Regulations in lending: TILA (1/7)
UCL Letter #5: March 29, 2020
Welcome to the fifth letter of Undirected Cyclic Thoughts. I mentioned before that this may take a healthcare bend. This letter doesn’t. Well, the impetus for it is still healthcare-related, but that doesn’t count. Today I want to discuss the first of a few key regulations associated with lending.
A bit of context: there’s a company called CareCredit. I don’t like CareCredit, and neither should you. I guess that’s for another letter, but, in any case, CareCredit is a healthcare credit card company. They were spun out of GE Capital years ago and are traded as an entity called Synchrony (NYSE: SYF). Why is that relevant? Well, they have to file a 10K every year. And I read their 10K, and outside of risks associated with being general pieces of shit they outlined a bunch of risks associated with (i) interpretations of and (ii) regulatory actions that can be taken based on a number of lending laws.
Specifically, they say:
The relationship between us and our U.S. customers is regulated under federal and state consumer protection laws.
Sure, makes sense.
Federal laws include the Truth in Lending Act, the Equal Credit Opportunity Act, HOLA, the Fair Credit Reporting Act (the “FCRA”), the Gramm-Leach-Bliley Act (the “GLBA”), the CARD Act and the Dodd-Frank Act.
Ok, some of those ring a bell.
These and other federal laws, among other things, require disclosures of the cost of credit, provide substantive consumer rights, prohibit discrimination in credit transactions, regulate the use of credit report information, provide financial privacy protections, require safe and sound banking operations, prohibit unfair, deceptive and abusive practices, restrict our ability to raise interest rates on certain credit card balances, and subject us to substantial regulatory oversight
Wow, that’s a mouthful.
After reading the above paragraphs, I realized two things. One, some of these regulations ring a bell. Two, I have no clue what they really say.
So… this is the first of 7 letters that will explore these laws and acts. Each piece of legislation is rather dense, so unpacking it within one post wouldn’t do any of them justice.
By the end of this series, ideally I (and you, if you keep reading — I probably wouldn’t) will be able to articulate why these acts came about, what they say, what they practically mean for a lender, and any fun anecdotes that will make this slightly less of a slog.
Ok. *deep breath*. Let’s begin.
The Truth in Lending Act
This was the first act mentioned. On the surface it seems like a good idea. I’d be concerned if it was “The Lies in Lending Act.” So, how does CareCredit reference it?
The CARD Act made numerous amendments to the Truth in Lending Act, requiring us to make significant changes to many of our business practices, including marketing, underwriting, pricing and billing.
Alright, it looks like the Truth in Lending Act is important insofar as it predated the CARD act and some of it still stands on its own two feet. Let’s look at why it was introduced.
EVERYBODY GETS A CAR!!!
Actually, before we do that, let’s back up and understand the time period leading up to the introduction of TILA in the late 60s. Normally, as I’m sure you’re aware of, legislation REALLY lags the inspiring circumstances. TILA is no different and the originating factors for it can be found in the 50s. In fact, if you think Oprah’s car give away got people excited in 2004, you can only imagine what would have happened in the 50s.
The 50s were dominated by postwar expansion in the U.S. It was a clash of social conservatism and materialism brought about by keeping up with the Jones’s. It was a decade of middle class expansion. What we now know as consumerism was forever embedded in American DNA. There was white flight and urban sprawl. Everyone wanted their own house with a white picket fence and an automobile. That last sentence is important. Everyone wanted their own home and their own automobile.
Home ownership rates had started to skyrocket after the end of WWII, with developers buying land outside of city limits to build massive plots of tract houses. Huge, planned suburbanization projects like Levittown came with low-interest loans and enough houses to take care of the roughly 4 MILLION BABIES born yearly during the 50s.
Between 1950 and 1958, registered automobiles nearly tripled, from 25M to 67M. It was the decade of hotrods and drive-in movie theaters. Remember the movie Grease? Yeah, that’s the 50s. All these war production factories were repurposed to pump out cars for the suburbs. I mean, just look at this family below - what’s not to love?
If you had a beer with a father in the 50s, the only thing he’d probably complain about is that rock-n-roll guy who gyrated his hips a bit too much and went by the name of Elvis. I guess if you asked him in the late 50s, maybe he’d point to the communists, but I digress.
Anyway, the point of this narrative is that there was white flight to the suburbs and owning a house and a car was the thing to do. It was the standard for the middle class. It was the decade of spending.
And with spending, as always, two things happen. 1) You want to buy more, and 2) you want to buy more expensive things. Not unlike today, few people were buying houses outright in cash; few people were buying cars outright in cash. So what happened?
The credit card was born, the auto loan industry saw its heyday, borrowing skyrocketed and homes were used as collateral.
Check out that Diners’ Club Card. It was first form of a credit card. Revolving debt for restaurant-goers. Love it.
What could go wrong?!
Well, since we’ve all lived through ‘08, I imagine that’s not a very clickbait-y subheader. But let’s see what happened when you have a boom in spending that meets relatively unregulated forms of lending.
A lot of it happens
In this period, roughly 50% of families had some form of installment debt (e.g. non-revolving) - think the usual mortgages and auto loans. Funnily enough, some of the more popular loan products in the 50s were for refrigerators and televisions. 54% of refrigerators and 46% of televisions were bought on credit. Those must have been the times, huh.
A ton of different lenders
From the Diners Club with their credit card to every small bank willing to lend you money to buy a house, there were a lot of lenders. By 1959, 88% of all DEPARTMENT STORES were offering revolving credit products. To add fuel to the fire, lack of bank deregulation (e.g. banks couldn’t cross state lines) meant tons of small banks. In fact, 1950 counted 14,000 distinct banking organizations!! A number that would end up falling to 7,000 over the next 50 years due to consolidation that came on the heels of loosening regulations, or allowing banks to cross state lines.
Oh yeah, no consumer credit bureau
If you’re thinking, “what a shitshow,” you’re not wrong. By the end of the 50s, there were over 1,500 independent localized credit bureaus. Each was doing their own form of underwriting, with input data such as divorces and deaths listed in the local paper!!!
So it’s not like everybody refused to disclose costs. Most lenders disclosed their own form of… “something.” The issue was that the “something” was not standardized. This meant that consumers had no mechanism to compare terms or anything of that sort. Why does that matter? Well, when you’re not able to easily shop and compare products, it’s hard for the market to work its magic and weed out bad players.
If that’s your reaction, good. Because in summary, you have millions of consumers… hearing about revolving credit for the first time, it being used as a sales tactic in a department store, and having no idea what the true costs were. Recipe for success if you ask me.
Congress: We should do something
And do something they did! It took them a while - 8 years from idea to action. But they did something. Such a shocker in this day and age.
The “Truth in Lending Act” was Title I of the broader Consumer Credit Protection Act, which was passed in 1968 and went into effect a year later.
The TILA is conveniently written in 3 parts. I’m going to walk through them one-by-one, but it gets quite dense. If you’ve made it this far and are wondering whether you want to finish the post, I would recommend making a graceful exit.
1. GENERAL PROVISIONS
This is the opening scene. In most stories, you’d want a good catchy hook that draws you in. But, well, lawmakers wrote it, so the opening scene is reduced to (a lot of) definitions and qualifiers.
In fact, they begin by admitting that the real name is not the “Truth in Lending Act.” The real name is “Title I - Consumer Credit Cost Disclosure,” which is actually the more accurate title given how banks reacted to the act.
Next they run through some of the context we talked about at the top, and making bold claims like that with their act, “economic stabilization would be enhanced.” I guess they were kind of right? Like most of the time, consumers are now able to compare credit terms and avoid uninformed use of credit.
Lastly, they lay out the definitions of terms and scope. Some statements are obvious, what a consumer is, what credit is, what an organization is, the distinction between open- and closed-credit, etc. Others are more nuanced or interesting:
They take the first steps to define what exactly a “finance charge” is. Remember, if you’re paying a restaurant on a diner’s club card and this is your first foray into credit, the line between finance and paying for dinner can be blurry:
According to them, a finance charge is the sum of all charges associated with an incident to extend credit, commonly including: (1) interest or “time price differential”, (2) a service or carrying charge, (3) a loan or finder’s fee, (4) a credit report fee, or (5) any premium for insurance protecting the creditor against default.
If you’re thinking, “wow good for them, they defined a finance charge!” Erm, stay tuned. This approach to defining a “finance charge” comes back to bite them in the ass.
They lay out guidelines for calculating the annual percentage rate of interest (APR). This is one of the earliest attempts at getting everyone on the same page:
I. With a closed-credit transaction, the APR should not vary and the interest rate in effect on the date of the transaction shall be the APR. This APR should yield the sum equal to amount of the finance charge (defined above) when using in a standard simple interest calculation.
II. Where a creditor imposes the same finance charge for balances within a specified range, the APR must be computed on the median balance within the range. You see this less nowadays.
III. The APR can be rounded to the nearest 25 bps for transactions (a) paid in equal installments, and (b) where the rate is based on a discount, periodic or other rate.
For context, LIBOR hit the dance floor in the 70s. So as of TILA, there’s no standardized rate at which banks lend to one another. It’s pretty much this is the APR, this is the APR based on this range owed, or this is the APR based on our nice chart that someone printed.
One massive throwback is the enforcement provisions. Since there’s no CFPB, they let responsibility for enforcement diffuse through any organization remotely associated with money:
For national banks, the Comptroller of Currency is in charge.
For member banks of the Fed, the Board of the Fed is in charge.
For banks insured by FDIC, the Board of the FDIC is in charge.
Government: If none of those apply, good luck. We recommend reading the map and trying to see if one of these people may be in charge: the Director of Bureau of Federal Credit Unions, the Interstate Commerce Commission, the Civil Aeronautics Board (RIP), and the Secretary of Agriculture.
Small bank owner in Arkansas:
And of course, they discuss penalties. Very important. If there’s no penalty, banks don’t care. And if there is a penalty, banks still may not care. But the small ones probably will:
According to TILA, if you violate any of the subsequent sections, you’re on the hook for no more than $5,000 and can be imprisoned for no more than one year.
It’s unclear if this is on a per-incident basis, but let’s assume it is. Luckily, we’re dealing with a lot of small banks.
That wraps it up for the intro. What may to you seem like an exercise in writing a financial glossary was in fact one of the biggest wins of the TILA. Think back to the last time you had an argument, only for it to deteriorate into a he-said-she-said argument over what the meaning of X is. That my friend, is what the government has set out to nip that in the bud. In the 50s and 60s, not only was this common but at times it was even nefarious (and, maybe legal?).
2. CREDIT TRANSACTIONS
This is where we take our nice glossary above and start applying it for the first time. The government made some definitions, now they want you to use them.
Each credit shall disclose clearly and conspicuously, […], to each person to whom consumer credit is extended and upon whom a finance charge is or may be imposed, the information required under this chapter
At this point, you don’t even know what EXACT the information required is, but it’s already better than what we had in 1967. We have a few definitions for APR, we know one of a dozen agencies may or may not be in charge, we know you could get fined $5K and spend a year in prison, and now we know you need to disclose stuff:
Sec 125: Right of rescission as to certain transactions
As we discussed previously, the backdrop for this act includes (1) a lot of people buying homes, and (2) a lot of people using credit from a lot of different lenders. One byproduct of this environment was that people didn’t understand the lending agreements into which they were entering. And not only that, but they were using their homes as collateral.
This section takes a first pass at fixing it by saying, “Look, if the consumer is using any ‘real property’ in a transaction, then they have 3 days to back out of the deal.” Moreover, given the whole “truth in lending” nature of this act, the creditor needs to INFORM the obligor of these rights.
Think about this for a second. I’m a middle-class materialism-obsessed American. I want to show-off to my neighbors, so I enter in some silly deal to use credit for a refrigerator. I’m informed of my rights to rescind. I proceed anyway and use my house as collateral and put down a 20% downpayment. I go home from the Refrigerators-for-less store. I brag to my partner, “Hey look sweetie, we’re going to have 3 square feet of coldness arriving any day now.” My partner says, “What the fuck are you thinking?” And, I think, “Uh… I should go cancel this agreement.” What are we missing here?
Oh right, the creditor must return any money or property associated with the transaction.
The one carveout here is for home mortgages whereby the property being bought is the collateral being used. That seems fair.
Sec 126: Content of periodic statements
This section is less than a dozen sentences long. But I’ll do you a favor and summarize it in even fewer!
If you give your consumer periodic statements for closed-end credit (e.g. a loan or installment plan), then you must include 3 items: (1) the APR, (2) the day by which payment must be made in order to avoid more charges, and (3) “other things required by other sections of this act.”
Basta! Said a former lawyer now spending his nights at the MCC.
Sec 127: Open end consumer credit plans
Ok, so this part is important. Open-end credit plans were relatively new at the time and this is where interest calculations and “finance charges” were reaking havoc. There are three main disclosure requirements here.
I. You need to disclose stuff when people are applying.
Mainly, the requirement is for the consumer to understand the how, why and when a finance charge will be imposed (e.g. upon which balance, based on what rate). Outside of that, there are disclosure requirements for when any other non-finance charge can be made and when the lender can take interest in a consumer’s property to secure payment.
One interesting snippet in this section, is that it is completely OPTIONAL for a lender to disclose the average effective APR from accounts. We’ll come back to this later.
II. You need to disclose stuff on billing statements.
This is pretty cut-and-dry. You need to let the consumer know his or her balance at beginning and end of period, whether more credit was extended and how it was used (e.g. let the consumer help combat fraud), how the finance charges were calculated, and when he or she needs to pay to avoid more charges.
III. Lastly, if you have existing open-end credit plans, then you need to go back to Part I and do that for your existing consumers.
Sec 128: Sales not under open end credit plans
This is a complimentary section to 127, but focuses on “credit sales.” When I first read this, I was a bit confused as to how this is different from Sec 129. It turns out that what Congress is talking about is any sale when credit is extended or arranged by the seller:
The term includes any contract in the form of […] a lease, if the bailee or leasee contracts to pay […] a sum substantially equivalent to or in excess of the aggregate value of property and services [….].
Practically, think of leasing a car, or, I guess in the 50s, leasing a refrigerator? Anyway, good things come in three and this section is no different.
I. You need to disclose stuff.
Most of the “stuff” is pretty straightforward: the price of the property or service, any downpayment, the remaining principal, the total charges, and total sum of the remaining principal and other charges.
The rest of the “stuff” is still sensible but wasn’t exactly what lenders were down for in the 60s: the amount of the finance charge, the charge expressed as an APR (unless it’s below a certain amount*), the payment plan (#, amount, due date of payments), the default and late fees, and any property interest used as collateral.
* They were foresighted enough to include a call-out that splitting the credit line in half to avoid the APR disclosure threshold is not kosher.
II. Everything you need to disclose in Part I should be done prior to credit being extended. We recommend you get the obligor to sign as much.
III. If a random person sends you a piece of mail and asks you for financing, and your terms are publicly available, then you still need to disclose everything in Part I prior to the date the first payment is due.
IV. If the sale is one of a series of transactions (which are effectively refinancing or extending previous transactions), then you still need to disclose everything in Part I prior to the date first payment is due.
Sec 129: Consumer loans not under open end credit plans
Alright, so this is nearly a clone of Sec 128. So much so that I skipped it and got confused. This section essentially says, (1) this applies to a consumer loan that is not covered by Section 127 or 128, (2) for these loans, see Part I - III in Sec 128.
Sec: 130: Liability
This is probably where every car salesman and used car salesman skipped to. They were likely thinking, “Jesus, this is a lot of overhead. What happens if I don’t want to do this?” And to be honest, part of me doesn’t blame them.
The answer is this. If you don’t do what Congress says you should do, you are liable:
Twice the amount of the finance charge, with a floor at $100 and ceiling at $1,000 (remember, $1,000 in ‘68 is ~$7,000 in '17).
If action in court needs to be taken, you need to pay the above and attorney’s fees
But! If you can move quickly and right your wrong within 15 days of discovering that you made a mistake, you’re fine. But, if we find out first… you’re in the doghouse.
Of course, if you really made a “bona fide”, one-off error that was not systematic, you won’t get in trouble. That would be cruel, especially back in the days of decentralized lending. I mean, my god, things were done by hand back then!
3. CREDIT ADVERTISING
Alright, so we spent quite a few words running through credit transactions. It seems we’re already in a decent place. If you’re a lender, you need to let people know what they’re getting themselves into, you need to let them back-out, and you need to explain your periodic statements. Fair enough.
As it turns out, Congress was foresighted here yet again! In fact, I bet if you asked them back then, “If Europe requires privacy disclosures for this thing called the Internet, what % of people will actually read the disclosures?”, they would have accurately said “0%”… which brings us to their words of wisdom on advertising:
Sec 142: Advertising of down payments and installments
No advertising can state:
That a specific periodic credit amount can be arranged, unless the creditor usually arranges credit payments for that period and amount.
The a specific downpayment is required unless the creditor usually arranges down payments.
Essentially, don’t misrepresent reality. Don’t be a snake oil salesman. Of which… there seems to have been a few?
Sec 143: Advertising of open end credit plans
This covers any advertising of revolving credit. Essentially, you can’t reveal any details unless you reveal all of them, including:
The time period within which credit can be repaid w/o incurring a finance charge
The method of determining the balance upon which a finance charge may be imposed
The method of determining the amount of the finance charge
The periodic rates expressed as APR, if relevant
Sec 144: Advertising of credit other than open end plans
This covers credit sales and other closed-end credit offerings, with the exception of advertisements for residential real estate. That being said, it’s pretty simple.
Rule #1: If you state the rate of a finance charge, it needs to be stated in APR form.
Rule #2: If you state any one detail (e.g. down payment, number of installments, etc), you need to state all of them, including the amount of the loan, the down payment, the payment plan, and the finance charge in APR form.
Sec 145: Nonliability of media
One last thing: if you state some nonsense in your ad, the owner of the publication or billboard is not at fault. I guess this was back when there was a newspaper lobby?
What did TILA really mean?
Practically, this act leveled the playing field for lenders and consumers. By defining and requiring disclosure of finance charges, consumers are able to shop around for loans and credit offerings.
Whereas before it would take someone with a master’s in accounting to understand the effective cost, now… well maybe you too could understand? I mean, only 10% of people had a college degree and 40% had a high school degree. So maybe not quite. But they did spend some formative years dealing with a distraction across the ocean!
Nonetheless, it sounds like a pretty good improvement to me. I mean I guess you could say, “but this act says nothing about what the rates can be!” And you’d be correct. But Congress would probably reply, “if you believe in markets, which is as American as fighting Nazis, then you shouldn’t need to state them.” If everyone is forced to disclose standardized rates and there is no Sherman-Act-violating monopoly, the rates and prices should compete their way down. Banking should become a commodity. I guess it kind of has?
The other big win was the progress made to protect home ownership. Whereas prior to the act, consumers could easily sign into a house-backed loan or credit line without an understanding of the terms, now consumers not only get standardized definitions of the costs but they also have the right to back out. I imagine this saved a lot of marriages.
Overall, I think they did a decent job? I mean, it wasn’t a walk-off home run but definitely a double.
So, what does this mean today?
Definitely something, but unfortunately not as much as it was meant to mean. It was only an amount of time before lenders found their ways around it.
The lasting effects on APR and finance charges have been a net-positive. But it was the way Congress defined APR and “finance charges” that lost them their home run. The definitions were simply not broad enough to keep bankers sitting on their hands.
In fact, a cynic could argue that TILA was the mother of promotional rates. If you go back to the Part II on Credit Transactions and skip over to the section on open-ended credit, you’ll see OPTIONAL in all caps by a disclosure requirement.
What requirement is it? It’s the (optional) requirement that the bank disclose an average APR of sorts. Why would a consumer want that? Well, if you think back to what an APR is, as defined by Congress, it’s the finance charge expressed as percentage form making credit comparable between lenders. But with open-ended credit it’s hard to know what the exact finance charge will be, which makes stating an APR for a specific customer impossible. As such, lenders are able to disclose the promotional rate (0% interest!!) but have egregious late and over-limit fees that kick in after the promotional period is over.
In addition to the promotional rate fiasco, instead of reflecting costs and fees in APRs and “finance charges”, lenders have also moved into unbundling origination costs into a variety of fees in both closed- and open-ended credit products.
Whereas before you may have one interest rate disclosed for an open-ended credit line, now you have fees for balance transfers and cash advances and purchases. All of these result in charges not theoretically included in the definition of a “finance charge,” meaning the APR’s used for comparison aren’t as uniform as the TILA set out to make them.
On the other hand, whereas before you had a standard fee and interest rate for a mortgage, now you may pay the broker up to three times (including once for interest on lender-paid compensation to the broker - WTF?!) and you definitely pay both the lender and broker various fees for preparing documents, checking credit and reviewing your application. That’s not to mention “real estate fees” or “expediting fees.” Congressional hearings keep finding true finance charges that result in APRs much higher than those stated on loan documents, leading to acts like the Home Ownership and Equity Protection Act and the Mortgage Disclosure Improvement Act.
But as we recognized at the beginning, regulation always lags behavior. So what has happened when banks started to push an innovative way to lever fees? Well the government took a decade or two and then did something. And then what happened? Banks got more innovative and the cycle repeated itself.
As such, few risks from public companies are about TILA itself nowadays - it’s been around so long that it would be akin to being worried about changes to the constitution. Instead, the risks from public companies are about acts like the CARD Act. Acts which came as reactions to clean up some of the rather, erm, innovative behavior that cropped up.
And so, we’re left with a disclosure like this from CareCredit:
The CARD Act made numerous amendments to the Truth in Lending Act, requiring us to make significant changes to many of our business practices, including marketing, underwriting, pricing and billing.
Or, my translation (which I am giving away for free should any CFO need language for next quarter’s earnings statement):
The XYZ Act made numerous updates to the Truth in Lending Act, which makes us disclose, as charges and as APR, all of the sneaky ways we’ve come up with to make money in lieu of our business line becoming more of a commodity.
The Truth, The Whole Truth, and Nothing but the Truth: Fulfilling the Promise of Truth in Lending
Explaining the Decline in the Number of Banks since the Great Recession