Let's punish lenders of easy credit

U.S. households with at least one credit card, according to the Federal Reserve Bulletin:

• 1977 -- 38%.

• 2001 -- 76%.

Low-income households (bottom 20% of all households) with at least one credit card:

• 1977 -- 11%.

• 2001 -- 43%.

Total owed on U.S. credit cards, according to CardWeb.com:

• 1990 -- $172.6 billion.

• 2006 -- $745.1 billion.

Make lenders more responsible

So White has proposed a rather elegant solution: Penalize the lenders who continue to push credit on the weakest borrowers.

To understand how this would work, you need to understand the difference between "rational consumers" and "hyperbolic discounters."

We rational consumers are the ants in the ant-and-grasshopper story, saving for a rainy day and paying our credit card balances in full every month. Hyperbolic discounters, by contrast, want to start saving at some point in the future, but in the present they want to spend.

"Thus a hyperbolic discounter is like a person who always wants to start dieting tomorrow, but never today," White wrote. Each month, "they resolve to start paying off their debt, but when the next bill arrives they consume too much and postpone repaying until the following month."

Hyperbolic discounters make up a good chunk of the households that Synovate refers to as high-risk. About 28% of U.S. households are using more than 30% of their credit limits, Synovate says, and half of those are using more than 75%.

A look at possible solutions

The changes in the bankruptcy law should have made all borrowers more cautious, because erasing debt has become more difficult. But we rationals have always been cautious, and the live-for-today hyperbolic-discounting grasshoppers don't think that far ahead.

Because of that, "just moving the rules of bankruptcy in a pro-creditor direction is at best a very partial answer," White wrote. "Instead, an appropriate policy response to this kind of over-borrowing must both discourage hyperbolic discounters from borrowing too much and penalize lenders who take advantage of hyperbolic discounters' tendency to over-borrow."

Some economists have suggested fencing in creditors by doing away with rewards for credit card use, which they say encourage over-borrowing. But that, of course, would penalize us rational types. Another solution, which I support, is returning to old-school usury laws, which limit how much interest lenders can charge. Unfortunately, that doesn't seem to be in the cards.

A third option: Change how debt is treated in bankruptcy courts. Instead of treating all credit card debts and other unsecured loans the same, as we do now, White suggests treating loans differently depending on when they were made and how indebted individuals were at the time the loan was extended:

• First, the courts would figure out reasonable debt loads for rational consumers at various income levels.

• Debts above those levels would be eligible to be erased in bankruptcy.

• When multiple lenders were involved, debts would be ranked in chronological order, with the most recent being discharged first.

Determining "rational" levels of debt needn't be difficult. We could say that any credit extended to people using more than 30% of their current credit limits, or whose total debt payments (mortgage, car loan, student loans, credit cards) exceed 40% of their incomes, qualifies as irrational. Loans extended to these folks after their debts hit these levels would be eligible for expedited erasure in court. No means testing, no burdensome paperwork -- just cancel the debts, and it's done.

If lenders are rational, this system should discourage them from continuing to offer money to already-overextended grasshoppers. We'd be saving the least sensible among us from themselves and short-circuiting a lot of family financial and emotional distress.

Liz Pulliam Weston's new book, "Easy Money: How to Simplify Your Finances and Get What You Want Out of Life," is now available. Columns by Weston, the Web's most-read personal-finance writer and winner of the 2007 Clarion Award for online journalism, appear every Monday and Thursday, exclusively on MSN Money. She also answers reader questions on the Your Money message board.

Published Dec. 6, 2007

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