Should This Be Legal?

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Are there some deals that are so bad that they shouldn’t occur? Or it is enough to say that people have choices, and if they make bad choices, tough?

I had lunch with a bankruptcy lawyer, who followed up with an email story:

Today I was interviewing one of my clients and she said that one of the loans she that she had should have been illegal. I asked her what she meant and she said that the loan she received should never have been permissible. Turns out she had a car loan with Volkswagen with an interest rate of about 3% and a loan balance of approximately $23,000.00 Because she had her home mortgage with Wells Fargo (or at least that is what she thinks is the reason) she received an offer from Wells Fargo for an equity loan on her car! (i.e. just like a home equity loan except the collateral is a car instead of a house) I had never heard of such a thing before. In any event, she agreed to do the deal with Wells Fargo (she needed to money to pay her bills and was much too embarrassed to go to family and friends) so she agreed to the refi and at closing she received $4850 in cash, Wells Fargo received $1300 in fees and the total amount of the debt went from $23,649 (the amount owed VW on the original car financing) to, hold on to your seats, $48,852! The interest rate on the new loan was a mere 16.24% (remember the old rate with VW was approximately 3%). Of course she defaulted and Wells Fargo repossessed the car and is now seeking its deficiency balance. Amazing to see an equity loan on a rapidly depreciating asset but when she received the loan Wells Fargo told her that she had paid down her car loan so quickly she had accumulated equity and they had a way to get the equity now.

The Wells Fargo loan was made in 2006 — the cost of the new financing was $17,900 — almost as much as the balance (i.e. $23,649) then due on the original note with VW. Also, the term of the new loan with Wells Fargo — 72 months, on a 2005 VW Passat!

The woman in the story got an immediate benefit ($4850 in cash), and that saved her some serious embarrassment. But these charges are head-snapping.

What is the best way to think about this? The woman is an adult, she received a benefit, she is stuck with the deal. The company’s terms are unconscionable, disclosure was inadequate, and charges at these rates should be banned.

Or is there a third option that nudges toward a more rational decision, but that leaves open a number of degrees of freedom? So, for example, should this be permissable, but only if

1) there are very, very aggressive disclosures
2) the consumer seeks out the deal
3) some form of third-party advice is available.

In other words, are there other nudges that would maximize consumer benefits? Yes, I’m reading Richard Thayler’s and Cass Sunstein’s book Nudge, and it makes me think about consumer credit.

The current system seems plainly wrong to me. The question is whether nudges can work, or if some deals are bad enough that they should be banned outright. No one can buy an exploding toaster, even if it would be a little cheaper or even if the buyer was warned. But perfect safety is not required, and someone can still start a fire with a toaster. What’s the right approach with financial products?

If a regulatory opportunity opens up so that it is possible to get more effective consumer protection, we may need to think about right way to go.

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