A Wakeup Letter to Washington

Note to lawmakers: It's high time to take care of unfair costs for consumers. Let's have some change for fair play.

Take a memo.

To: Our new Congress; the President-elect

From: Nickeled-and-dimed Americans

Re: The (other) financial mess

Congratulations on winning your elections. We trust you won't spend too much time celebrating, though. We taxpayers have had to lay nearly $1 trillion on the line to keep the banking and credit system from collapsing. Cross our fingers, it just might work.

Your task now is to reform the financial industry that helped get us into this jam in the first place. Already there's a fervor in Washington to clamp down on the wholesale side of Wall Street's business, to tighten capital requirements and to get on top of derivatives and the other kooky securities investment banks trade.

All good. But please don't ignore the retail end - that is, the way lenders and brokers do business every day with us consumers. That's a mess too. You've allowed these companies, including some of the very ones we're bailing out now, to do pretty much whatever they want to drain us of our money.

Even the most responsible and savvy borrowers among us have trouble avoiding the tricky fees and rate-hike triggers on our credit cards. You've allowed our kids to get sucked into the debt culture before they've even gotten a job to pay the bills.

And then there are the financial products that are just plain poison, like mortgages that homeowners can't possibly repay and loans with interest rates to rival what guys with names like Sammy Knuckles used to charge.

As we're seeing now, irresponsible lending doesn't just hurt the people who take the bait. It can undermine the whole economy.

We aren't saying that lenders shouldn't make a profit. And we aren't saying that we borrowers aren't responsible for our own choices. We just want transparency and safeguards against faulty financial products.

Here's what you should be working on:

Curb Credit-Card Gotchas

We understand the basic bargain behind credit cards (or think we do). For the convenience of charging, we have to pay some interest. If we pay on time, we should get a lower rate because we've proven that there's little risk we won't pay back.

But if we miss payments, we'll pay more - and even get dinged with some penalties. The card issuers call this risk-based pricing. And whenever lawmakers discuss new regulations, issuers strenuously argue that this system must never be undermined, for the good of consumers.

Ken Clayton of the American Bankers Association says that if lenders aren't allowed to charge their riskier customers a penalty, "some people will lose access to credit at reasonable prices."

Well, sure. Of course lenders ought to be able to set rules for borrowers - the only trouble here is the complexity. It seems to us that card companies aren't pricing for risk so much as teasing us with one low rate and then building multiple traps into their contracts to get us to shell out more, no matter how creditworthy we are. After all, virtually anyone can occasionally incur a late fee.

For starters, there are contracts that stipulate that the terms of the loan can change "at any time, for any reason" - which makes us wonder what all the rest of the gobbledygook is there for.

Among the reasons a card lender might choose to hike our rates: We missed a payment owed to someone else. (The lenders' jargon for this is universal default.) And when we're hit with a new rate, it's generally applied not only to new purchases but to any outstanding balances.

Penalty fees have become an important part of the card lenders' business model. According to IndexCreditCards.com, the average late fee is up to $35; the fee for going over the credit limit is about the same. (And those charges accrue interest too.)

Bills are often mailed out uncomfortably close to the due date. Sometimes the deadline isn't just a date but a specific hour. You can even be charged when paying on time: A Washington Mutual card assesses a $15 fee for paying online on the due date.

And then there's the stuff that seems intentionally perplexing. Many cards, for example, offer tantalizing 0% rates on balance transfers while charging a higher rate on regular purchases.

If a customer doesn't pay off the balance transfer immediately, all the monthly payments go to that 0% loan while the balance for the other, higher-rate charges just compounds and compounds.

Another common trick is "double cycle" billing. Here's how it works: Say a cardholder with no previous balance charges $1,200 and pays off $500 when the bill is due. You might think that interest would be assessed only on the remaining $700.

And with some cards that's true. But with double-cycle cards, a customer would owe interest in the next billing period on $1,900 - first on the original $1,200 and then on the $700 left over.

It's tough enough for full-fledged grownups with steady incomes to navigate this credit-card maze. So it worries us when we see that credit-card companies are aggressively pulling in college students. If they're over 18, they don't need a parent's consent to sign up.

A 2008 survey of new college grads for the credit bureau TransUnion found that 24% start their adult lives with more than $5,000 in credit-card debt. Many students have no means of support other than their parents, scholarships or loans.

But if kids don't or can't repay, says Robert Manning, author of Credit Card Nation, lenders "send bill collectors after parents saying, 'Do you really want to ruin Sally's life over $6,000?'"

How to Fix It: We're hopeful that change is coming. "A critical mass is building for reform," says Travis Plunkett, legislative director of the Consumer Federation of America (CFA). Last year the Federal Reserve, which regulates banks, proposed new rules and asked for public comments. An unprecedented 62,000 consumers wrote in.

The Fed's proposal is a good start. If chairman Ben Bernanke actually approves the new rules, they'll ban double-cycle billing, prohibit applying rate increases to old balances and force companies to consider a payment on time if received by 5 p.m. of the due date.

The Fed would also require card companies to apply payments above the minimum proportionally. So if a cardholder who owes $2,000 for new purchases at 19% and $3,000 for transfers at 0% made a payment of $500 over the minimum, the bank would have to apply $200 to the new purchases and $300 to the cash advance. How perfectly sensible.

If the Fed doesn't act or waters down its ideas, then Congress, it's up to you. The Credit Cardholders' Bill of Rights, sponsored by Carolyn Maloney, D-N.Y., passed the House in September.

It would do much of what the Fed proposed and then some. It would bar universal default and "any time, any reason" rate hikes and require card companies to send out bills 25 days in advance of the due date.

The measure would also cut down on surprises. Card companies would have to notify customers of any rate increase 45 days before it went into effect. That would give us more time to make other plans or shop around for a better rate.

In an ideal world, we'd like Congress to go further. If a card has a credit limit, the lender should enforce it, instead of letting the transaction go through and then spanking us with a big fine.

And lawmakers should forget about those complicated deadlines and require lenders to accept a payment if it's postmarked on the due date. If that's good enough for the IRS, it should be good enough for a card company.

But most important, we've really got to protect students. Manning proposes a common-sense solution: Those between ages 18 and 21 should be allowed to have credit, but only if they have some income. Student loans and bailouts from the Bank of Mom and Dad shouldn't count.

Cap Those Crazy Rates

Many states still have laws that limit the interest a lender can charge. But in 1978 the Supreme Court ruled that national banks could charge a consumer the rate of the state where the bank was based.

So a deluge of banks and card companies fled to South Dakota and Delaware, where there were no maximum rates. In response, other states rolled back interest rate limits too. After that, the sky - or perhaps outer space - became the limit for consumer-loan rates.

It's now perfectly legal - and not at all uncommon - to lend money at triple-digit APRs. Sure, you might blame the folks who pay these rates for their troubles - it's true they generally have credit problems - but we're learning now that over-indebted consumers can hurt the whole economy.

This experiment in unrestrained rates should end. Even mainstream companies now feel free to charge rates that might embarrass loan sharks. What makes it more confusing is that those rates are often quoted as fees.

Consider the "courtesy overdraft" protection some banks and credit unions give their customers. Some courtesy: Often without warning, the bank adds, say, $500 to the customer's available balance.

The account holder might see it at an ATM and cheerily use a debit card or checks to pay for groceries, dry cleaning and gas without realizing that his real balance is maybe only $49. The average charge per incident is $20 to $35, plus $2 to $5 a day on the amount outstanding, until the loan is repaid. A $100 overdraft with a $20 fee that lasts for two weeks has an effective APR of 520%.

Even worse are predatory loans that target the poor and near-poor. The most prevalent are offered by so-called payday lenders, who now have more than 22,000 outlets across the country.

The loans work like this: A strapped consumer who needs to pay a bill writes a personal check, usually for $350 to $1,000, for an advance on funds. He gets the cash minus the fee, generally about $15 to $30.

The payday lender holds the check, usually for two weeks, until the borrower's next paycheck comes in. Then the check is deposited. If the borrower doesn't have enough funds to make good on the check, he renews the loan. That's another fee.

The Center for Responsible Lending found that a customer who rolls the loan over the average 10 times a year winds up paying $793 for a $325 loan. "It's a debt trap," says Jean Ann Fox of the CFA. "Once you get in, you can't get out."

How to Fix It: When payday lenders opened around military bases and charged soldiers huge rates, Congress took umbrage and passed the Military Lending Act of 2007. It caps rates including fees on payday and other high-priced loans at 36%, but it applies only to military families. Well done. But why not protect everyone?

Lenders complain that limiting the rates they can charge would hurt some consumers because many people wouldn't be able to get credit at all when prevailing interest rates were high. But if the maximum is pegged to rise and fall with some index, this shouldn't be as big a problem.

Of course, traditional financial institutions could be doing more to reach lower-income borrowers. We're glad to see some credit unions stepping into the breach. In North Carolina, where lawmakers cracked down on payday lenders, credit unions and banks ramped up loans of less than $600 by 37% in four years. APRs there were capped at 36%.

Mop Up Mortgages

You lawmakers don't need us to tell you that there's work to do on mortgages. Right now you're focused on containing the financial damage, helping banks deal with their toxic mortgage-backed assets and trying to stanch the rate of foreclosures. But you should also take a close look at how the mortgage business works at the ground level. It's not pretty.

Here's the basic problem: Too many of the people we deal with when buying a home have no incentive to refrain from chiseling us. It was bad enough that banks were willing to write those crazy no-income-doc, teaser-rate loans that borrowers couldn't repay. But mortgage brokers, whose advice many people relied on, were actually rewarded for steering borrowers into costlier mortgages.

To shop for a loan, brokers charge home buyers a fee and receive a payment called the yield spread premium (YSP) from the lender they recommend. Generally, the higher the rate on the loan, the bigger the YSP the broker receives.

That's hardly a boon for the home buyer. In a 2002 study of 2,000 mortgages, Harvard law professor Howell Jackson found that borrowers paid more when a YSP was involved - $1,046 extra. YSPs, wrote Jackson, "serve primarily to increase compensation to mortgage brokers."

Then there are closing costs. According to Bankrate.com, which conducts an annual survey, in 2008 they ranged from $2,650 in North Carolina to $4,015 in New York.

Some of these fees are simply junk: copying, mailing and other items that should be included in the cost of doing business. Others are services provided by third parties selected by the lender.

Home buyers get little help in shopping for low closing costs. The government requires lenders to provide buyers with a good-faith estimate, but law professor Christopher Peterson of the University of Utah calls it "a joke."

Why? Lenders pay no penalty even if the numbers are a far cry from those on the final closing documents. By that time it's a bit late for the buyer to negotiate.

How to Fix It: In July, Congress passed legislation requiring mortgage brokers to become licensed and take courses, including ethics. That's long overdue. Now it's time to dump the YSP.

Michael Donovan, a Philadelphia consumer lawyer and former SEC trial attorney, argues that the YSP may already be prohibited under federal closing laws, which bar kickbacks. If it isn't, it should be.

The Department of Housing and Urban Development has proposed new regulations for closings - for the third time in eight years. The new rules would require lenders' final closing costs to be firm; third-party services could not be 10% higher than those in the good-faith estimate. Alternatively, and more convenient for the buyer, new regs would allow the lender to offer one all-inclusive price for closing services.

Reform may not be in the cards, however. Already, 224 House members have urged HUD to withdraw these proposals for fear they'll endanger small lenders.

Get a Tougher Watchdog

Finally, we need a government outfit that looks out for us consumers. It's fine to come up with new laws making this or that kind of loan illegal, but lawmakers aren't always going to be able to keep pace with the financial industry's, er, innovations.

We need one strong agency that makes this a full-time job. Call it the Financial Products Safety Commission, as Harvard law professor Elizabeth Warren suggests.

It would approve or disapprove products for sale, set education and licensing requirements for financial professionals who deal with the public, and create uniform disclosures for financial products.

Most important, it would have strong enforcement powers - to issue warnings and recalls and to file suits to block hazardous products. Compared with this year's $1 trillion bailout, these problems may seem like the smallest of potatoes.

But they're big to us. And if you deal with them now, maybe you'll prevent the next crisis.