Thanks for inviting me. I’m here tonight because I’m a big fan of Alternatives. You forget it when you look at the range of activities Alternatives has for its members and what it does in Ithaca, but Alternatives is actually a very tiny bank. In the banking world, you say a small community bank has 200 million in assets. Well here’s Alternatives with 40 million. But its influence obviously is much larger than what its assets would suggest.

A number of years ago I did a research project where I was supposed to find credit unions that were making special efforts to serve low and moderate income households around the country, and I was traveling to different states, out in California, Texas, Florida and so on. Everywhere, I talked to these credit union members and said "who else should I be talking to?" and everywhere people would say "you ought to see the Alternatives Federal Credit Union in Ithaca, New York" and of course I did come and visit and that’s where I learned about it and became one of its biggest fans.

What I’m going to talk about tonight is really three questions: First I’m going to talk about the observation that many low and moderate income households pay more for financial services than do middle and upper income households and ask why. The second question I want to ask "what’s the problem with that?" In other words, how big is this problem? And the third question "what should we do about it?" And in talking about what we should do about it, I’ll relate somewhat to the programs that Alternatives has.

Let me first start with the observation that many low and moderate income households pay more for financial services and why is that. I think the answer is that there are both good reasons and bad reasons for it, or legitimate and illegitimate reasons. Let me start with the legitimate reason, and that is, that many low and moderate income households are higher risk borrowers; not all, but many. Just to give a suggestion of how big the problem is, Freddie Mac agency, two years ago did a survey of households with incomes of $25,000 and under, and they asked them a whole series of questions about their bill paying habits, debt income ratios and so on. And based on their answers, they classified about 36% of those households as having quote, "bad credit records." In other words, they wouldn’t be good candidates for most mainstream lenders. When I’m talking about many low income houses having bad credit records, I’m not saying all; obviously 64% did not in that study, but it’s a very significant group. That’s millions and millions of people. But I’d say there are both good and bad reasons that low and moderate income households have these bad credit records. The bad reason is that for some people there is no spending discipline, they place little importance on paying bills or debts. But there are some good reasons and that is it’s darn hard to save when you have low income. About 20% of the households that have incomes of $25,000 and below, have no savings whatsoever; in fact they have no deposit account of any type. And the other 20% have only very modest savings, so on a month to month basis their financial savings is about $500 or below. So there’s 40% of the households with incomes of $25,000 or below that have essentially no to very modest financial savings.

What that means is that you have no financial margin of safety, so every time an economic crisis arrives or an economic lump hits you, you have nothing to fall back on and it becomes a major household crisis. And these kind of disruptions, which hit us all occasionally, are much more common for lower income households. Lower income households or moderate households are more likely to have employment disruptions. They’re also less likely to have health insurance, so when health problems hit that becomes a major expense. And they’re more likely to have an old car or a home with a heating system perhaps that’s older. So, these kinds of economic disruptions hit them more often and many of them have very little financial savings in which to fall back on. So, what do they do? When these crises hit, you delay paying some bills, you’re juggling quickly and you’re trying to manage your way through the crisis, and that means delaying paying bills, in some cases defaulting on obligations, and that puts you in this high risk category. These relegate characteristics - you’ve got a history of not paying bills on time - is what puts you in the subprime market, and it’s a higher risk market. Lenders in that market find when they lend to people who have these characteristics, their loss rates are higher and also costs of monitoring borrowers is higher and they pass those costs on, and that’s what I call in subprime lending "the legitimate side." I’ll come back to that in a little bit.

The illegitimate side is predatory lending, or more commonly, "swindling." Predatory lending means charging someone more than what their risk profile would indicate is justified. Predatory lending, in other words, means selling something for more than you know it’s worth. And we are all vulnerable to predatory financial services. It’s been in the headlines: the allegations about Merrill Lynch selling stocks to people for prices that people within Merrill Lynch thought were probably not justified. And you’re particularly vulnerable to predatory business practices where there’s a gap in the knowledge between the buyer and the seller. So, if I hold up an apple and say "I’m selling this apple, what will you bid for it?" we can have a hard negotiating session here, and you could say "well, that’s fair," I’ve got the apple, you can see the apple and examine it and so on. If I hold up an apple, though only I know is rotten to the core, and you don’t know it and I sell it, then you say "that’s swindling." If I don’t tell you that information, then it’s swindling. It’s that gap in knowledge where you can take advantage of another party.

Low and moderate income households are particularly vulnerable to predatory lending, because on average they have lower education levels, so there’s more asymmetry of knowledge there, and I think more importantly than that, their social networks are less likely to be financially sophisticated. There are studies are out there. How do people get information about financial products? Getting a mortgage - how do I get information about that? What studies show is that most of the time, people use informal networks. So, you ask around at the office, you say "you know, I’m looking for a mortgage, where did you get your mortgage?" Or, "someone made me an offer for this mortgage, does that sound right," or, "I’m thinking of getting a car deal." You ask your neighbor, you ask the people you work with and so on.

Well, you know there is a lot of segregation by income level in the U.S., and so if you’re a low and moderate income person, you work along low and moderate income people and you live alongside low and moderate income people. So, just as you may have lower levels of education, less experience with financial system, so do the people you interact with. As a middle or upper income person, you may work alongside bankers or lawyers or whatever; or they’re your neighbors, so when you ask, you get a more sophisticated response than someone who has low or moderate income. So often, that makes them particularly vulnerable targets for predatory lending.

What are some of these predatory practices? Well, it means steering the customer to a higher loam rate than what the customer’s risk rating would justify. So, for example, some high rate lenders only offer high rate loans. And, occasionally they get someone who comes in with a prime credit rating. They should refer that person to a lower cost lender, but many will go ahead, because the person doesn’t know any better, and up and sell them a high rate loan. They also will often add unnecessary high cost credit insurance or other fees, so they’re adding other products that the person doesn’t need; or they’re overpricing. They will engage in loan flipping: very frequent renewals of the loan with fixed charges every time, which effectively raises the rate on the loan. They may make a home equity loan with artificial charges, without regard to the borrower’s ability to pay out of income, so essentially they’re stealing the equity, or trying to steal the equity, and often these predatory practices are packaged with home improvement scams.

Why is this such a problem? Well, in the case of predatory lending, I think the answer is obvious; that is, we don’t like it when anyone is ripped off. Even in the Merrill Lynch case we say "that’s not fair" and that brings up outrage in us. It’s particularly upsetting when someone’s swindling people who are already struggling. I think that’s particularly vicious. So, you read these heart-rending accounts of older people who have equity in their home who are perhaps not so financially sophisticated and someone comes along and essentially steals the equity in their home. Those sorts of practices are particularly outrageous and obviously upsetting. In the case of subprime credit (remember I said "giving risk-based lending is legitimate") that’s not the same thing, though, I’m not saying there’s no problem. That someone who’s struggling financially has to pay more for financial services because that person has a history of not always paying bills on time, there’s still a problem there. That makes it very hard for that person to get out of the situation struggling financially.

So, for example, if a household gets, say, a $6,000 loan to buy a used car and has to pay a 30% annual interest rate to the car dealer because they have a history of not paying bills on time, that means the interest on the car payments that first year are going to be $1,800 whereas if they were a prime credit borrower they might be, say, $600. That’s $1200 additional payments for the car, and that’s going to make it much harder to build up any savings and get out of the situation. Or another example: Imagine a household with $20,000 of income and it gets a $50,000 home mortgage, but because of a subprime credit history, they have to pay 4% risk premium. That means they’re going to pay about $2,000 more a year in interest payments than they would if they were a prime borrower. Think about it: $2,000 out of their $20,000 income, if you’re trying to support a family, is a big chunk of money. So, even though from the lender’s point of view, you say "yes, I understand why the lender has to pass on these costs," from the social point of view you have to say "still, there’s a real problem here." That’s going to make it very hard for people to make it out of tough financial situations.

Well, what should we do about it? In the case of predatory lending, I think the case is two-fold. One is regulation. I’m not going to talk about the ideal set of regulations here, I’m just saying it makes perfect sense for the government to require lenders, for example, to make easy disclosure of loan terms so people can understand them, to enforce standardized disclosure terms so its easy to compare terms across various financial service providers. It’s appropriate for government to prohibit or discourage some sort of loan contract. So for example, I don’t want to get into technical details, but what’s called the HOEPA, or the Home Ownership and Equity Protection Act, says that when you make home equity loans as an interest rate above a certain trigger point, there are extra protections that the borrower gets: Six days to decide whether they want to rescind that contract rather than the standard three. There are restrictions on using balloon payments on those sort of loans, and I think those kind of protections are perfectly appropriate and that’s legitimate for the government to be active in that area, trying to set restrictions to reduce or limit possible predatory practices.

But there are also limits as to what regulation can do. For example, you can’t simply push down, with laws, interest rates to prime levels and expect people who are subprime borrows to still get credit. So you can’t, by law, mandate that everyone will get a low interest rate, or people with high risk simply won’t get access to credit. The other problem with regulations is there are ways for clever, for motivated people to evade the regulations. So, for example, if you force me to offer a low interest rate on a used car that I’m selling, what I can do is just raise the price of the car to the person rather than raise the interest rate. On the home repair case, I can do shoddy work with home repair, lowering my finance charges, but doing shoddy work on the home repair. I can encourage you to buy another product that you might not want to buy, so I’ll offer you a low interest rate loan but I’ll make it clear that this will only be available to you if you buy something else, maybe some credit insurance I’m selling that you don’t really want. One of my favorites is quite common in Texas, called the sale buy back. In Texas there are limits on the interest rates small lenders can charge, so a common way to evade it is you have a person come into your office and say "do you have a television at home?" And the person will say "yes." What you say is "I can’t make a small loan to you and charge a high interest rate, that’s against the law; but what I’ll do is I’ll buy your television from you right now. You don’t even have to bring it in, just leave it at home, I’ll buy your television from you right now for $100. Two weeks from now you come in and buy it back from me for $120." That’s kind of a clever arrangement. Constantly, there are legal challenges to these things. People are coming up with clever arrangements to get around regulations.

I think regulations can’t do everything you’d like to do with predatory lending. And that brings me to the second point, which is the other thing you need to use for predatory lending, which is financial literacy efforts and efforts to replace these missing social networks. That is, help people understand the costs and benefits of various financial services and encourage them to shop around. For more complicated services such as mortgages, insurance, decisions that you have to make about your 401k and so on, I think it’s important to have institutions like Alternatives, where a person can go in and say "here’s something I’m being offered, what do you think about it?" So, you have this not for profit Alternatives. Mini low income housing development agencies play this role, and I think that’s essential. I’d like to see more government funding to go into that to make it a little less patchwork. But I think that’s the two things: the regulation with the financial literacy and the advice that will help reduce predatory lending problems. I commend Alternatives for its activities.

For the subprime issue, I think the answer is two-fold as well. First, which Alternatives can’t really do anything about, is raise peoples’ incomes and provide improved access to health insurance so they don’t face this problem in the first place. So, it’d be helpful to have a more generous earned income tax credit and easier access to health insurance, especially for low and moderate income households. Alternatives can’t directly do anything about that, but I do know that indirectly it’s active in its surveys of what is a living wage in this region, and I think that is very commendable. I think the other approach to subprime problem is financial literacy, and here the goal is two-fold; that is, one is remedial, so people who have bad credit ratings, you work with them. You try to show them how to clean those up. So, you say "look, write those creditors. And if you’re disputing a charge, here’s how you do it. If you acknowledge that you owe that debt, then let’s work out a payment plan." That sort of one-on-one remedial help is very important to help people move from the subprime category into the prime category. And the other approach is preventative. That is, help people build savings to make them less vulnerable to periodic financial crisis. This means helping people set a list of goals, teaching them behavioral tricks such as ‘pay your self first’ and other things. I know Alternatives promotes that. And easy access to savings vehicles; so providing people with low cost savings and checking accounts, such as Alternatives does.

Alternatives, I think, has much to be commended for: Their credit path, which talks about moving people from living from paycheck to paycheck to transactors; to be small savers then borrowers, then eventually owners through their IDA program.

Let me conclude that the problem is large and it is discouraging to think that there are 20 million households nationally that are largely without financial assets and many of these and others are relegated to the subprime market where they’re exploited by predatory lenders. The up side to this observation, though, that there are 20 million people across the country, is that even a small rate of success means you could benefit millions of people. Now, Alternatives sitting here in Ithaca, isn’t going to be able to have a direct influence anywhere beyond Ithaca, and you could say "well, that’s a small part of the problem." But remember credit unions all across the country are watching Alternatives, Alternatives is at the forefront of this effort, and it gets to be a model to encourage other credit unions and with thousands of credit unions across the country, I think that could have a big impact. So I say to Alternatives, keep up the good work. Your influence is much bigger: Not only is your influence important here in Ithaca, but it’s important across the country.

Thank you.