Elizabeth Warren Starts a Credit Crunch

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The Senate is expected this week to consider the conference report on the financial regulation reform bill. One plank of this bill is the establishment of a new Consumer Finance Protection Bureau. Given that it’s hard to argue against more “consumer protection,” it is worth reviewing the impact of a related effort by Congress in 2009 that focused on credit cards.

Many users of credit cards face high rates and seemingly arbitrary gimmicks. Rates can go up at any time; users face penalties for paying late; and credit lines (or limits) may be cut for any reason. Yet, many consumers remain dependent on such forms of revolving credit to weather shocks or meet unexpected bills.

In an attempt to legislate away the “bads” of credit cards, Congress passed a little-known bill – the Credit CARD Act of 2009 – introducing drastic regulations on the activities of credit card companies. Under the provisions of the new law, credit card companies could not arbitrarily alter rates, limits, or fees. In passing the bill, Congress was influenced by the work of Elizabeth Warren, who has argued for stronger consumer protection in this area. Fittingly, Warren is also the top preference of Congressional Democrats to be the first head of the CFPB.

While the aims of the bill were laudable, the measure has led to numerous consequences that were perhaps unintended from the point of view of lawmakers. First, providing access to revolving credit (that’s not backed by assets) is an expensive business. Credit card companies charge relatively high fees to recoup expenses, including consumer write-offs.

Though the law was intended to take affect in February of this year, it had an immediate effect as credit card companies raced to raise rates and cut credit lines while it was still legal to do so. For instance, this graph from Robert Hall shows how interest rates paid on credit cards started rising in the first few months of 2009, exactly when the credit card bill was passed. Credit card rates were stable in prior months, when the economy was doing poorly. Interest rates in other categories – such as mortgages and car loans – stayed flat or declined over the same period. This all suggests that the passage of credit card reform resulted in higher interest rates on credit cards.

Companies also cut lines of credit for customers. As Jamie Dimon, CEO of JP Morgan, wrote in a letter to shareholders:

In 2009, in addition to the terrible environment, the U.S. credit card business faced fairly dramatic changes because of a new law enacted by congress in May. The new law restricts issuers’ ability to change rates and prohibits certain practices that were not considered consumer-friendly. These changes alone are expected to reduce our after-tax income by approximately $500 million to $750 million – but this could possibly change as both consumers and competitors change their behavior.

In the future, we no longer will be offering credit cards to approximately 15% of the customers to whom we currently offer them. This is mostly because we deem them too risky in light of new regulations restricting our ability to make adjustments over time as the client’s risk profile changes.

We reduced limits on credit lines, and we canceled credit cards for customers who had not done business with us over an extended period.

In fact, the industry as a whole reduced limits from a peak of $4.7 trillion to $3.3 trillion. While we believe this was proper action to protect both consumers and card issuers, doing so in the midst of a recession did reduce a source of liquidity for some people.

To be sure, Dimon’s argument should be taken with a grain of salt. The industry may also have lowered some credit limits for reasons unrelated to the passage of the law. But, this is a very plausible account – if you make it harder for credit card companies to supply credit, they will supply less credit – and is consistent with the data.

Even if this contraction in credit is desirable in the long-term, the timing of this law – coming during the depths of the recession – has to be questioned. Just as families were struggling most to make ends meet and the Federal Government was attempting to restore demand through enormous stimulus programs, a new consumer protection law resulted in a credit crunch for millions of Americans.

Given the substantial downsides of the credit card bill, it should be expected that policies based on the same ideas will have similar results. Even if the financial reform bill is signed into law this month, it will take months for the new Consumer Finance Protection Bureau to be up and running. Given the lessons of the credit card bill, perhaps it wouldn’t be so bad if the Bureau didn’t get started until after the economic recovery was assured.