Saturday, June 20, 2009

The Case for Consumer Protection

My friend Elliot and I have an ongoing debate about the role of regulation and whether or not any government regulation can be effective in the slightest. Elliot is a by all accounts a smart guy. He has an MBA from Carnegie Mellon and works at a respected leverage finance firm in the Midwest. But, his intelligence and understanding of markets are what make his opinions on the inability of the government to create legislation that protects consumers so shocking. Elliot's position is that the government is so inept at creating prudent and efficient regulation that whatever measures are enacted will either harm the people and businesses they are trying to protect or will be easily avoided by parties affected by the regulation. Unfortunately, his concerns have recently been spot on when it comes to regulating the financial industry. Over the last 10 years the financial wizards on Wall Street and their co-conspirators closer to Main Street have consistently been multiple steps ahead of regulators. As a result of patchwork, fragmented and mostly hands-off regulation, many financial firms have been able to operate under the radar or with few restrictions on leverage, lending practices or risk-taking.

Despite the concerns of many people associated with the financial services industry that mirror those of my friend, the Obama-Geithner team this week unveiled a somewhat ambitious white paper that detailed how it proposes the industry should be regulated going forward. Since the release it has not been hard to find critics of the plan. In fact, just about everyone has had at least some issues with aspects of the overhaul. For instance, here is the take from Simon Johnson of MIT and here is Paul Krugman’s opinion. These men who have been an opposite sides of many debates during the current recession appear to agree on one thing: that the Obama plan fails to address the regulatory lapses and perverse incentives that led to the most blatant excesses. While some amount of uncertainty regarding the proposals is to be expected, what has caused the most uproar and what will likely be one of the major hurdles in getting the bill through Congress is the proposed Consumer Financial Protection Agency (CFPA). According the Wall Street Journal:

A centerpiece is the creation of a Consumer Financial Protection Agency with authority to write and enforce rules across a slew of financial products.

Firms will be given the option of offering "plain vanilla" products -- such as a credit card without hidden fees or penalty interest rates -- without having to jump through regulatory hurdles. The goal is to make it possible for consumers to shop around without worrying about getting burned by the fine print.

During our initial discussion regarding the CFPA, Elliot asked me for any example of regulation that works without doing more harm than good. When he first asked me it was tough to think of a piece of regulation off the top of my head that did not have some unintended consequences. But after some digging I think I have found one. How about the regulation of consumer product safety standards? According to this thoughtful and prescient article, since the US created the Consumer Product Safety Commission (CPSC) under Nixon, thus creating minimum safety standards for consumer products, the rates of injuries and deaths due to faulty products have gone way down.

After reading the compelling case made by Elizabeth Warren (the person now overseeing the TARP program as chair of the Congressional Oversight Panel and who is credited with inspiring the portion of the Obama white paper regarding consumer protection) in her 2007 article linked above, I started to ask myself why should financial products not have some minimum standards as well? Because they don't kill people like bad toasters? What would our lives be likes if companies sold us household products basically saying, “buyer beware?” Just because a bad mortgage can't physically harm you does not mean it can't ruin your life. Just ask all the people who were too ignorant, too naive or too greedy to spend the time to get to understand their mortgage agreement about how it can ruin your life. My guess is that many of them would have horror stories about predatory lenders and misleading statements.

Presented with evidence of swindled or just plain foolish consumers, my friend Elliot would immediately counter with a Darwinian, survivor of the fittest argument based on the theory that people should be able to fend for themselves and that it is not the government’s job to protect people from destroying their own balance sheet. In that context he would argue that in a free market lenders should be free to sell any products they want and any potential regulation would negatively impact efficiency and innovation. While I somewhat agree that the regulation would inevitably be imperfect and would have unintended consequences, I do not believe that is a reason not to try to get some form of prudent regulation in place. I think the theory that people can make their own unwise financial decisions without affecting the rest of us has been destroyed by the contagion that began in the subprime mortgage market, spread to banks and other financial institutions and now has precipitated a global recession that has caused millions of job losses.

If I were creating legislation to attempt to protect the financial system from a future shock like the current one, my goal would simply be to prevent excesses. I know that sounds relatively simple and follows common sense. However, during the leverage boom years in the mortgage and credit card industries, excesses seemingly built up in every corner of those markets. That’s why I think a standard that focuses on eliminating the most destructive marginal practices would present a balance between over regulation and too little regulation. As an example of an egregious practice that she feels should be limited by future regulation, Warren highlights YSPs or Yield Service Premiums in which mortgage brokers are awarded extra fees from mortgage lenders when they steer people into higher interest loans:

For example, a family that might qualify for a 6.5 percent fixed-rate, 30-year mortgage could easily end up with a 9.5 percent mortgage because the broker can pocket a fee (what the industry calls a "yield service premium," or YSP) from the mortgage company to place the higher-priced loan. High YSPs helped drive the wild selling that led to the recent meltdown in the subprime mortgage market.

Despite the characterization of YSPs by one Fannie Mae vice president as "lender kickbacks," the practice of taking these fees is legal. Under pressure from the mortgage-broker industry, Congress and the regulatory agencies have generally approved of YSPs. In fact, mortgage brokers face few regulatory restrictions. It is no surprise, then, that mortgage brokers originate more than half of all mortgage loans, particularly at the low-end of the credit market. YSPs are present in 85 to 90 percent of subprime mortgages, which implies that brokers are needlessly pushing clients into more expensive products. And the costs are staggering: Fannie Mae estimates that fully 50 percent of those who were sold ruinous subprime mortgages would have qualified for prime-rate loans. (emphasis mine) A study by the Department of Housing and Urban Development revealed that one in nine middle-income families (and one in 14 upper-income families) who refinanced a home mortgage ended up with a high-fee, high-interest subprime mortgage.

Even though the data referenced above is somewhat anecdotal, I think it is very troubling and indicative of excesses that could be purged from the system. If those people who were unnecessarily pushed into subprime loans had secured fixed rate mortgages, would we have avoided the subprime meltdown? I have no clue. But what I do believe is that the situation would likely not be as bad as it is today in which we are facing mortgage delinquencies all the way up the income and FICO ladders as a result of the extreme drop in home prices that started in areas infested with subprime loans.

Of course there are major differences between consumer products and financial products. One major one is that consumer products are created using approved patents and processes that have worked for years and have been tested by manufacturers, regulators and consumers. Also, even though your average Wal-Mart offers a plethora of different toasters, there are only so many different toasters that can logically be created. When it comes to financial products however, little tweaks in payment mechanisms, maturities or interest rates can lead to just about an infinite number of marginally different offerings. What this means is that standardizing financial products could limit innovation that is actually beneficial for customers and inhibit customization that provides consumers who have idiosyncratic needs with needed flexibility.

Despite these obvious differences, I don’t think the resultant difficulties necessarily lead to the conclusion that the government should not at least try to enhance consumer protection when it comes to financial products. I have no idea what the legislation (if it is even passed) will eventually include. I don’t know if it will work to prevent predatory lending or help people avoid products that are not right for them. What I do know is that whatever the legislation does or does not say could end up affecting more people than just those who are prone to making irrational or uninformed financial decisions. I think this crisis has proven that we are all in this together (even on a global basis) and if excesses in certain sectors of the financial markets are not curbed, then the derivative effects can be costly to market participants and non-participants alike.

In closing, I think Warren sums up her argument really well with the following concluding passage:

Personal responsibility will always play a critical role in dealing with credit cards, just as personal responsibility remains a central feature in the safe use of any other product. But a Financial Product Safety Commission could eliminate some of the most egregious tricks and traps in the credit industry. And for every family who avoids a trap or doesn’t get caught by a trick, that’s regulation that works.

(I have embedded a Scribd document of the Elizabeth Warren article from 2007 that I highly recommend if you want to understand the consumer protection component of the Obama proposal)

(Picture courtesy of

Elizabeth Warren Summer 2007