The Consumer Financial Protection Bureau released a "preliminary outline" of proposals shortly after midnight aimed at addressing one of the persistent problems of the credit market:  "payday loans" with triple-digit interest rates that often become debt traps for borrowers. This is an eary public step in a long process that will test the young agency's ability to regulate an industry that sells a dangerous product to consumers while claiming that borrowers know exactly what they're getting into - as at least some borrowers undoubtedly do.

Although storefront payday lenders do not now operate in Pennsylvania or New Jersey, consumers everywhere are exposed to the risks via Internet-based lending.

Even before the formal release, advocates at organizations such as National Consumer Law Center and the Pew Charitable Trusts warned that the CFPB's alternative approaches could expose borrowers to risky loopholes.

In a statement embargoed until 12:01 a.m. the CFPB said:

Today the Consumer Financial Protection Bureau (CFPB) announced it is considering proposing rules that would end payday debt traps by requiring lenders to take steps to make sure consumers can repay their loans. The proposals under consideration would also restrict lenders from attempting to collect payment from consumers' bank accounts in ways that tend to rack up excessive fees. The strong consumer protections being considered would apply to payday loans, vehicle title loans, deposit advance products, and certain high-cost installment loans and open-end loans.

"Today we are taking an important step toward ending the debt traps that plague millions of consumers across the country," said CFPB Director Richard Cordray. "Too many short-term and longer-term loans are made based on a lender's ability to collect and not on a borrower's ability to repay. The proposals we are considering would require lenders to take steps to make sure consumers can pay back their loans. These common sense protections are aimed at ensuring that consumers have access to credit that helps, not harms them."

Today, the Bureau is publishing an outline of the proposals under consideration in preparation for convening a Small Business Review Panel to gather feedback from small lenders, which is the next step in the rulemaking process. The proposals under consideration cover both short-term and longer-term credit products that are often marketed heavily to financially vulnerable consumers. The CFPB recognizes consumers' need for affordable credit but is concerned that the practices often associated with these products – such as failure to underwrite for affordable payments, repeatedly rolling over or refinancing loans, holding a security interest in a vehicle as collateral, accessing the consumer's account for repayment, and performing costly withdrawal attempts – can trap consumers in debt. These debt traps also can leave consumers vulnerable to deposit account fees and closures, vehicle repossession, and other financial difficulties.

The proposals under consideration provide two different approaches to eliminating debt traps – prevention and protection. Under the prevention requirements, lenders would have to determine at the outset of each loan that the consumer is not taking on unaffordable debt. Under the protection requirements, lenders would have to comply with various restrictions designed to ensure that consumers can affordably repay their debt. Lenders could choose which set of requirements to follow.

Ending Debt Traps: Short-Term Loans

The proposals under consideration would cover short-term credit products that require consumers to pay back the loan in full within 45 days, such as payday loans, deposit advance products, certain open-end lines of credit, and some vehicle title loans. Vehicle title loans typically are expensive credit, backed by a security interest in a car. They may be short-term or longer-term and allow the lender to repossess the consumer's vehicle if the consumer defaults.

For consumers living paycheck to paycheck, the short timeframe of these loans can make it difficult to accumulate the necessary funds to pay off the loan principal and fees before the due date. Borrowers who cannot repay are often encouraged to roll over the loan – pay more fees to delay the due date or take out a new loan to replace the old one. The Bureau's research has found that four out of five payday loans are rolled over or renewed within two weeks. For many borrowers, what starts out as a short-term, emergency loan turns into an unaffordable, long-term debt trap.

The proposals under consideration would include two ways that lenders could extend short-term loans without causing borrowers to become trapped in debt. Lenders could either prevent debt traps at the outset of each loan, or they could protect against debt traps throughout the lending process. Specifically, all lenders making covered short-term loans would have to adhere to one of the following sets of requirements:

The warnings?
National Consumer Law Center Associate Director Lauren Saunders says:
"Despite the strong fundamentals of the CFPB's approach, loopholes would permit some unaffordable high-cost loans to stay on the market. The CFPB has taken an 'either/or' approach: 'prevention or protection.' But borrowers need both. Lenders must be judged both on whether they evaluate affordability before making a loan and also on whether those loans default, roll over or are refinanced in significant numbers.
"The proposal would permit up to three back-to-back payday loans and up to six payday loans a year. Rollovers are a sign of inability to pay and the CFPB should not endorse back-to-back payday loans.
"The proposal would permit a triple-digit six-month installment loan if payments are limited to 5% of the borrower's gross income, regardless of the borrower's expenses or debts. That is a dangerous approach that blesses unaffordable high-rate loans. Looking only at income ignores key elements to evaluate affordability: the borrowers' expenses and how the loans perform in practice. The 5% threshold is loosely based on the Colorado payday loan experience. Yet Colorado's data show that 38% of state payday borrowers default and nearly half of larger loans are 'flipped' loans taken out the same day as an early payoff of the previous loan.
"It also is not enough to evaluate individual consumers' ability to pay at the outset of a loan. Any business looks at how its loans perform overall and the CFPB should do the same. A lender that makes triple-digit loans with high default rates, high numbers of bounced payments, or other indicators of unaffordability should not get a pass.
"The CFPB does not have authority to cap interest rates which is the single most effective way to curtail predatory lending. State interest rate caps will remain critical even with federal rules to regulate payday loans.
Nick Bourke, who heads Pew's small-dollar loan project, says:
"In its proposal, the CFPB mostly recognizes that affordable payments are the key to fixing the small-loan market—and that is a good thing. Unfortunately, the 'short-term, protection' section of the proposal is a loophole that would devastate borrowers by allowing balloon-payment loans. Instead, the CFPB should require that all loans have affordable payments, which is what the vast majority of the 12 million Americans who use payday loans want the bureau to do.
"The ingredients are there for success if the CFPB closes the balloon-payment loophole. Unaffordable balloon payments are harming consumers today, and a strong ability-to-repay rule can fix that. Payday loans take one-third of a borrower's next paycheck, and title loans take half of monthly income. That is far too much: Research shows that most payday borrowers can afford to spend no more than 5 percent of their paycheck on a loan.
"The CFPB should stay focused on ensuring that all small loans fit within borrowers' budgets. And we know that can work. Colorado's successful 2010 payday loan reform, requiring all loans to have affordable installment payments, proves that a market without balloon-payment loans works better for borrowers while keeping credit widely available."
In a statement also embargoed till 12:01 a.m., CFPB Director Richard Cordray called the agency's announcement a "preliminary outline," and concluded:
"We are releasing this outline to kick off our efforts to solicit specific feedback from small entities that will be affected by this rulemaking. As we are getting this feedback, we will also continue to consult with consumers, industry, and others. We will then formally issue a proposed rule and provide opportunity for everyone to comment. We will move as quickly as we reasonably can, but we will be thoughtful and thorough as we continue this work, in accordance with our best lights about how to address these issues.
"In the end, we intend for consumers to have a marketplace that works both for short-term and longer-term credit products. For lenders that sincerely intend to offer responsible options for consumers who need such credit to deal with emergency situations, we are making conscious efforts to keep those options available. For consumers who need more time to repay, there should continue to be opportunities available for affordable installment loans. But lenders that rely on piling up fees and profits from ensnaring people in long-term debt traps would have to change their business models. Consumers should be able to use these products without worrying that they will end up stuck in a deep hole with no way out. We urge you to join us in helping to achieve that goal."
The CFPB is kicking up a firestorm as gently as possible. But that's what Congress, in the aftermath of a financial crisis triggered by overly loose regulation, created it to do.