Doubling down

WHETHER USED AS an income bracket, a collection of values and attitudes, or a state of mind, “middle class” is a pretty broad category. But at its core, middle class connotes material comfort born of personal responsibility. The luxuries associated with a middle-class lifestyle are contingent, the fruit of effort, not entitlement. And if financial security is a key objective of middle-class striving, the building blocks of such assurance are not the portfolios and trust funds of the wealthy, nor the government safety net that the poor rely on, however tenuously, for their backstop. The middle class earns its economic peace-of-mind paycheck by paycheck. That makes it a particularly precarious form of security, one that could evaporate with the next round of layoffs. Now, according to Harvard Law School professor Elizabeth Warren, middle-class worriers have something more to worry about: bankruptcy.

Warren has studied the bankruptcy system in the United States for 25 years. One of her discoveries, made in the course of writing her first book, As We Forgive Our Debtors, published in 1989, was that declaring bankruptcy—a legal process that allows individuals and families to be relieved of debts they cannot pay—is largely a refuge of the middle class. Warren and her two sociologist co-authors had expected to find bankruptcy filers who were “among the marginal in society—maids, day laborers, people who have no job skills, no decent jobs,” she says. But in the court records, she says,“We kept coming across home mortgages. We kept coming across people whose incomes had been above the median income. There was a lot of indirect evidence that we might be dealing with a much more middle-class population, the middle class on the ropes.” Warren and her colleagues returned to the bankruptcy courts with a more detailed questionnaire for filers, followed up by telephone interviews. The result, in 2001, was The Fragile Middle Class, which documented an alarming rise in bankruptcy filings, typically triggered by job loss, catastrophic illness, and divorce.

In her new book, The Two-Income Trap, Warren teams up with her business-consultant daughter, Amelia Warren Tyagi, to look more deeply into the causes of middle-class financial collapse. Reviewing yet again her voluminous data set on bankruptcy filings, what stuck out for Warren was the number of women filing for debt relief in 1999— nearly half a million, up from only 69,000 in 1981. Even if women’s financial distress could be traced to divorce, it wouldn’t explain why their vulnerability was increasing, Warren reasoned.“Indeed, the economics of divorce should actually be easier than it was a generation ago,” says Warren.“Women are better educated. They have better workforce experience. They can make more money on their own, and that was supposed to save them from the economic consequences of a divorce. Moreover, ex-husbands are paying more and paying more consistently than they did a generation ago, especially in the middle class.”

The problem was that “the family itself has become a more vulnerable economic unit,” says Warren. “So when it breaks apart in divorce, it’s a lot more likely today to file for bankruptcy than it was a generation ago. Even if it doesn’t break apart in divorce, it’s a lot more likely to end up in bankruptcy than it was a generation ago. To understand the vulnerability of the family we decided to start where they spend their money.”

To find out why today’s two-income household is more tapped out than the old one-income family ever was, I spent an hour talking home economics with Warren in her Cambridge office. What follows is an edited transcript.

COMMONWEALTH: You come up with a number of fairly startling comparisons about the risk of bankruptcy. You say more people will file for bankruptcy this year than have heart attacks or get diagnosed with cancer. More will file for bankruptcy this year than will file for divorce. More will go bankrupt than graduate from college. Not only that, you say that for every person who files for bankruptcy, probably seven more ought to file to get relief from their debts because they are in pretty similar financial conditions. What’s more, you say that’s not so much because of the tough economic times that we’ve been in recently. In fact, these trends emerged during the 1990s, which was the longest economic expansion since World War II. So why the bankruptcy boom?

ELIZABETH WARREN: It’s because of structural changes in the economy and in the family itself. The two are intertwined. When I took my first job, my husband routinely referred to the money I made as pin money. Today, that’s an insult beyond measure. No woman would sit still for a characterization like that —and rightly so, because it no longer reflects the economics. When I was first married, we bought a house, we bought groceries, we committed to a car payment, based exclusively on my husband’s income. In that sense, [my income] really was pin money. It was extra money—money to re-carpet, money to take a vacation, money to buy a new couch. But it was not money to live on, day to day. American families today…spend both paychecks. And those two paychecks are committed to long-term financial obligations— mortgages, car payments, health insurance. That means there’s now no cushion anywhere. They’re desperately committed to hanging on to both of those incomes. If something happens—either a job loss or a medical problem that causes one of them to drop out of the workforce—their income plummets.

WARREN: That’s not supposed to be so, right? We’ve told ourselves this story for an entire generation now: American families are collective spendthrifts. They’re out there buying designer water and high-end tennis shoes until they go straight to the poorhouse. I’m not just talking about De Graaf and Schor. Pick up any newspaper article, run a Google search or a Nexis search on newspaper articles on consumer spending. It’s presented as a factual assertion that needs no backing up because we all know it to be true. Until we look at the numbers. The numbers say that, for the median-income, two-parent, two-child family, the conventional wisdom is flatly false. These families have been collectively defamed about their spending habits. Why have they been defamed? Why is this myth so rock solid in our collective consciousness? First, I think it’s because some people are spending like crazy. The top 20 percent of the income spectrum is really buying a lot of stuff. The granite countertops, the spa bathrooms, and the media room in the new house—that’s all going to the top end. It’s not going to the middle. Look at housing for middle-income families. More middle-income families live in houses that are more than 25 years old than ever before. Housing size for these families has increased by less than half a room, from 5.7 rooms to 6.1 rooms [from 1975 to 1997]. It’s not McMansion status. So part of it is what captures lots of attention in the press and our collective conscience (and what’s frankly more fun to look at) are those high-end houses. It’s a lot more fun to talk about the can-you-believe-the- latest-household-amenity than it is to talk about the fact that most families are struggling to buy a 40-year-old house with three bedrooms and one and a half baths. So that’s part of it. The second part of it is that we desperately want it to be true. I would have liked to have found that these families were overspending on eating out and designer underwear and too many movies, because if that were so, I could say to these families: no more eating out, no more designer underwear, and no more movies. If you do that, I promise you, you’ll be safe financially. Instead, these data tell us that middle-income folks have spent in the most responsible way possible, and yet bankruptcy filings are doubling, and doubling again, and doubling once again. That’s a heart-breaking piece of news. It means the correction is something a whole lot tougher than “No more Red Lobster for you.”

CW: Still, the additional income from that second earner in the household is going somewhere. You suggest that it’s getting put to fairly insidious use, in what you call a “bidding war in the suburbs.” What is it that suburbanites are bidding up, and why?

WARREN: More than anything else, they’re bidding up the price of housing in zip codes that have decent schools. Families with children shop with one thought in mind: Where will my children go to school? Every other decision they make flows from that. What will happen to my little ones if I buy this house? That’s, of course, because school assignments go entirely by zip codes. Once that happens, it means that the value of a house in a decent school district—not extraordinary, but a decent school district — starts moving up relative to the price of housing in weaker school districts. Housing specialists can describe the average price of housing as only increasing 5 percent, but the disaggregated data show that inflation-adjusted housing costs for people with children and for people with no children have diverged substantially in a generation. That’s the best evidence of what’s going on. And then there are the studies where, over and over, a 5-point difference in test scores for a school will be reflected immediately in housing prices.

The Philadelphia example is my favorite. The University of Pennsylvania struggled to keep the neighborhood around it from plunging into complete collapse. Penn poured money into that neighborhood with very marginal results —until they built an elementary school. Once they built an elementary school, prices tripled in that neighborhood, while they went up only modestly in the rest of Philadelphia. It’s the same old crumbling houses [in the Penn neighborhood], the same narrow backyards, and the same peeling paint. But it now comes with a decent elementary school. [Prices went up because] parents rushed in to try to get a home where their children could go to good schools.

If the education system were getting better and better all around America, [housing prices] wouldn’t be an issue. But that’s not how parents perceive the educational world. Their confidence in the public school system is in shambles. It’s crumbled. So parents are trying to pick among the ruins to find the school districts they believe represent a decent chance for their children to make it safely through school, get a good education, and launch them toward college. But as it becomes harder and harder to find good school districts, the prices in those particular zip codes keep going up.

CW: That explains a lot about what’s happening in the greater Boston area, where the suburban real estate market remains red hot despite the fact that our population is barely growing at all.

WARREN: It makes no sense, does it?

CW: But there certainly is something that’s driving the prices up in places people consider desirable, and they consider them desirable principally based on the kind of school system it has.

WARREN: Schools, schools, schools. What’s ironic about this is that people aren’t moving to far-out suburbs because everybody wants to [have a long] drive into downtown Boston. We focus on housing costs, but the economic effects of parents trying to buy into school districts echo everywhere else in the family’s financial budget and in its time budget. We focus on housing because it’s the most tangible and the easiest way to look at it, but it’s there elsewhere, too. Hours are cut out of parents’ lives [because of commuting] solely so that they can keep their children in schools that are an hour, an hour and a half, from where they work.

CW: So how do you disentangle this nexus of school and location to give parents a chance to opt out of the bidding war?

WARREN: Boy, we struggled with this one, and struggled with whether or not to talk about solutions in the book, whether we could just stop there and say it’s a problem. You know, we wondered if we could be like [rocket scientist] Wernher von Braun—where they come down is not my department. But our editor jumped all over us and said, you must have some idea of what should happen. We both said, sure: Decouple school assignment and zip code. If there were metropolitan-wide school choice for all parents and if schools were permitted to admit children based on test scores, talents, lotteries —anything but zip codes—then the economic pressure on families would be released almost immediately. If the divorced woman with two children could live in an apartment four miles away from the school her children had been in and still keep those children in that school, then the chances she would go bankrupt would drop like a rock. It really is that straightforward. I want to emphasize here, we’re talking about parent choice, giving all parents the choice they’re looking for. Parents have choices now. It’s just that they exercise that choice with $250,000 [home] purchases. Those who can’t make a $250,000 purchase just have a much narrower range of choices. And those who can make $900,000 purchases have a much wider range of choices. Taxpayers pay for education. Parents ought to be able to make the same school choices [no matter where they live]. Zip codes should not act as barbed-wire fences to keep out children whose parents cannot afford homes in that district.

CW: But it isn’t just in access to suburban schools that education drives the middle-class bidding war. It’s in higher education, too. In public institutions, as well as private, the price of higher education has risen far faster than the rate of inflation. Not because it has to, you say, but because the colleges have found out that they can get away with raising their prices pretty much with impunity. For a Harvard professor, that seems like biting the hand that feeds you.

WARREN: That is the advantage of tenure. Don’t tell [Harvard president] Larry Summers I said that.

CW: So what should be done to halt the academic arms race that’s forcing middle-class families to bid in to a college education they really can’t afford for their kids?

WARREN: Universities, particularly publicly supported universities, must refocus on educating the students rather than on fielding the fanciest academic team. Legislatures have a right to demand more access and better education for the children of their citizens, of their constituents, in return for more funding. On one level, this one isn’t even hard. If my taxes are going to support a public university, then my legislators have an obligation to make sure that the public university is devoting adequate funds to educating those children and to opening enough slots in the system so that all of the children of the state can be educated. Ultimately, my view is private colleges can do what they want to do. But public colleges are paid for with my tax dollars and your tax dollars, and that means the public has a right to demand something in return. Now, I want to make clear, if public universities were more financially accountable, the effects would echo right through the private universities. Harvard may still be able to do whatever Harvard wants. But public universities and private universities are in the same competition for students and for faculty. If there’s more accountability on the public side, there will be a demand for more accountability on the private side as well, by the parents of the children who apply to their schools. No one is going to pay a private college five times what they pay a public college if the public college is offering a first-rate education. Ultimately, I think that’s how reform works.

CW: Isn’t that how the bidding war begins? Isn’t that why public institutions try to land big-name scholars, the high-flying folks, to bolster their reputations and justify their rising costs?

WARREN: You put your finger on it. Think how the world would look if the question legislators asked was not how many professors do you have who are ranked as having among the 100 most publications in the last five years, but instead asked, how many students have you educated and what can they do when they leave here? Find some criteria for evaluating whether the colleges are meeting their educational mission, not their scholastic prestige mission or their sports prestige mission. Universities will do what the Legislature demands that they do or what the parents demand that they do. Right now, the people who pay the bill, parents and state legislatures, ask for prestige —academic prestige and sports teams that win. So long as that’s the case, that’s what the universities are going to provide. If the customer asks for something very different—a good education at a reasonable price for the students who come here—that’s what the schools are going to provide. There’s a lot of indication that that is happening some places. Public colleges, in particular, but also some private colleges are re-examining their mission — whether their mission is to put on sports shows or whether their mission is to train terrific engineers and sociologists. There’s a debate out there that exists independently of us. What we’re bringing to the debate is our area of expertise: the economic effects on families of failing to fix these problems. What’s our new insight on the public education system, for grades K through 12? It’s the economic impact on the family of a failing public school system. What’s our insight on college? It’s the economic effect on families of failing to hold costs under control.

CW: So having two incomes has gotten families financially overextended and fueled bidding wars around the goods that are most precious to them. But you say it’s not only the two incomes that have gotten families overextended; it’s also how we’ve leveraged those incomes into crushing amounts of debt. You trace the debt explosion to two root causes. One is the deregulation of lending in the 1980s. But the other is the push toward what has been called the “democratization of credit,” which you say has simply given people the right to get in over their heads.

WARREN: It just sets my teeth on edge. It’s almost a marketing slogan: We now steal from everyone.

CW: So how do these two factors get middle-class America to the point of jumbo mortgages and a fistful of credit cards all maxed out?

WARREN: Credit has become a product just like any other, like toasters. Only credit is deregulated and toasters are deeply regulated. Manufacturers are not permitted to market toasters in the United States that have a one-in-12 chance of bursting into flames. Credit purveyors are permitted to market home mortgage loans that have a one-in-12 chance of throwing a family into bankruptcy. That’s the principal difference. When the credit industry was deregulated, it quickly learned that it could pour money into marketing debt to marginal families and increase its profits even as the number of families who ended up in default grew. When credit was regulated [a generation ago], lenders examined their borrowers closely. That was because the profits in lending were modest, so lenders made profits by getting paid back. Today, that whole calculation is out the window. The way to make profits is by lending lots of money at very high interest rates to very risky people. Some borrowers will never pay back, but most will make a lot of minimum monthly payments at huge rates of interest. The same thing is true in the mortgage business—lend a lot to struggling families. So you get two reinforcing events: Families that feel increasing pressure financially to get into those homes and good school districts meet the lenders, who have every incentive to dole out as much credit as they humanly can. When the two run into each other, the result is a wreck for the economics of the American family and high profits for the consumer credit industry—profits now measured in the tens of billions of dollars. That’s tens of billions of dollars that are drained out of the pockets not of the wealthy—and not of the poor, interestingly enough—but drained out of the pockets of middle-income, hardworking families.

CW: You got a pretty stark lesson in that during your one day of consulting with Citibank, didn’t you? You couldn’t talk them out of giving credit cards to people who were in no position to carry the debt.

WARREN: Exactly. And just to expand beyond the story in the book, Fair Isaac, the financial consulting company, has been marketing a product for four or five years now, which they claim could cut the bankruptcy losses for every credit card issuer in America by more than 50 percent. It’s a computer screening program to pluck out the most vulnerable borrowers, the ones who are most bankruptcy-prone. Have the credit card companies done this? They’re not interested, because…the most profitable families are the families that look just like the bankrupt families but are not quite financially dead yet. Actually, I should add, many bankrupt families also produce net profits for their lenders. The high loan-to-value-ratio mortgages, the credit cards that these families paid on for years and years before they filed for bankruptcy, have already produced a profitable return on investment by the time the family files for bankruptcy. The reason, of course, is the family has been paying large amounts of interest and tiny amounts of principal for years. Sure, the credit companies wish no one would go bankrupt and everyone would continue to pay forever and ever, but even bankrupt families can be very profitable for them.

CW: Your solution for this certainly goes against the tide, which would be to re-impose regulation on interest rates. But you suggest tying interest-rate limits to the prime interest rate. That way, interest rates can rise and fall with the market but still restrict the margin between prime and consumer loan rates.

WARREN: You put your finger exactly on the key. It’s the margin — the difference between what lenders must pay in order to get money (the wholesale cost of funds) and what lenders are permitted to charge consumers (the retail cost of funds). As long as we have a modest margin that lenders can impose on home mortgage loans, on car loans, on credit card loans—and they could be different for those three— lenders will have an incentive to screen borrowers and not to lend to families already in financial trouble. When margins are five times higher than the cost of funds—that is when the cost of funds is down around 5 percent and lenders can get 25 percent on the loans—it’s like leaving money on the sidewalk. Someone is going to come along and pick it up. If it’s possible to create that [huge] margin, then some creditor is going to come in and try to lend to those families no matter how much financial trouble they are in.

CW: Even with the bidding war for housing, the inflated college tuitions, and overextended credit, it’s usually loss of a job, debilitating illness, or divorce that disrupts the two-income equilibrium keeping families afloat. It’s then that a middle-class family finds itself faced with the prospect of declaring bankruptcy. But when we hear about personal bankruptcy in the news, it’s usually in the context of efforts in Congress to tighten up rules to thwart unscrupulous borrowers who want to escape financial responsibility for their debts. Is bankruptcy law in need of reform?

WARREN: Yes, but bankruptcy law should be modified to give families more help, not to squeeze them harder. What we hear in the news about the bankruptcy system and the need for bankruptcy reform is driven by a well-financed campaign sponsored by the credit industry. There is no money to sponsor a campaign on the other side. Families in financial trouble have no political action committee. They have no $500-an-hour lobbyists in Washington. They have no one to tell their story. Massachusetts has been a leader on the political front in Washington in trying to preserve protection for families in financial trouble. Sen. Kennedy, Sen. Kerry, and Congressman Delahunt have been aggressive in fighting against changes in the bankruptcy laws [that would weaken protection for debtors] and trying to propose changes that would maximize protection for the most desperate families. I wish that were the case for every single person sitting in Washington, but unfortunately it’s not.

CW: So what would you propose in terms of public policy reforms that would help families out of the two-income trap?

WARREN: Number one is to re-impose usury regulations [strict legal limits on loan interest rates]. Usury laws have been around since biblical times, and there was a reason for them. They had it right in Deuteronomy—am I a family-values girl or what? Usury laws were also around in Colonial times. In the early 1980s, the credit industry was deregulated without a single public discussion about the economic impact of such a move. Now the credit industry has become a monster, a monster that is devouring middle-income families. Restoring usury laws would be my first proposal.

My second proposal would be to provide short-term disability insurance. The entire national conversation about money and medical problems today is about health insurance. We should have a national conversation about health insurance. But we should also have a national conversation about disability insurance. Today’s worker has a one-in-four chance of becoming disabled and without income sometime during his or her working years. Middle-income families can’t bear that kind of risk. Fewer families have protection from disability than from medical bills…. The third proposal would be to give parents metropolitan-wide school choice, to permit schools to admit children and parents to select schools, based on some criteria other than zip code. School assignment based on zip code is killing the American family.

CW: In the meantime, what advice do you have for middle-class families about avoiding bankruptcy?

WARREN: Take a hard look at fixed expenses. It’s fixed expenses—mortgages, car loans, health insurance—that sink families, not trips to McDonald’s and expensive sneakers. Have a plan if something goes wrong. For every purchase, think about what it means if dad is laid off or one of the kids gets really sick or the family breaks up…. A family that has a plan, that has set aside four mortgage payments or that knows that they could sell this house and move in with mom, is a family that has a chance to weather the storm.We propose in the book the notion of a financial fire drill. Families have to think hard about the risks they run, and they need an escape route laid out in case one of those bad things comes their way. Here’s [another] one. For families thinking about buying a house, who are told, over and over, to stretch and commit both incomes, because housing prices only rise: Think once, think twice, and think one more time before taking that plunge. Buying a house is an inexorable commitment. The demand for payment arrives the first of every month no matter what, no matter who’s working, no matter who’s sick, no matter who is getting divorced.

And think about collective action. Our politicians have overlooked middle-income families. They’ve focused on all kinds of subgroups, all kinds of groups that have lobbyists and make campaign contributions, and they have looked right past the heart of America. Those families need to speak and they need to speak loudly. No, those families don’t need to speak; they need to shout. It’s time to look at what’s happening to us. A consumer credit industry run amok is not hurting high-income people. It’s hurting those [middle-income] families, and it’s time for those families to say to their politicians: Choose between me and the banks. You can represent one of us or the other of us, but you’re not going to represent both of us.