Indebted Americans need help, not restrictions on settlement services

• Key insight: Legislation that would place new rules on organizations that help consumers reduce their debt burden should not exempt services that have historically favored the priorities of lenders over debtors.
• Supporting data: A borrower with $34,000 in unsecured debt would repay $40,000 through credit counseling, and $28,500 through debt relief.
• Forward look: Organizations offering financial guidance to consumers in distress should be obligated to act in consumers’ best interests.

The Federal Reserve Bank of New York recently reported that credit card balances climbed to $1.26 trillion, back near last year’s record. Roughly 60% of the 175 million American adults holding credit cards carry a balance. The Fed’s researchers also report that many U.S. households live paycheck to paycheck.

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At the same time, over half of consumers say they would need over six months to repay their short-term debt. Those households need an exit.

On July 22, the House Subcommittee on Commerce, Manufacturing and Trade took up a discussion draft of legislation called the Debt Settlement Consumer Disclosure Act. Representatives Russell Fry and Scott Peters are spearheading the bill. It would require debt settlement firms to prominently display a warning that their programs can damage credit. It would also require monthly statements for every enrolled debt and prohibit exaggerated savings claims. These duties would be extended to affiliates, marketers and lead generators.

The lead witness was Celia Winslow of the American Financial Services Association, or AFSA. This trade association represents the lenders whose potential recoveries decrease as borrowers settle for less than face value. Her testimony ran more than 20 pages. Its most revealing sentence was a footnote, asking Congress to exempt nonprofit credit counseling agencies from the bill’s requirements.

Consider these two products: Nonprofit debt management plans lower a borrower’s interest rate while requiring repayment of 100% of principal; settlement does the opposite: it reduces the consumer’s principal. I’ll give you one guess as to which product recovers more for the creditor.

In the context of nonprofit debt management plans, the term “nonprofit” refers to the company’s tax status. These nonprofits are generally funded in two buckets: partly by consumer fees and partly by “fair share” payments remitted by the creditors whose accounts they repay. Many of these nonprofits have a history of prioritizing creditors’ needs over debtors. In 2006, the IRS found that of the 63 agencies that accounted for over half of industry revenue, 41 had put their tax exemption in jeopardy because they prioritized creditors’ benefit above all else.

The National Foundation for Credit Counseling, the group AFSA asks Congress to exempt by name, markets its creditor relationships to prospective member agencies as a chance to “optimize revenue opportunities,” and advertises that its board of trustees and advisory councils include senior executives of major creditors.

Ms. Winslow’s central charge is that debt settlement is uniquely illegitimate. Why? Because the business model relies on “deliberate consumer default.” They literally tell customers to stop paying their bills. Testing this out, I spoke with a representative of such an agency, Accredited Debt Relief, by telephone last week. On the call, he directed me to do exactly that: Stop paying my bills.

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But this will not come as a surprise to anyone who has worked at a recovery desk. Creditors settle debt every day. They typically do so internally through hardship programs or through collection agencies. When they give up, they sell charge-offs to debt buyers. The Federal Trade Commission’s study of that market found buyers paid an average of four cents per dollar of face value. Then the buyer settles, too. Creditors should prefer that outcome, since it facilitates higher recovery through settlement over bankruptcy.

Discounting distressed debt is the ordinary back end of consumer lending. Charge-offs are priced into every loan issued. The dispute at issue is who gets to negotiate the discount, and whether the borrower has anyone on their side.

The hearing never reached the obvious question: who these customers are. Most people who come to debt relief are already struggling. They are past the point where additional borrowing is possible or practical. Reducing the balance owed is the only lever they have left. The average client in these nonprofit plans repays around $24,000, by AFSA’s own figures. Yet recent data comparing the two products found that a borrower with $34,000 in unsecured debt would repay $40,000 through credit counseling, and $28,500 through debt relief.

The free market dictates that consumers should have access to both. The debt relief industry has operated for 16 years under the FTC’s Telemarketing Sales Rule, which already requires extensive disclosures, prohibits advance fees, and ensures companies are paid only when they deliver results. Conversely, the proposal Congress is considering would impose additional requirements on debt relief while expressly exempting credit counseling.

Simultaneously, AFSA’s own members are still being asked to meet the disclosure standards it urges on others. In March, 13 state attorneys general sued OneMain Financial, whose head of external affairs sits on AFSA’s board, alleging it packed installment loans with undisclosed add-ons. OneMain disputes the claims and says it will contest them in court. In May, Mariner Finance, whose chief executive also sits on AFSA’s board, settled similar claims with the Tennessee attorney general for $11.1 million in consumer redress, without admitting wrongdoing.

The answer is not to pile redundant requirements onto a responsible, heavily regulated industry segment. The better alternative is to hold credit counseling to the same standard debt relief has met for 16 years. Organizations offering financial guidance to consumers in distress should be obligated to act in consumers’ best interests. Current federal debt-relief rules already exist, and their required fee structure matters: A company that does not deliver a settlement does not get paid.

If AFSA wants to be taken seriously, they should want access to a well-regulated product that has given millions of people a fresh start.