Diatribes of Jay

This is a blog of essays on public policy. It shuns ideology and applies facts, logic and math to economic, social and political problems. It has a subject-matter index, a list of recent posts, and permalinks at the ends of posts. Comments are moderated and may take time to appear. Note: Profile updated 4/7/12

25 April 2009

Rotten Business


As Calvin Coolidge famously told us, “the business of America is business.” He was one of our least effective and least loved presidents, but his words have more than a germ of truth. Throughout most of our history, the innovation and vitality of our private sector made America pre-eminent.

Yet there are times when the ripe fruit of business has become rotten to the core. We are living in one of those times.

Mortgage Lending
Credit Cards
Health Insurance
Conclusion
Coda: The Diogenes Test
Update (6/11/09)
Update (12/28/09): Student Loans

Mortgage Lending. By now everyone knows the cause of the mortgage crisis that triggered our economic collapse. Mortgage lenders made loans to people they knew couldn’t pay them back, and borrowers took the loans to get something for nothing. Everyone hoped to profit at someone else’s expense. The whole thing was an exercise in dishonesty and stupidity, which are often indistinguishable.

Good business takes hard work, but it’s not rocket science. You provide a useful product or service at a fair and reasonable price. You tell customers honestly about its advantages. You admit its flaws and treat customers fairly and so earn their trust. As long as you are reasonably efficient and do not overprice, word will spread, and you will succeed.

That’s how business was in our best days and how it may some day be again.

Our mortgage industry broke from this simple formula. Its services were not useful. It made loans that were unsustainable for whole classes of customers. It purposely made loan terms confusing, lied to customers about possible consequences, and presented dishonest, rosy scenarios of ever-rising home values and ever-easier credit.

What many don’t yet realize is that the mortgage-lending business was hardly alone. Unbeknownst to the public and the media, dishonesty, greed and stupidity overtook whole other industries. The credit-card, health-insurance and student loan industries are among them.

Credit Cards. Like mortgage lending, credit cards are a simple business. You borrow money at low rates from the interbank or commercial-paper markets. You lend it out to consumers at higher rates. You make prudent provision for foreseeable defaults. You use the rate difference to finance your computer systems, administration and promotion. What’s left over is profit.

It should be a simple, boring, low-margin business. The only possible challenges are predicting default ratios and possible interest-rate fluctuations in a volatile economic environment. Modern credit-rating agencies provide ample data to assess default rates, leaving macroeconomic forecasting the only significant challenge.

But bankers weren’t satisfied with this simple, honest picture. They wanted more.

So they pushed credit cards on less and less reliable borrowers at higher and higher interest rates. To avoid the need for more accurate forecasting, they gave themselves the right to change terms at will—even on outstanding credit balances. Then they made terms so complex that even people with degrees in law or business had to take an hour or more to read and understand them, if they had the time. Bankers created a wide array of consumer “gotchas,” from esoteric balance calculations through late and over-limit fees, which they hid in plain sight in fine print.

Except for recurring annual fees, cardholders incurred little or no cost as long as they didn’t use their credit. But when they started to use the credit services promised them, the prices immediately went up, often dramatically. And the more they used the credit, the higher the price became—through cleverly concealed rate increases, charges and fees. It was as if the cardholder had bought a car from an oil company that, as part of the purchase price of the car, doubled the price of gas for every 10,000 miles driven.

In our collapsing economy, more and more consumers rely on credit. As they do, the total price they pay goes up and up, banks’ profits increase, and the economic collapse spirals downward.

Congress and our federal regulators have blessed this state of affairs for thirty years. In the late seventies and early eighties, they made a Faustian bargain. They abolished all substantive limits on credit-card and other lending terms. They even wiped out state usury laws, which had put absolute, numerical limits on interest rates. (The limits had ancient roots, going back to the Bible, which capped rates at ten percent, and the Quran, which capped them at zero.)

In exchange for “anything goes” regulation, Congress and the agencies offered so-called “disclosure.” They let lenders do whatever they wanted as long as they disclosed their terms to consumers. This regime was supposed to provide more “variety” and “consumer choice.” Consumers could fend for themselves, the story went, and everyone would be better off.

But of course the premise was absurd. The average consumer cannot fend for herself, not against people with higher degrees in business and law, highly paid to confuse her and take her money. It was like taking candy from a baby, but honest business it wasn’t. Congress made it legal but couldn’t make it right.

Health Insurance. The story of health insurance was similar. It’s a tougher business than mortgage or credit-card lending. It requires insurers to forecast trends in medical conditions and expenses as the population ages and as medical technology increases in capability and expense. That’s not an easy task.

But from the consumer’s perspective, health insurance and lending are conceptually similar. The consumer pays monthly insurance premiums in exchange for reimbursement of routine but unexpected medical expenses and protection against catastrophic loss from a sudden injury or life-threatening disease. Just as the consumer expects the mortgage lender to help him keep the house he bought under mortgage, or the credit card to provide credit when needed (up to its limits), he expects his health insurance to cover necessary health-care expenses, subject to any deductible and up to the policy limits.

But business deceived these expectations, too. Not only did it leave 47 million would-be insureds totally out in the cold. According to Consumer Reports’ independent studies [subscription required], it also left 40% of people who have health insurance without reliable coverage of medical needs and emergencies. (One study’s subtitle is, “Why 4 in 10 Americans can’t depend on their health insurance.”)

The conceptual basis of this fraud was the same as that for credit cards. Unregulated, private health insurers would provide “variety” and “consumer choice.” Consumers would fend for themselves, pitting their knowledge of medicine, insurance and law against the skill of highly trained specialists seeking to hide “gotchas” in fine print.

The result was predictable. Four in ten were “gotten.” The worst afflicted were those who bought six-month “temporary” policies at low premiums. These policies had iron-clad exclusions for “pre-existing conditions,” which insurers enforced rigorously—and separately for each six-month policy. If an insured so much as reported a twinge before the relevant six-month period, and if that twinge had any plausible relationship to a claim, the insurer would deny it.

Again, the whole exercise was fundamentally fraudulent. Who could imagine that highly-trained specialists would not be able to deceive ordinary consumers with no special training and little time to read fine print? In the case of insurance, there wasn’t even the pretext of uniform regulation. Every state had and has a separate regulatory regime for insurance. Although a few were diligent, most were asleep at the switch.

Conclusion. All of these industries—mortgage lending, credit cards, and health insurance—had one thing in common. Until the collapse, all were based on sophisticated and systematic deception of consumers which, at the time, was perfectly legal. Credit cards and health insurance still are.

In that respect they were like the pervasive deception of derivatives buyers (by sellers and rating agencies) that was the immediate cause of our economic collapse. The only difference was that buyers of derivatives were supposed to be sophisticated. The fact that so many investment bankers deceived their own peers so successfully only highlights how easy it is to trick ordinary consumers. To paraphrase Calvin Coolidge, the business of America had become sophisticated swindling.

President Obama is right to use the full force of law to fight this trend. He’s right to re-regulate finance with much tougher rules of much broader scope. He’s right to impose substantive regulation on credit-card terms, because regulation by “disclosure” has failed utterly. He’s right to impose uniform federal regulation on health insurance and to set up at least one government-run competitor to keep that business honest. And he’s right to reject the absurd notion that ordinary, busy consumers can—through “disclosure,” “variety” and “consumer choice”—outwit highly educated and sophisticated business people bent on misleading them for profit.

But in a larger sense, this problem is not one of regulation, law or even politics. One political party, it is true, has pushed this regime of deliberate deception well beyond its reductio ad absurdum. If there is any justice, the political price that party has paid and is paying will continue for at least another generation.

Yet the real problem is one of culture—business culture. When the party of business vigorously supports and promotes business that is fundamentally deceptive and dishonest, our whole culture has turned sour. Foreigners know this. It will be a long time before the Germans and French, let alone the gentle, trusting Icelanders, rely on fast-talking Manhattanites again.

But I don’t think we ourselves yet understand how rotten we have become and how much we need to reform our business culture. However skilled they may be at their trades, politicians and lawyers cannot resurrect American business.

Read the Wall Street Journal, especially the editorial pages and their rabid public comments. There you will find every form of rationalization and excuse. Business did nothing wrong, they say. Everyone else is to blame. Some hint at a vast left-wing conspiracy to destroy business and impose a “socialist” agenda. Others blame the hapless victims, just as they might blame rape victims for wearing immodest clothes.

Precious few understand that no one destroyed American business. American business destroyed itself.

We have stopped innovating in basic industry. We have stopped making things and have turned to shuffling paper. Much of the paper we now shuffle is inherently misleading and deceptive, however legal and accurate (in technical terms) it may be. So our long national decline will continue until our business leaders come to their senses, start doing honest business again, and stop making excuses for swindlers.

Coda: The Diogenes Test

Lest readers think the foregoing post is just abstract blather, they might be interested in how I saved my own retirement fund.

For some years my wife has had a Citibank credit card. About three years ago, we began to get cold calls from Citibank’s “boiler rooms,” trying to sell my wife things like credit insurance and various forms of identity-theft protection.

The calls took advantage of the exception to the Federal Trade Commission’s “do not call” rule for existing business relationships. The callers were persistent, aggressive and dishonest. In one case my wife said “no” and the caller put her down for “yes”—necessitating several days of unpleasant telephone calls and threats of suit to cancel unwanted business.

It’s hard to believe now, but Citibank was once one of the most prestigious names in finance. Along with Chase Manhattan Bank (since merged with investment bank J.P. Morgan), it had been the gold standard in consumer banking. It had enjoyed a reputation for integrity strong enough to attract former Treasury Secretary Bob Rubin to serve as its CEO.

When an icon of integrity and honesty (which Citigroup had been) begins to act like a crooked home-improvement contractor with his foot in your door, you don’t have to be a genius to figure out that something had gone very, very wrong. I was not at all surprised later, after the collapse came, when Citigroup ended up high on the government’s intensive-care list.

So I began applying what I call the “Diogenes test.” Remember Diogenes? He was the ancient Greek who roamed Athens with a lantern, looking for an honest man. Greek myth says he never found one.

Although without lantern, I started doing the same thing. As I watched and read the news and business reports, I started applying a simple, human test. Is the person I’m watching, listening to, or reading honest and credible?

The results were astounding. Beginning around 2007—and for months at a time—I saw no public offical or business leader (besides Warren Buffet) whose words I could trust. Not one. Their words simply didn’t match their actions, their self-evident motivation, their firms’ actual condition, or surrounding circumstances that any well-informed person could see. The worst of them, like Dubya and House Minority Leader John Boehner, struck me as the most dishonest or stupid public figures I had seen in my 60-plus years. (Dishonesty and stupidity can be indistinguishable.)

There were other warnings as well. Among them was the sudden collapse of a commercial real-estate venture in a foreign country I was visiting in late 2007.

By year-end 2007 I’d had enough. I sold out and put my retirement money in money-market funds, where it’s been ever since. My wife, who’s more conservative than I, had done the same thing even earlier.

Although I’ve since dabbled in the markets with other, speculative money and lost a bit, we both decided not to risk our retirement until we see evidence of a return to the honesty, integrity and transparency that built the world’s largest economy. We’re still waiting.

Update (6/11/09):

In the interest of full disclosure, and to avoid misleading readers, I must report that we’re back in the stock market again, even with part of our retirement funds. While the recession is by no means over, it seems clear that the global economy is on the mend. Here Tim Geithner deserves some credit; it appears that I wrote too soon and misjudged him (See posts 1 and 2).

This does not mean that a word of the preceding post needs changing, except the coda’s last two sentences. The credit-card industry is smarting from a slap on the wrist by Congress, but I don’t see any fundamental change in its inherently deceptive practices. As for health care, we are about to see an all-out public-relations push to convince ordinary Americans that black is white and the sun is dark, so that the three great health-care lies can prevail again and continue to boost the health-care industries’ dishonest profit.

What has changed is my understanding, explained in another post, that the global economy in our multipolar world is inconceivably more robust and resilient than it was in 1929. As a result, our national bent for hucksterism in a few critical domestic industries like banking and health care is no longer fatal.

More important, there are still some fine industrial companies in the United States, which produce things and do so honestly and well. Many of them do most of their business abroad, where there are also similar companies. If you invest in firms like these while they are still undervalued in the recession, you will do well. But as for me, I’ll never invest in any firm (like many banks and health-care firms) that makes its money by swindling ordinary folk, however subtle and sophisticated its swindling may be. The short-term gain, if any, wouldn’t justify the long-term risk and moral pain.

Update 12/28/09: Student Loans

A particularly egregious example of sophisticated swindling is missing from my list above: student loans. The omission embarrasses me. I’m an about-to-retire teacher who, over four decades ago, got a magnificent education at our best public universities for next to nothing. If I left this festering sore off the list, students and ex-students with exploding debt must indeed be an abandoned constituency.

Of course I am and have been aware of the scourge of skyrocketing student debt. Today it’s not uncommon for graduates of college—let alone graduate or professional school—to emerge from the womb of academia owing $100,000 or more for their degrees. Debts of $50,000 and up are routine. In contrast, when I graduated from one of the world’s best public universities in the mid-60s, I had no debt whatsoever. Part of my “luck” was due to scholarships based on merit, but most was due to the low cost of public education then. My “tuition” was $200 per year, so all I had to cover was books (which were cheaper) and living expenses.

The story of how we as a nation have thus abandoned our most promising youth is a tragedy with deep roots in our selfish neglect of public infrastructure generally. Unlike Republican phantoms, this is real generational theft. But there’s worse. The student loan “industry” is among the most rotten of our rotten businesses. David Brancaccio of the news series Now told the story in a piece of investigative reporting that PBS recently repeated, no doubt because the Obama Administration is just now pushing for long-overdue reform.

The story is appalling. Not only do private businesses earn money on loans that have no risk because the government guarantees them. (Talk about corporate welfare!) They also exploit students and ex-students outrageously. Among the tactics discussed in the program are: (1) charging supranormal interests rates, (2) imposing interest and fees that collectively increase loan amounts to up to four times the principal borrowed, (3) failing to inform borrowers of their legal options and rights, and (4) conversely, allowing borrowers excessive “forbearance” while interest and fees (payment of which the government guarantees) pile up.

Everyone who wants to see how rotten our financial sector has become should watch the Brancaccio feature. This is a perversion of capitalism that Adam Smith would never recognize: a business that makes easy money off of government guarantees by exploiting our most promising and vulnerable youth. Welcome to yet another moral wasteland made by Republicans’ ideology of “private profit first, last and always!”

Not only is sophisticated swindling rampant. The system of loans that grew like a cancer makes our health-care system look rational. Needless proliferation of “choices” and paperwork, all with confusing fine print, caused one student to end up paying off seventeen different loans for a single college career. How much “choice” of loan does a student need, for God’s sake? Money is money! The only possible rationale for such a sick system is to increase the wealth of the loan sharks who filled Republican campaign coffers. In that the system has succeeded.


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