and are attracted to products and programs linking tax time and savings. Several experiments demonstrate that auto-enrollment in retirement and other savings plans increase participation and contribution amounts, especially among lower-income and minority populations.

Federal protections including FDIC insurance coverage and protections against lost cards. Protections on funds provided under FDIC or equivalent insurance are important both in terms of providing actual insurance against loss and because federal protections are valued as an important signal among lower-income consumers. Given a choice to use a federally protected prepaid card or not, consumers prefer federal protections that limit losses on a lost or stolen card. A Network Branded Prepaid Card Association survey shows that consumers view prepaid cards as a way to obtain such protection.

Transparent fees. Fees are important to this consumer segment, but low fees do not appear to affect overwhelmingly product take-up. Instead, fee transparency, access to services and interest earnings matter as much or more than low fees for lower-income consumers. Anecdotal evidence suggests that for underbanked consumers with few banking options, low advertised fees may be a big enough incentive to take up the card. However, practitioners observe that as consumers incur a series of fees, they re-think the value of the card and often drop it. So, for first-time users with few options, low fees may tip consumers into adopting the card but may not be enough to ensure continued use.

Areas for Further Research

Consumer education, marketing and messaging are important factors in driving consumer demand and take-up. Marketing that explains the specific capabilities and customer value-add is likely to lead more consumers to adopt a prepaid product.

Less is known about the extent to which consumers in this segment desire the ability to interact personally with a financial institution for routine transactions. A more thorough understanding of the importance of a bank or card issuer's presence within the neighborhood would complement the evidence that consumers desire and benefit from early-stage, in-person customer service. Lastly, limited research and anecdotal evidence suggest that electronic daily balance notices and real-time balance information, bill pay and purchases, electronic check writing and remittance capabilities would be valued by lower-income users.

Reinforcing the Need for an Account

Many lower-income households that live paycheck to paycheck do not rely solely, if at all, on traditional bank accounts for cash management. They are discouraged by minimum balance requirements, high overdraft penalties, delayed crediting of checks and monthly maintenance fees. Yet, alternative financial services are sub-optimal, offering little consumer protection, savings capability or ability to establish a credit history. Though alternative financial services provide immediate liquidity, they do not tend to build wealth.

Our work involves crafting and analyzing policies that promote the development, protection and intergenerational transfer of wealth and assets. As envisioned, the ATA would enable consumers to take a step in this direction.

Individually, the prepaid industry and policy institutes, such as the New America Foundation, have amassed critical knowledge of the preferences and behaviors of these individuals. Market research, such as the national segmentation study of the underbanked to be released next month by The Center for Financial Services Innovation, will contribute key learnings that will enhance the success of such endeavors. We welcome your involvement as we continue to refine the product features and functions that would maximize consumer interest, encourage participation by the financial services industry and develop a policy strategy to leverage the near universal process of tax filing.

A Convergence of Opportunities: Delivering Prepaid Accounts at Tax Time

Ron Tang — Thu, 21 Feb 2008 00:00:00 -0500

What if there’s a way to bring prepaid products to millions of new consumers, with the help of the federal government?

I think there is. By leveraging billions of dollars in annual tax refunds, there’s the potential to deliver a prepaid product that benefits consumers, industry and the government alike. Called the Assets and Transaction Account, or ATA for short, it’s envisioned as a network branded prepaid account that would be delivered through the tax filing process and loaded with tax refunds, to start.

Each year the U.S. Treasury Department issues millions of refund checks worth billions of dollars to tax filers. IRS data show that almost half of all tax filers who are due a refund receive them via a paper check. That’s at least 60 million paper checks that are processed, printed and mailed. And that’s billions of refund dollars that could be deposited into financial institutions in a way that instantly “banks” consumers, while saving the government millions of dollars each year.

What Would the ATA Look Like?

The ATA would be delivered to tax filers who didn’t direct deposit their refund into an existing account or elect to receive a paper check. Financial institutions would issue the products, which would be loaded with tax refunds, direct deposits of wages and salary and, ideally, other sources of money. To facilitate savings, 5 percent of the tax filer’s refund would be deposited automatically into a savings purse. At a minimum, the ATA would be FDIC-insured, network branded and provide ATM access, POS capabilities, and Web- and phone-based bill payment options.

How Big Is the Potential Market?

IRS data show that of the 60 million refunds that were not direct deposited, 39 million were paid to households with adjusted gross incomes of $60,000 or less. In fact, almost 28 million of them had adjusted gross incomes of $30,000 or less. These are the households that are most likely to use costly financial services, like check cashers, to convert their refunds into cash. Because many are liquidity-strapped, when they do use checking accounts, they are more likely to incur bounced check fees, often as much as $39 dollars per overdraft. They also are less likely to have adequate savings to cover emergency expenses like car repairs or unexpected medical bills -- leading them to payday lenders and other expensive sources of credit.

These households, however, do receive on average about $1,700 in federal tax refunds. And when looked at in the aggregate, as much as $70 billion annually is refunded to households with AGIs of $60,000 or less, via paper check. The potential of those refunds as deposits along with interchange revenue create a powerful case for financial institutions to make a prepaid product available at a reasonable cost to consumers.

Is There a Mechanism to Address BSA Issues?

Yes. The personal data presented on the tax returns is the basic information required in a customer identification program. The government could use the information to help in the identity verification process.

Is the Government Ready for This?

Actually, the Treasury Department already is headed down this path. After a one-year pilot, Treasury is rolling out the Direct Express initiative nationwide. Direct Express is a MasterCard-branded debit card account into which Social Security payments are deposited. In addition to the cost savings, Treasury developed Direct Express to provide un- and underbanked Social Security recipients with a safer and more convenient option to paper checks. Although the product is not loadable with funding sources other than benefits, it is a positive signal that Treasury is interested in moving in this direction.

What Are the Next Steps?

Given the convergence of opportunities for the government, consumer and industry, the prepaid industry has a powerful platform to engage and encourage movement in this direction. Over the next 10 months, I’ll be leading an effort to craft a federal policy proposal to deliver an ATA at tax time. Its success depends on input and guidance from the industry.

I welcome your participation in the discussion.

Viewpoint: Fed's Mortgage Move is a Good Start

Ron Tang — Fri, 21 Dec 2007 00:00:00 -0500

With foreclosures reaching record levels and predictions for further trouble ahead, the Federal Reserve Board on Tuesday unanimously approved potentially sweeping changes to how mortgages are marketed, made, and serviced, especially in the nonprime market. Will the Fed be able to meet its goal of a "comprehensive set of protections to consumers" when the comments come flying?

The proposed revisions to regulations under the Truth in Lending Act are designed to realign relationships in the mortgage business, so borrower and lender are once again interested in the same result: a good mortgage.

The rules, unlike guidelines bank regulators issued over the last 18 months, would apply to all mortgage lenders and other participants in the process (such as brokers, independent mortgage bankers, and appraisers), not just banks, thrifts, and credit unions. That the Fed has proposed them at all is both an indication of how bad the situation has become and a testament to new leadership at the central bank.

The proposed regulations would, for a new class of "higher-priced mortgage loans" (meant to cover not only subprime but also the some part of the alt-A market), require lenders to lend based on the borrower's ability to pay at a fully indexed, fully amortizing rate, verified by independent third-party documentation. Escrows for taxes and insurance would be required (for at least the first 12 months the loan is outstanding), and prepayment penalties would have to expire at least 60 days before the first payment change.

The proposed regulations also respond, for all loans secured by a primary residence, to abuses in brokerage, appraisals, and servicing. Advertising abuses, such as calling a loan fixed when it's not, would be prohibited. Lenders would be required to provide borrowers with information about payments, finance charges, and interest rate early in the shopping process, and before charging any application fee.

There is plenty of room -- all of which will undoubtedly be taken in the 90-day comment period -- to argue with specifics in the proposal. Is the definition of "higher-priced loan" sufficiently broad, or too broad? Is 60 days enough time to refinance after a prepayment penalty ends, before a rate reset takes place? Do the proposal's safe harbors strike the right balance between providing creditors with a degree of certainty and not undermining the good intentions of the rule?

Randall Kroszner, the Fed governor most responsible for the proposal, said the Fed's goal "to protect borrowers from practices that are unfair or deceptive, but to do so without unintentionally causing responsible lending to shrink or unduly limiting consumer choice" was "challenging to perfectly achieve."

Issuing the final rule after receiving comments will be even harder. Now that the Fed has stepped up with a series of proposals that would affect all lenders, it's time for the good lenders to stop shielding the bad, and recognize that we need some new rules, badly.

As for Congress, if the Fed moves quickly it will beat the timetable for regulatory improvement that's in either the House-passed Mortgage Reform and Anti-Predatory Lending Act (which requires final regulations to be issued 12 months after enactment) or the bill Sen. Chris Dodd introduced Dec. 12 (six months). But the Fed has not eliminated the need for legislation.

There are areas the regulations have not touched, mostly because they are beyond the central bank's authority. These include nationwide licensing, testing and registration of mortgage brokers; liability -- beyond the initial creditor -- for violations of standards; requirements for pre-foreclosure counseling and modification attempts; and bankruptcy law changes to permit judges to modify home mortgage loans that are "underwater."

And the Fed can't provide the money needed for substantial increases in housing counseling, assistance to communities in trouble because of the foreclosure crisis, or even the enforcement of its own proposal by states and the Federal Trade Commission -- all essential if we're to minimize the damage the mortgage crisis still has in store for us. That's the job of Congress and state legislatures.

What the Fed did on Tuesday is a major move in the right direction. But there's still so much more to do.