Friday, May 22, 2015

Credit Unions, Usury, and the Rise of Consumer Credit in the United States

Credit unions were one of a number of American institutions that tackled the credit problems of the urban working class in the early 20th Century. Taken together, these institutions helped to demonstrate that industrial and salaried workers were safe credit bets, opening the door to consumer lending by commercial banks and helping to foster our "consumer culture."
The question of credit for Jane and Joe worker was bound up with the issue of usury. "Usury" narrowly defined means the charging of interest on a loan, but more broadly it can mean "excessive" interest, illegal interest, or simply dishonest or abusive lending practices.
The Judea-Christian heritage frowned on the charging of interest, particularly on loans to individuals in need. In Exodus (22:25 RSV) we read: "If you lend money to any of my people with you who is poor, you shall not be like a moneylender to him, and you shall not exact interest."
Nehemiah (5:1-6), hearing the complaints of the people of Israel in a time of famine, scolds the nobles and says, "Let us abandon this exacting of interest. Return to them this very day their fields, their vineyards, their olive orchards, and their houses, and the percentage of money, grain, wine, and oil you have been exacting from them." As a result of such teachings, Jewish law forbade charging interest on loans, except loans to non-Jews.
The New Testament also encouraged generosity in lending without expectation of gain and voiced suspicion of accumulated wealth. The Christian church continued the ban on lending at interest, but, of course, such bans could not prevent people from having to borrow, nor lenders from getting around the bans in one way or another. One escape hatch was the proviso in Jewish law that Jews could lend to non-Jews. This led to some Jews, excluded from most occupations, becoming lenders to Christians, ranging from pawnbroking to financing wars.
With the Industrial Revolution, starting in England in the 18th Century, it became more and more evident that credit was a necessary lubricant for business and trade. Economists like Adam Smith saw interest as a useful tool, although he advocated limits on how much could be charged. The churches themselves, especially the Protestants, began conceding that some interest was morally allowable. England eventually abolished its usury limit of 6 percent in 1854, leaving control to market forces. (Borrowers who feel an interest charge is exorbitant can take the lender to court, but this obviously doesn't happen often. In recent years, consumer advocates have pushed for usury limits to protect borrowers.)
Credit and Usury in America
In colonial times and following independence, most Americans were farmers. Money (coins, ordinarily) was scarce due to an imbalance of trade with England. Trade was often done through barter, the exchange of goods such as furs, tobacco, and livestock, or services. A doctor might be paid in butter or by chopping his firewood.
Another substitute for money was credit. A Philadelphia cabinetmaker reported that 92 percent of his sales were on credit. Obviously, to stay in business, he had to know his customers well and be willing to postpone payment when necessary. And he, in turn, had to have good credit with his suppliers. Grocers and other merchants would allow customers to have "book credit," to be repaid in thirty days or at irregular intervals. In short, the economy ran on credit. Mostly it was "friendly credit" among people who knew each other. Reputation and record of repayment counted for a great deal in whether you would be granted credit.
Despite the country's reliance on credit, moralists preached that debt was the road to ruin. Benjamin Franklin typified the divergence between preaching and practice. His publications praised thrift and staying out of debt. He told his friend, Dr. Benjamin Rush, that credit produced idleness and vice and that he wished all debts were irrecoverable under law. Yet, Franklin borrowed and lent freely during his business career.
Having inherited Britain's colonial usury limits, states tried to restrict interest rates, typically setting the legal limit at around 6 percent per year. But enforcement was weak and these limits were widely evaded, especially in the frontier states. One popular evasion noted by Abraham Lincoln when he was entering politics was "note-shaving," deducting various "expenses" from the amount turned over to the borrower, which put the real interest rate above the legal rate.
During the 19th Century, America shifted from a rural economy to a capitalist industrial economy. The nation adopted paper currencies, and money became more plentiful. While the farmhand might be paid mainly in room and board, city workers were paid cash wages, and many financial transactions were carried out in cash. But credit remained a key economic factor on all levels.
Cities were flooded with newcomers, some fleeing the privations of farm life, others arriving from Europe seeking what has come to be called the "American Dream." The new economy provided wealth to the "robber barons" like Rockefeller and Carnegie, but was not so kind to most Americans, many of whom lived in squalid conditions and toiled for long hours in dangerous and dirty jobs at low wages.
Americans continued to have contradictory attitudes toward credit. When a millionaire borrowed to build a factory, it was considered praiseworthy "productive" debt. When a housewife borrowed to feed or clothe her family, that was "consumptive" credit, which did not contribute to society but wasted its resources. ("Consumption" was the name used for what we call tuberculosis, and the term "consumptive credit" carried connotations of illness and disease.)
Commercial banks catered to the needs of business and the wealthy. They did not attempt to provide credit to ordinary working people, for a number of reasons.
  • Bankers shared the popular prejudice against "consumptive credit."
  • Banks needed to maintain high liquidity to guard against "runs," and restricted their lending to short-term notes. This prevented them from extending long-term credit like mortgages.
  • It was hard to judge the creditworthiness of working people. In addition, workers were vulnerable to layoffs, illness, and workplace accidents, which could interfere with their prompt repayment of loans.
  • Workers borrowed small amounts, which were uneconomical to lend without violating state interest rate ceilings.
Who Was Lending to Working People?
The emphasis on thrift was natural in a society where scarcity was the norm, and where the growing industrial economy needed savings to invest. But production by itself means little if nobody is consuming products. As early as 1855, an article in the magazine DeBow's Review argued that "if all men practiced the precepts of (Franklin's) "Poor Richard," society would not advance, since the consumption of all the vast variety of unnecessary commodities would cease." The nation could not sustain its commercial growth without a buying public. That realization would eventually lead to a greater understanding of "consumptive credit."
Meanwhile, a variety of institutions arose to meet the credit needs of working people. Of course, borrowing from family or friends continued to be a source of credit, but this put strains on relationships. For many, including immigrants dealing with an unfamiliar culture, the easiest and quickest source of credit was the pawnshop, where a piece of jewelry, an article of clothing, a piece of furniture, or some other portable object could be pawned for cash and later redeemed. Most pawners were women who needed to stretch their husband's often meager pay. Many customers made regular visits to "my uncle," as they referred to the pawnbroker. The typical loan was five dollars or less, which meant the pawnbroker needed a high rate of interest to make any money. States and municipalities allowed pawnbrokers to charge more than the typical usury ceiling, but often the pawnbroker tacked on extra charges that raised the real interest rate much higher.
Pawnbrokers were attacked as parasites preying on the poor and thriftless, but there is not a great deal of evidence that they profited more than any other business. In hard times, they failed as often as other types of enterprises. Because many pawnbrokers were Jewish, the pervasive anti-Semitism led to the popular image of the pawnbroker as a grasping "Shylock."
Up next in the socio-economic scale of credit came the small loan companies. These arose in the mid-19th Century as the industrializing economy fostered an army of wage and salary earners. The lenders were men who had some capital and used it to make loans of 10 to 40 dollars for short periods of time. At a legal usury rate of 7 percent per year, a loan of $20 for a month, would yield the lender a profit of 10 cents. Obviously, this would not cover the expenses involved in making the loan. Either lenders simply charged illegal rates, or worked around the law by charging separate fees, giving the borrower less than the face amount of the loan, or requiring the borrower to buy a painting or piece of jewelry at an inflated price. The small loan firm catered to a variety of borrowers, ranging from newspapermen to civil service employees to factory and railroad workers. In New York, one investigator found that two-thirds of the city's personal lending came from small loan brokers.
Small loan offices were tucked away from public sight but they boldly advertised in newspapers. They were seldom prosecuted. Most of their employees were women, because they could be paid less than men and were less likely to be assaulted by unhappy customers.
The small loan agencies loaned on two forms of security -- "chattels," such as pianos or jewelry that could be seized in case of default, and salary assignments, in which the borrower pledged his or her future salary as security. The reliability of the borrower was investigated, elaborate questionnaires were filled out, and legal-looking documents signed. Cosigners might be required. Some of this was for show, because the transaction could not be legally enforced.
The borrower undertook to make regular weekly payments until the loan was repaid. If the borrower fell behind in payments, collection tactics started out with reminder letters, then telephone calls, then personal visits. Physical violence was not used. (That came into play when big city mobsters got into loansharking in the 1950s, but even there, heavy violence was rare.) But the agency might use a "bawlerout," a woman who would confront the borrower in front of his or her co-workers or family and accuse the hapless debtor of being a deadbeat. Because many employers would fire any worker who fell into debt, there was great pressure on borrowers not to default on loans.
Some lenders charged what we might consider reasonable interest for such loans, albeit illegal under the usury limits, others gouged their customers. Like modern-day payday lending, the small loan firm made most of its money not from the occasional borrower but the repeat customer who fell behind in his or her payments and continued to pay interest but not the principal.
Like the pawnbroker, the small loan broker was castigated as a "loan shark," and the trade was periodically subject to journalistic exposes and attacks by crusading district attorneys. But it continued to flourish because it was needed.
The next rung up the credit ladder, and increasingly important as the19th Century progressed, was installment credit. As noted earlier, retail merchants often offered "book credit" to good customers. Installment credit arose when sellers of farm equipment found farmers reluctant to buy the new machines being invented, like threshers. If they let the farmer pay in installments, the sale became easier. Next came the manufacturers and retailers of sewing machines, pianos, encyclopedias, and other goods that typified the "good life" for upward-striving families. Eventually, almost anything could be purchased on the installment plan, and merchants found installment credit not only increased sales but the interest they could charge was a profitable sideline. When automobiles came along, manufacturers and dealers at first demanded cash payment but eventually found that installment purchase was the most profitable way to go.
An emotionally significant variant of installment credit was the home mortgage, where the buyer put down a hefty down payment, typically 30 percent of the price of the home, and then paid off the remainder of the price and interest in regular monthly payments over a period of four to 10 years. These mortgages were provided by savings banks, individuals, and savings and loan associations.
Installment lending, more than any other form of credit, raised the question of what was productive and what was consumptive credit. Was a sewing machine productive or a useless luxury? How about a phonograph or radio that increased a family's well being? Or a car that could be used both for a trip to the seaside and to drive to work? More and more purchases came to be classed as productive. By the 20th Century, it was increasingly recognized that there was no rational way to assign worth to one or another form of credit. And as the new field of home economics focused on wise purchasing by housewives, and as organizations like consumer leagues were formed to advance the cause of buyers, the term "consumptive credit" gave way to a less negative term, "consumer credit."
Reform Movements Affect Credit
The late 19th and early 20th centuries saw civic-minded reformers attacking business practices on all levels, from the Standard Oil Trust down to sweatshops and small loan brokers. This period has been dubbed the Progressive Era. Some business reformers focused on working conditions and child labor. Still others focused on the credit problems of the poor and low-paid workers, especially the high interest rates they had to pay, which were seen as contributing to poverty.
Two philanthropists played significant roles in the effort to make small loans more affordable to working people: Mrs. Russell Sage of New York and Edward A. Filene of Boston.
Mrs. Sage was the widow of a hard-headed, miserly railroad and financial speculator. A clue to Russell Sage's character can be found in an incident in which a crazed broker came into his office with a satchel of dynamite and demanded $1,200,000. Sage seized a clerk and used him as a shield. The satchel exploded, killing the bomber and one of Sage's secretaries. The clerk, by the name of Laidlaw, lost a leg, while Sage escaped with minor injuries. Laidlaw, who said he was now indigent, sued Sage for compensation. The millionaire refused and the courts upheld him.
In contrast to her husband, Mrs. Sage was interested in charity work and social reform. When the old skinflint died in 1906, he left $65 million to his wife, who embarked on a life of philanthropy. Among other things, she established the Russell Sage Foundation, which began investigating the problem of credit for the masses.
Mrs. Sage's foundation hired a young man named Arthur Ham in 1910 to promote more equitable credit for working people Early efforts included helping create credit unions in New York State, but soon Ham and the foundation focused on raising state usury limits for small loans to allow lenders to make a reasonable but not exorbitant profit. That would allow the more honest lenders to be licensed to operate legally and attract capital into the business and undercut the usurious unlicensed lenders, it was thought. Any loan of $300 and under was considered a small loan, although most loans were under $100. Working together with small loan companies that wanted to emerge from the legal shadows (like the one that became Household Finance Corporation), Ham and the Foundation were successful in reforming many state laws governing small loans. While loansharking obviously never vanished completely, this led to the thriving consumer finance industry of today.
Credit Unions
Edward A. Filene, a shy young man who walked with a limp and suffered from eczema, was forced to abandon plans for college when his father became ill. Instead, he began working in the family's clothing store in Boson. His talent and leadership helped turn the store into a leading retail establishment in the city. Having made a fortune in retailing, Filene embarked on a career of philanthropy and civic reform.
He became interested in the fledgling credit union movement, which was growing only slowly in a handful of states, including Massachusetts. Filene, a non-practicing Jew, later said part of his motive in seeking credit reform was to fight the popular image of Jews as usurers. In 1920, he plunged fully into supporting the young movement by hiring a lawyer, Roy Bergengren, to form what they called the National Credit Union Extension Bureau (CUNEB) and to work to spread the movement nationally. Bergengren turned out to be a natural for the job -- idealistic, yet practical, a tireless promoter and advocate.
The credit union was a cooperative in which members pooled their savings to make small loans to each other at legal rates. Depending largely on volunteer labor and often operating out of a desk in the workplace, its expenses were low. Although most well-defined groups could start a credit union if the state permitted it, the most successful credit unions were formed in factories and government offices. Defaults were kept at a minimum because the borrowers were usually known to the committee that approved loans, the borrower often had to have co-signers, and there was pressure from fellow workers whose savings were at risk.
Under Bergengren's leadership, with Filene's financial support, state after state passed credit union laws, and hundreds of credit unions were being organized across the nation. The passage of the Federal Credit Union Act in 1934 made it possible to organize credit unions in any state that did not have a credit union law or had an inadequate one, and credit unions proliferated throughout the Depression. By 1939, the nation had more than 8,000 credit unions serving some 2.3 million members. The U.S. credit union movement has turned out to be one of Edward A. Filene's most lasting achievements, today serving more than 100 million Americans, with assets in excess of $1 trillion.
We could mention other efforts to combat loan sharks, but they were less significant than the credit union movement and the campaign to raise interest rates for small loans.
Commercial Banks Enter the Field
The 1920s were a time of rising prosperity and mass-produced products like automobiles. With increasing wages and convenient credit now available to many households, the United States found itself with the world's first mass market. Consumer debt skyrocketed, to the accompaniment of jeremiads that the nation was abandoning the old virtues. But it turned out that Americans were usually careful in their use of credit and repaid loans on time. Consumer debt, it turned out, was as much a taskmaster as the meanest Victorian boss, requiring hard work, budgeting, and its own kind of thriftiness.
A few banks began to test the waters. In 1928, National City Bank in New York established a consumer loan department. The Depression led more banks into the field when business lending fell sharply and it became clear that, even in the greatest downturn the nation had ever experienced, most consumers faithfully paid their debts. Interestingly, after a falloff in consumer borrowing following the Crash of 1929, consumer borrowing rose through the Depression.
Banks' deposits gave them a low-cost source of funds that enabled them to charge lower interest rates than many competitors. The Glass-Steagall Act of 1933 established the Federal Deposit Insurance Corporation (FDIC), which largely eliminated the fear of bank runs and encouraged banks to start making longer range loans like mortgages. By 1939, 20 percent of commercial bank loans were going to households. The market was bifurcated, however, with banks catering to white collar workers and professionals and credit unions and finance companies serving a less affluent clientele.
The Glass-Steagall Act also set the credit mission of each type of depository institution. Banks provided commercial and consumer loans. Savings banks and Savings and Loans provided home mortgages. Credit unions provided consumer loans.
By the 1940s, commercial banks were the leading consumer lenders, a position they have held since, but credit unions and finance companies have continued to flourish. In 1980, credit unions gained their own deposit insurance fund, which encouraged consumers to make greater use of these institutions. Additional legislation and regulatory changes have made it easier for credit unions to expand membership either through expanding fields of membership or by mergers, and have eliminated most restrictions on the products and services they can offer, putting them into direct competition with other lenders.
Consumer Credit Today
Before 1970, most consumer loans were held by the institutions making them. But increasingly, holders began "securitizing" their debt assets, starting with mortgages but then extending to a wide variety of other assets ranging from credit card receivables to student loans to royalties anticipated from David Bowie's songs. These instruments were known collectively as Collateralized Debt Obligations, or CDOs.
The basic idea of a CDO is simple: a group of similar debts is combined into one package and sold to another institution. The seller receives an immediate payment that it can use to make more loans. It also is absolved of any risk connected with the loans in the package.
The buyer receives an instrument that will pay a regular income over the life of the loans in the package. To protect against possible defaults on the loans, the buyer has the CDO evaluated by the credit rating agencies and also receives various guarantees, either from the federal government or private insurers.
Securitization had many advantages, and it became a profitable industry in itself. American CDOs were purchased by banks and other financial institutions all over the world. But as the instruments became more and more complex, many buyers did not fully understand what they were purchasing, and regulators were asleep at the switch. The securitization industry turned out to be a house of cards as higher than expected defaults on CDOs of sub-prime mortgages cast doubt on all other CDOs, which began to tumble in market value. In turn, credit in general froze up, so even the most creditworthy institutions could not borrow.
The Great Recession of 2007-08 had begun, and it would take billions of dollars in government "bailouts" and years for the U.S. economy to recover. The economies of many other nations were also shaken. But while consumers retrenched somewhat during the recession, it became clear that consumer borrowing would bounce back and continue to be the principal driver of the American capitalist system.
Consumer Credit Protections
The last half-century has seen passage of a number of federal and state laws designed to protect Americans in their borrowing. One is the Truth in Lending Act, which among other disclosures, requires lenders to state interest in terms of the Annual Percentage Rate (APR) so consumers can compare terms of various lenders. The Equal Credit Opportunity Act prohibits credit discrimination on the basis of race, color, religion, national origin, age, sex, or marital status.
In the wake of the Great Recession, Congress created the Consumer Financial Protection Bureau (CFPB) with the mission of setting up new protections for borrowers, which could include the customers of "fringe bankers" (see below).
Credit Bureaus, New Products
The first credit bureaus arose in various cities in the 19th Century to serve the needs of businesses who wanted to determine the creditworthiness of their business customers, who might be located in distant locations. Since the 1970s, national credit bureaus have made it easier for lenders to check the ability of individuals to meet their obligations.
New consumer credit products have come into existence, most notably credit cards, student loans, home equity loans, adjustable rate mortgages, and sub-prime mortgages. The nation is awash in consumer credit, with a consequent rise in consumer debt, making consumers more vulnerable to unexpected events like the Great Recession of 2007-08.
Many non-credit financial products have also become available, from debit cards to money market funds to IRAs to annuities to long term care insurance This bewildering array of choices is forcing consumers to take on greater responsibility for their financial future. This has been called "Do It Yourself" consumer finance.
There is a great need for consumer education, and this is a role very suited to credit unions, which have emphasized member education since their founding days. Many credit unions have taken up the challenge.
The question of usury has not gone away. In the 1990s, after lobbying for more relaxed state usury laws, a new set of "fringe bankers" emerged, including the payday lenders and check cashing outlets. They offer small loans difficult for mainline institutions to make at reasonable rates. Once again, there is an outcry against "predatory lenders" who are said to be parasites upon the poor. Some credit unions are taking up the challenge of offering small loans at rates below those charged by the fringe bankers. The rise of risk-based lending, in which credit unions charge higher rates of interest on loans to less creditworthy borrowers, is helping them offer credit to members that have low credit scores from the rating agencies. However, there is push-back from credit unionists who believe that members should be treated equally as far as loan rates are concerned.
Sources
  • Financing the American Dream: A Cultural History of Consumer Credit, Lendol Calder, 1999, Princeton University Press. A widely-praised, detailed look at the rise of consumer credit.
  • Consumer Finance: A Case History in American Business, 1970, Irving S. Michelman, Augustus M. Kelly, New York. An entertaining look at the Russell Sage Foundation's efforts to bring small loan businesses into the legal market. It also deals with the rise of consumer finance in general.
  • In Hock: Pawning in America from Independence through the Great Depression, Wendy A. Woloson, 2009, The University of Chicago Press.
  • A Brief Postwar History of U.S. Consumer Finance, Andrea Ryan, Gunnar Trumbull, and Peter Tufano, Autumn, 2011, Business History Review, p. 461-498, Harvard College. Spells out the need for greater consumer education.
  • Money and Credit: A Sociological Approach, Bruce G. Garruthers and Laura Ariovich, 2010, Polity Press.
  • The Credit Union Movement: Origins and Development 1850 to 1980. J. Carroll Moody and Gilbert C. Fite, 1981, Kendall/Hunt Publishing Company. The standard history of the origins of the U.S. movement.
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Paul Thompson, CUDE,  is author of "Development of the Modern U.S. Credit Union Movement 1970-2010" and "What You Need to Know About Today's Credit Union," a manual for new credit union employees and volunteers. Both available from www.lulu.com.

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