The Right Way to Regulate

In the weeks ahead, Congress may finally provide American families with a seat at the financial regulatory table in Washington, D.C. If Congress passes the Consumer Financial Protection Agency (CFPA) Act of 2009, on which the House Financial Services recently reported favorably, it will establish, for the first time, a federal agency whose sole mandate is to evaluate financial products through the lens of consumer fairness. By putting the tools to evaluate loans in the hands of borrowers, it would also give families the chance, as well as the responsibility, to protect themselves.

For years, the consumer credit market has been broken. Healthy markets depend on full information between parties to contracts, but lenders have systematically hidden the costs and risks of consumer credit products while burying a wide assortment of tricks and traps in the fine print. The result is that consumers can’t compare the costs of different products or distinguish safe lenders from risky lenders. Because the costs and risks are so well-hidden, the broken market undermines real consumer choice, inhibits consumer-oriented innovation, and leads many borrowers to over-consume credit, putting themselves--and our whole economy--at risk.

In the weeks ahead, Congress may finally provide American families with a seat at the financial regulatory table in Washington, D.C. If Congress passes the Consumer Financial Protection Agency (CFPA) Act of 2009, on which the House Financial Services recently reported favorably, it will establish, for the first time, a federal agency whose sole mandate is to evaluate financial products through the lens of consumer fairness. By putting the tools to evaluate loans in the hands of borrowers, it would also give families the chance, as well as the responsibility, to protect themselves.

For years, the consumer credit market has been broken. Healthy markets depend on full information between parties to contracts, but lenders have systematically hidden the costs and risks of consumer credit products while burying a wide assortment of tricks and traps in the fine print. The result is that consumers can’t compare the costs of different products or distinguish safe lenders from risky lenders. Because the costs and risks are so well-hidden, the broken market undermines real consumer choice, inhibits consumer-oriented innovation, and leads many borrowers to over-consume credit, putting themselves--and our whole economy--at risk.

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This broken credit market results largely from the fact that consumers lack the same sorts of basic safety protections that they enjoy in markets for virtually every product we touch, taste, or smell. While several federal agencies exist to regulate banks, the regulators themselves are competing for the banks’ business. Today, financial institutions can “shop” for the regulator that regulates least, picking their regulatory agency by changing their charter. When a financial institution changes its charter and leaves a regulator, it takes substantial fees with it--paying them instead to the new regulator. Not surprisingly, the regulators understand the competitive environment they face. They have been quick to race to the bottom, offering the lightest touch in order to maximize fees and budgets. Even if they ignored these pressures, the regulators have other missions that take a higher priority. Banking examiners tend to focus on things like balance sheets and capital adequacy requirements, while the Chairman of the Federal Reserve focuses on monetary policy. For both, consumer protection is far down the list of priorities.

For proof, just look at the record of the agencies over the past generation. The Federal Reserve had the power to outlaw the most egregious subprime practices, but it chose repeatedly not to enact stronger rules and not to enforce existing consumer protection laws. The Office of the Comptroller of the Currency (OCC) has been more vigorous in its enforcement--but on the side of the banks instead of consumers. The agency worked hard to ensure that certain banks under its protective umbrella were shielded from state laws that might have averted some of the worst financial pain.

The current crisis offers a case study for the need for change.

In the years leading up to it, a huge industry thrived on a model of selling unsustainable loans to persons barely qualified, if at all, to pay the loan for a short term--typically two or three years. The business logic of the model relied on the high fees produced by serial refinancing, before the ARM “exploded” or the “Pay Option” Loan “recast.” Over the long run, serial refinancing was a losing game for the borrowers; it was staggeringly expensive, and it required perpetual increases in property value to provide the equity necessary to fund the next refinance. If the market flattened, and refinancing was impossible, the homeowners could lose everything they had invested.

As the signs of the coming crisis became clearer, federal agencies turned a blind eye to these practices. Despite calls from state attorneys general, housing experts, and academics, regulatory agencies took little interest in the ways the risks underlying these loans were repackaged and resold through mortgage-backed securities, derivatives tied to those securities, and credit default swaps of the type that ultimately swamped AIG.

At no point did regulatory agencies consider whether the harm to borrowers of highly leveraged, unsustainable loan products outweighed the benefit of short-term home ownership, nor did they ask whether refinancing was used to move people out of affordable mortgages and, eventually, out of their homes. At no point did any federal regulatory agency consider the predictable harm to our communities and their tax bases if unsustainable loans began to fail en masse, as lenders knew they would if home values leveled off. And at no point, as tricks and traps pricing became a prominent part of large banks’ revenue plans, did any regulatory agency consider how fee-gouging exacerbated the ongoing consumer debt crisis.