The seven-year saga of Madden v. Midland began as a dispute over a four-figure consumer debt. But billions of dollars' worth of loans, and the future of consumer lending markets, now hang in the balance.
Madden began in 2011 as a lawsuit based on a claim of usury. The plaintiff, New York resident Saliha Madden, had defaulted on $5,000 worth of credit card loans. The balance owed was later acquired by Midland Funding, a debt collector headquartered in California. Midland attempted to collect the debt with a default interest rate of 27 percent. Although the loan contract stipulated that it would be governed by Delaware law, which does not have a usury cap, Madden sued Midland, alleging unfair debt collection practices under federal law and usury under New York law — which considers interest rates above 25 percent usurious.
The District Court for the Southern District of New York ruled in favor of Midland, rejecting the claim of unfair collection practices and finding that the National Bank Act pre-empted the application of state usury law. But the Second Circuit Court of Appeals — which covers Connecticut and Vermont as well as Madden's home state of New York — reversed the District Court ruling, finding that the National Bank Act pre-emption did not apply to Midland because Midland is not a national bank. Therefore, the opinion went, applying state usury law in this instance would not hinder any national bank’s powers. The Second Circuit thereby remanded the case back to the District Court, which in turn found that New York law should apply since applying Delaware law, which provides for no usury limit, would “violate a fundamental public policy of the state of New York.”
Should the District Court’s decision stand, Madden would jeopardize the long-standing judicial precedent of “valid-when-made,” which holds that non-usurious debt remains valid when acquired by a third party, even if the interest rate implied in the latter transaction is usurious. Not surprisingly, the uncertainty sparked in the aftermath of the Second Circuit’s ruling has prompted policymakers to turn to a legislative fix to restore the “valid-when-made” precedent by making it federal law governing consumer credit markets.
U.S. courts have long recognized the potential that usury caps might make the credit market more illiquid. The Supreme Court’s 1833 ruling that cemented the valid-when-made doctrine stated that:
by converting a sale on a discount into a loan on usury, and thus rendering null and void the act of endorsing it, a contract wholly innocent in its origin and binding and valid upon every legal principle is rendered at least valueless in the hands of the otherwise legal holder, and a party to whom the provisions of the act against usury could never have been intended to extend would be discharged of a debt which he justly owes to someone.
Back then, private promissory notes were used as collateral for transactions, both within and across state lines. But, as the notes changed hands, acquirers might discount them more steeply than the original lender, sometimes exceeding state usury limits. Valid-when-made ensured that the original validity of a loan would not be affected by changes in its implicit interest rate in subsequent transactions.
More recently, courts have tended towards a liberal interpretation of the National Bank Act, holding that it pre-empts state usury laws in all cases and not just for national banks. Georgetown law professor Adam Levitin has argued that this interpretation is inappropriate and that the pre-emption should only apply to national banks, which are subject to a specific federal statute.
Levitin states that a broader pre-emption only goes back to 1978. This date is significant because the late 1970s marked a turning point in U.S. consumer credit markets as banks started to consolidate and expand beyond state boundaries, credit card use became widespread, and loan securitization took off. The case Levitin cites, in fact, concerned a credit card dispute and the applicability of different state usury statutes. As trade in loan instruments grew and participating institutions became more varied, allowing for valid-when-made to overrule state usury laws was important to ensure these transactions could take place.
Note that the elements which gave rise to the change in judicial doctrine are in and of themselves positive. A secondary market for loans enables financial institutions to offload risky assets and free up capital to lend to new borrowers. Securitization, for its part, achieves this while also creating diversified instruments and thereby lowering loan risk. Both tend to lower the cost of credit to borrowers.
Last month, the House of Representatives passed the Protecting Consumers’ Access to Credit Act with bipartisan support. The bill, now with the Senate Banking Committee, acknowledged that “the valid-when-made doctrine, by bringing certainty to the legal treatment of all valid loans that are transferred, greatly enhances liquidity in the credit markets by widening the potential pool of loan buyers and reducing the cost of credit to borrowers.” Legislative change will, it is hoped, put an end to any lack of clarity as to the ability for consumer loans to be subsequently transferred across firms and states. The freedom to transact is essential for consumer lending markets to operate efficiently. To understand this, we must move from legal to economic principles.
The interest rate on any loan is composed of two parts. The first part represents the time value of money, that is, the fact that access to funds today is more valuable than access tomorrow, or next year. Secondly, there is a risk premium that compensates the lender for delays and potential non-repayment of the loan. Other things equal, the greater the likelihood of non-repayment, the higher the risk premium and so the total interest rate.
When loans are backed by collateral, such as a house or a car, the interest rate can be lower because lenders can always recoup at least some loan value by seizing the collateral. Collateral also acts as a signal: only borrowers with confidence that they will repay would place their possessions as guarantee. Consumer credit, such as credit card debt, is typically unsecured, so it carries a higher risk premium.
More variable earnings, a higher chance of unemployment, propensity to incur unexpected costs, and the absence of a financial cushion to fall back on are all credit risk factors. Because they are more common among lower-income households, loan interest is viewed by some as regressive: those of lesser means will pay more for a given amount of credit. This is how modern proponents of usury laws have often justified them.
Yet, as with other price controls, the consequences are often the opposite of those intended. A high interest rate is the only way that a high-risk borrower can compete for funds with a lower-risk borrower. In the absence of adequate compensation for additional risk, lenders eschew the high-risk borrowers — who are often those most in need of credit. Not only that, but credit risks can change as a loan matures. If a borrower fails to repay on time, her credit score will change and interest rates on future borrowing will adjust upwards.
This is what happened to Madden: her default created additional monitoring and collection costs, and it also revealed information about her likelihood to repay future borrowing. In the eyes of any lender, Madden had become a higher-risk borrower than previously anticipated. Her interest rate went up.
Last year’s Second Circuit decision surely made Madden happy, but it is unlikely to benefit future borrowers who find themselves in her position. Riskier applicants are more likely to be among those rationed out of the borrower pool. There is, in fact, already evidence that Madden has changed the fortunes of borrowers in the three states covered by the Second Circuit’s ruling. Those with low credit scores saw loan volumes decline by half in the months after the ruling; for similar borrowers elsewhere in the country, loan volumes more than doubled.
Madden has thrown consumer lending markets in the three states affected into disarray, so it is appropriate for Congress to provide clarity through legislation and ensure access to credit is available to those who can and are willing to pay for it. Not just legal precedent but economic reality demand a move in this direction.