A new proposal from the Pentagon on high-cost lending would affect a wide swath of the consumer finance industry, including not only payday lenders but also banks and credit unions.
The move Friday by the Department of Defense marks the latest stage in its cat-and-mouse game with lenders that locate near military bases or target soldiers online.
In 2007, the Pentagon enacted a series of consumer protections for active-duty members of the military who applied for certain payday loans, car title loans and refund anticipation loans. But those measures proved largely ineffective in stemming the flow of expensive credit to soldiers.
The proposed revisions would broaden the protections to cover installment loans that carry longer loan terms than traditional payday loans, as well as credit cards and other credit-line products. Auto loans and mortgages would still be exempt.
The Department of Defense is not known for its expertise in financial matters, but it consulted with other agencies, including the Consumer Financial Protection Bureau, in developing the rules. Its 150-page proposal was embraced by consumer advocates who confidently predicted it would succeed where previous efforts to stamp out high-cost lending have failed.
"No more loopholes. No more evasions. The proposed rules will end the debt trap," Mike Calhoun, president of the Center for Responsible Lending, said in a news release.
Below are six conclusions that emerged Friday from interviews and a review of the proposed rules.
The Pentagon is trying to save certain soldiers from themselves. Only a small minority of enlisted service members faces persistent financial hardship, but many of those who are in that situation find themselves in a debt cycle, according to the Defense Department proposal.
One reason that the 2007 rules have not been more effective is that they rely on loan applicants to disclose whether they are active-duty military members, and some applicants have lied in order to qualify for a high-priced loan rather than be turned away by a noncompliant lender, the Pentagon found. Its report describes "widespread abuses" and "adverse effects on service members and their dependents who make false statements."
To address the problem, the Pentagon is proposing that lenders be required to check a database in order to determine whether a loan applicant is a member of the military. Lenders who followed this step would get protection from certain lawsuits.
The proposal's benefits likely outweigh its costs, according to the Pentagon. The regulations include an analysis that compares the costs of the regulations to financial institutions and the economy with the savings that are expected to accrue to the Pentagon.
The Defense Department estimates that the rules would cost financial institutions $96 million in the first year, as they adapt their systems to comply with the new requirements. It also acknowledges that the proposal may reduce the availability of credit, and estimates an annual cost to the economy of $20 million per year.
But the Pentagon also states that it loses about $57,000 each time a service member leaves the military involuntarily, and it estimates that happens because of financial distress roughly 4,700-8,000 times annually. Based on certain mathematical assumptions, the rules could save the Defense Department somewhere between $13 million and $137 million each year.
The credit-card business will likely be one of the most affected. Assuming they are adopted, the Pentagon's rules would prohibit the sale of credit cards with mandatory arbitration clauses to soldiers and their spouses.
Credit card agreements often include mandatory arbitration provisions, which consumer advocates dislike because they prevent aggrieved cardholders from filing lawsuits. Those cardholder agreements may soon have to be revised to make clear that mandatory arbitration does not apply to service members, said Alan Kaplinsky, a partner at Ballard Spahr.
But he added: "I don't think it would be necessary to have a special cardholder agreement just for people that are active members of the military."
The Defense Department proposal would also impose a 36% annual interest rate cap on credit cards. It does not appear that most mainstream card offerings would be affected by the rate cap, but some subprime products might be.
Overdraft fees are exempt, but overdraft lines of credit are not. The Defense Department is taking the same view of overdraft fees that bank regulators have: they are not a form of credit. That is despite the fact that some of the banks that rely most heavily on such fees have branches on military bases, according to a Wall Street Journal story earlier this year.
On the other hand, overdraft lines of credit, which can be significantly cheaper for consumers than overdraft fees, would be subject to the 36% interest rate cap when they are offered to active-duty soldiers. That treatment could discourage banks from offering overdraft lines of credit.
The Defense Department proposal will not be a template for the CFPB. The consumer bureau is preparing to propose its own broad rules on high-cost consumer lending, and Director Richard Cordray showered praise on the Pentagon's proposal Friday.
Nonetheless, the CFPB is working from a different playbook than the Defense Department.
That is because Congress has behaved schizophrenically when it comes to payday lending. The bipartisan 2006 law that spawned the Defense Department rules require a 36% rate cap for active-duty military members. But the 2010 Dodd-Frank Act prohibits the CFPB from establishing interest rate ceilings. So the CFPB is barred from taking the approach that is required of the Pentagon.
There will be industry pushback. The consumer finance industry's reaction to the Pentagon proposal was fairly muted Friday there is obviously sensitivity about criticizing an effort designed to protect service members but do not expect industry trade groups to acquiesce.
The most strongly worded industry response came from the American Financial Services Association, whose members include installment lenders.
"The traditional installment products offered by AFSA member companies are not the problem in fact they are often the best solution to the financial needs of service members and their families," Chris Stinebert, the group's president, said in a news release.
Carrie Hunt, general counsel at the National Association of Federal Credit Unions, warned in an email about the potential that the proposed rule will have unintended consequences.
Banking groups, which back in 2007 argued that banks should be exempted from the Defense Department rules altogether, are also expected to file comments on the new proposal.