The Right Way to Regulate

by Martha Coakley, Elizabeth Warren | November 18, 2009

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.

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.

The result of industry recklessness and regulatory failure was massive systemic risk that, once materialized, required equally massive government intervention that has cost at least a trillion dollars. While small businesses and families are left to fail when they take on unsafe risk or make bad decisions--1.5 million families and entrepreneurs will declare bankruptcy this year alone--we have been told we have no choice but to bailout the largest players in the financial sector.

One of the most important lessons from the financial crisis is that we need a regulator who will create safety baselines in the consumer credit market and bring clarity to a market loaded with tricks and traps. Clearer financial products will come from clearer rules in Washington.

The CFPA is designed to scissor through the existing consumer protection regulations, which are scattered among seven federal agencies and are as incoherent and ineffective as they are costly and cumbersome. The CFPA reported out by the U.S. House Financial Services Committee would create smart rules that would promote comprehensible, transparent products and, in turn, empower consumer choice and increase competition. This will be a welcome relief for many lenders--particularly community banks--that have been caught between the desire to offer clean products and the need to compete with the charlatans who promise lower prices, then boost their profits with consumer traps.

Of course, a market that allows for real competition drives price closer to the marginal cost of production and won’t be so profitable for some lenders. They want to hang on to their current business model. So, lobbyists have vowed to kill the agency and to make sure it never gets out of Congress. Others are furiously working to get exemptions and to dilute the agency’s overall effectiveness. According to Common Cause, banks, financial houses, and credit card companies pumped approximately $42 million into their lobbying efforts over the first six months of 2009 so that they can continue business as usual.

While the CFPA bill that emerged from the U.S. House Financial Services Committee is strong and has the potential to put an end to the Wild West era of consumer lending, the industry has already won some key concessions. A recent amendment weakened the ability of states to create rules that would go beyond the federal standards to protect their local citizens. This amendment grants discretion to the OCC to preempt state standards on a case-by-case basis when it determines that a state law prevents or significantly interferes with the business of a national bank. While this marks an improvement over current law, it is not as strong as the original CFPA proposal. Yes, compromise is the hallmark of the legislative process; however, states need plenty of room to maneuver to protect their own citizens.

States are important leaders in combating unfair and deceptive practices. Massachusetts, Illinois, New York, and North Carolina took the initiative to protect consumers and to go after predatory lenders well before the federal government intervened. Allowing states to participate meaningfully in rule-writing and enforcement efforts can lead to early detection of fraudulent practices, swift action to stop violators of the law, and the promotion of honest competition.The states can be a resource and a partner in protecting consumers, which is why the large financial institutions want them leashed.

Lobbyists have also succeeded at winning an ill-conceived exemption for auto dealers that originate consumer auto loans. The amendment would protect the ability of auto dealers to collect a fee for selling high-priced loans to customers--a practice that can cost families thousands of dollars. For moderate and lower income buyers, the high cost of these loans combined with limited other loan options makes these types of transactions ripe for predatory lending. (The abuses have been common and well-documented.) The exemption not only shields unscrupulous auto dealers from joint federal and state oversight, but it also gives those auto dealers a competitive advantage over community banks and other lenders.

We have already paid the price for lax regulation and unbridled free market decision-making: hundreds of billions of dollars in government bailouts, millions of consumers tricked into deceptive financial contracts, blighted cities and towns, and a financial crisis worse than any in our lifetimes. This price is too high. The CFPA would help make sure that we don’t repeat these mistakes in the future or ever again incur these enormous costs.

Martha Coakley is the Attorney General of the Commonwealth of Massachusetts. Elizabeth Warren is the Leo Gottlieb Professor of Law at Harvard University and is currently chair of the Congressional Oversight Panel.

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