Financial Literacy is a Failure?

In recent weeks the writings of law professor Lauren Willis have become much more widely distributed, in part thanks to a short piece in Money magazine. (see: http://money.cnn.com/2008/08/25/pf/teaching_money.moneymag/index.htm)

Professor Willis has at least 2 law review articles suggesting in essence that the financial market is too complex for the average consumer and only prescriptive legislation regulating consumer financial products will prevent consumers from taking on higher risk or cost products than necessary.

One 2006 Maryland Law Review article is titled: Decisionmaking & the Limits of Disclosure: The Problem of Predatory Lending and another 2008 in the Iowa Law Review Against Financial Literacy Education. Those who toil on consumer education topics might find the titles alone a little alarming. The articles are worth a read and certainly are serving to provoke discussion.

A few points are worth remembering.

First, regulation and education are complements, not substitutes. Policymakers can, and in fact do, regulate the terms of some products while also supporting consumer education.

Second, from a legal scholar's point of view regulation provides an absolute and highly standardized way to present a solution to a social problem. Economists tend to a bit more skeptical--if there is consumer demand the market will develop a work around almost before the ink is dry on a new law. The markets evolve so fast product regulation is more like a game of whack-a-mole.

Third, Professor Willis is correct much of the data on financial education and disclosure shows non-significant effects, and when findings are significant, plagued by selection bias--that is the consumers most likely to get information are the most motivated and successful even in the absence of education or disclosure. But this points more to failures in research methods and design than in public policy. As a society we do seem to believe education has value; there is not reason to think education only works in certain domains. Moreover, some research is carefully done and shows financial literacy education and disclosures are effective at statistically significant levels. There is not enough research in the field (so says the researcher) on financial education and disclosures, and far too little research on how to deliver information to consumers or when the ideal times to do so might be.

Consumer decisions in financial markets are more complicated than in the past: for example defined pensions are now more likely to be consumer-directed retirement accounts and fixed rate mortgages now come in multiple adjustable rate flavors. Consumers have the capacity to navigate this marketplace without resorting to high cost advisers. Before throwing out the concept of consumer education maybe policymakers need to take a fresh look at what is being attempted and how it can be improved.

Back to school

The thousands of new college students descending on campuses nationally are a keen reminder of how consumers can quickly become mired in credit card debt. College freshman are the target of credit card marketers for several reasons. This is a key time when consumer sign up for cards--many for their first card. Students are also typically cash strapped, thus likely to run a balance and pay interest.

College campuses have a range of policies--some actively work with companies and gain revenue from the marketing of credit cards. Others restrict access to campus property or regulate if card offers are tied to gifts or incentives.

For many students a credit card is a useful tool. Students tend to have expenses related to getting set up to learn (computer books etc) and as such going into debt to invest in future educational gains might make sense. Late night pizzas...not so much. Surveys sponsored by student lender Nellie Mae show more than 3 out of 4 undergraduates have at least one card. Those with cards on average owe more than $2,150. Most get their card their freshman year and many accumulate more than one card.

My own research shows few students look at mandated card disclosures unless directed. They are easily misled to think the introductory teaser APR is the actual APR. Almost none will look at details such as a default rate which might be three times the normal APR if the student defaults on any loan of any kind.

Thankfully most student credit cards have low balance limits. Some students may need these kinds of offers--and to make a few mistakes--to learn some hard financial lessons.

Campuses that limit offers to certain areas might be on the right path. Certainly students seeking a card can find one, but impulse applications at the bookstore might not be as prudent. Limiting free T-shirts, iPods or other features makes sense too--these may become a distraction from the actual terms and conditions of the card.

But most of all students need to learn, after all, and there is more most campuses can do. Simple brochures and email messages are a good start, as are workshops or seminars on financial topics. One small survey I conducted with undergraduates at Cornell University, where many students came from affluent backgrounds, showed more than two-thirds of students would attend a workshop on credit and financial management if it was offered at a convenient time and place.

Parents, or course, play a key role. My surveys show 87% of undergraduates say they learned about financial management from their parents. The number two source: the internet, at 40%. About one-third of the students I surveyed expect their parents to pay their bills for them and another third pay their own bills but have asked their parents for help in the past.

Parents with college students might consider having a regular conversation about credit card debt and budgeting with their kids. When they apply for a card ask questions about the APR and ask them what they think that means. Ask them to tell you about other fees--such as for using the card at an ATM to get a cash advance. All this will focus attention on costly features and details. And let them know your expectations about their spending. Even if you are willing to bail them out in an emergency, be sure they understand you are not a co-signer and the card is their responsibility. Since the majority of students use credit cards for convenience a low balance should be just fine for most students (often $500-1,000, or the cost of an unexpected plane ticket or emergency car repair). Beware that the card issuer may offer increased balance limits over time. Parents can discourage students from taking larger limits and make sure the student knows a larger limit just means larger bills.

With the proper tools, information and support, most students will do just fine with their first foray into the credit market. But parents and university administrators need to pay attention too.

Highlights of Student Credit Card Survey
Cornell University, Spring 2008 (n=182)

Use of Disclosures:

• 40% incorrectly identified the APR as the 'teaser' balance transfer rate
• 32% incorrectly identified APR as not changing or varying
• 40% incorrectly identified late payment fees
• 33% did not understand 'default rate' changes with late payments on other credit cards
  

Use of Cards:

• 55% used cards for convenience and always paid off the balance
• 15% carried a balance of $1,000 or more
• 20% paid a late payment fee in last 12 months
• 35% report using their card more when they feel stressed
• 75% report it is "very easy" or "easy" to get a credit card
• 10% reported ever being denied for a credit card
• 25% report getting credit card offers in the mail at least weekly
• Most popular marketing features: rewards or bonuses for making charges
• Least popular marketing features: free t-shirts or discounts for signing up
  

Attitudes:

• 69% report being "very likely" or "likely" to attend a seminar on personal financial management offered on campus at a convenient time
• 36% report "next to my student loan my credit card debt is nothing"

New Forms of Credit Disclosures?

Economist Richard Thaler and law professor Cass Sunstein ran an article in the Wall Street Journal suggesting policy makers re-look at consumer disclosures for credit products (and even cell phones). The authors mostly promoted themes from their new book "Nudge: Improving Decisions about Health, Wealth and Happiness." But in general they have a good point -- too often disclosures and consumer information strategies are dismissed. Would better disclosures have avoided the current subprime mortgage default problem? Surely not. But at least at the margin some consumers would have had more information.

I have some research in process showing that states requiring a signed "YOU MAY LOSE YOUR HOME" statement on disclosure forms for very high cost loans reduces the probability a consumer will go through with a loan offer from a lender. The effect is not large, but not zero either.

Thaler and Sunstein wrote "the Fed can substantially improve its proposal by requiring credit issuers to disclose relevant information electronically in a standardized, machine-readable format. In one simple stroke, new disclosure requirements would dramatically improve the current situation."

The key to their solution is that 3rd party providers will create a market to supply consumers with easy to read reports and recommended actions--much like investment tracking firms like Morningstar do in the mutual fund market.

They argue "electronic disclosure will merely supplement the current written disclosure requirements...the electronic disclosure we are advocating would make it much easier for nonprofit groups to help the poor make better choices because they could have all the information they need right on a computer."

Would it work? It is hard to say for certain, but at least this suggests technology can enhance paper and pen information disclosures. Before deciding consumer disclosures are a failure, policy makers ought to explore how disclosures--many of which are regulated by a hodgepodge of agencies and using forms dating back to the 70s--can be modernized and refined to better impact consumer behavior.

I agree with Thaler and Sunstein when they wrote"Some politicians have clamored for banning some types of mortgages, especially in the subprime market, but low-income or high-risk borrowers are often the ones that can particularly benefit from financial innovation." Product bans such as they fear are probably unlikely to happen, and in fact the private market has shut down most risky lending on its own. It seems likely these products will return, however. It may take a few years but $1000 downpayments, low credit scores and high debt to income ratios will be common again in the mortgage market before long. In the meantime, exploring better ways to communicate the terms, costs and risks of products to consumers should be a high priority. The Federal Reserve Board and FTC have some research efforts under way on the wording of disclosures, but more testing of innovations such as Thaler and Sunstein discuss has merit.

See the full op-ed at:

http://online.wsj.com/services/article/S B121858695060335079-search.html

Welcome

I am new to blogging but decided with all of the current events in consumer finance policy I should take a crack at posting interesting research, policy debates, articles and other information as it comes up. Thanks for looking!