The AEI Versus the Real World

Peter Wallison of the American Enterprise Institute accuses the Consumer Financial Protection Agency of being a liberal plot to restrict good financial products to sophisticated elites. Mike at Rortybomb does a point-by-point takedown complete with actual data, so I can stick to the high level (not to be confused with the high road).

Wallison’s op-ed reads like a caricature of conservative ideology – all supposed moral principle and no real-world implications. His argument is basically that by imposing restrictions on complex products (Option ARM mortgages) that are not imposed on plain vanilla products (30-year fixed-rate mortgages), the CFPA is limiting choice for the poor and unsophisticated and preserving choice for the rich and sophisticated; since according to conservative ideology choice is always good in principle, the CFPA is discriminatory.

Where do we start?

First, this is exactly the way consumer protection is supposed to work. If you go to a convenience store, or wherever you can still buy cigarettes, you can buy lots of things that don’t have warning labels. The cigarettes have warning labels.

Wallison dismisses warning labels with a non-argument: “If the issue is whether the consumer understood the risks of the more complex product, strong warning labels or written ‘opt-ins’ simply raise the same question and will not be a defense for the provider.” Warning labels and written opt-ins are used all over the economy; every time you sign a piece of paper saying that you understand the risks of something and you agree not to hold the provider liable, you are opting in. It is true that these do not always hold up in court, but that’s a fact-specific question. In general, they certainly do protect service providers, although Wallison asserts the contrary.

Second, this is exactly the way securities regulation works today. The Securities Act of 1933 creates exemptions for securities that are only sold to “sophisticated” investors. This is how hedge funds escape most regulation; they only allow sophisticated investors in. The CFPA is extending this principle to a class of financial instruments that, in 1933, no one thought could be complex enough to be limited to sophisticated investors.

Third, the CFPA is simply broadening the concept of fiduciary responsibility, which already exists for various categories of service providers, such as lawyers, CPAs, and some investment advisors. Someone with a fiduciary responsibility has to put the interests of his client first. In a financial context, this would mean that you can’t put a client into a financial product that does not serve his interests. The purpose of the CFPA is similar: you can’t sell a product to someone without first making sure the he understands what you are selling him. Now, this is not exactly the same thing as a fiduciary responsibility; it’s actually considerably weaker. The point is that the idea that you should not treat your customers in ways that harm them is hardly liberal or elitist.

Fourth, Wallison asserts, without example or argument, that the more complex products are better.

So who will be able to get those more complex products and services? Not ordinary Americans, whose lack of financial sophistication will make the risks of selling to them too great for most providers. The more complex products, the ones that are better tailored to the needs of the particular consumer, will be offered only to the more sophisticated and better educated — in other words, to the nation’s elites.

“Better tailored to the needs of the particular consumer?” We’re talking about exploding mortgages and reverse convertibles here. Speaking as someone who could pass any test of sophistication, my personal opinion is that the CFPA regime would actually benefit the “unsophisticated,” because the “more complex products” are just higher-margin ways for banks to relieve rich people of their money. It’s a good thing that most people are not allowed to pay hedge funds 2-and-20 for the privilege of not being able to take their money out whenever they want. But that’s another topic.

Fifth, Wallison asserts that this is “not because the products or services are inherently dangerous, like drugs or explosives,” and hence need consumer protection. This completely ignores the biggest news story of the last two years (OK, maybe the second-biggest story after the election of an African-American president). We have millions of foreclosures – that’s people losing houses who either (a) would not be losing their houses if they had been given traditional mortgages that they would have qualified for or (b) would have been better off renting and not losing down payments, closing costs, refinance costs, and their credit ratings. Those foreclosures have negative externalities for their neighborhoods, including lower property values and higher crime. (Mike already nailed this in his now-famous “degenerate crackhead” example in this post.) And we have the biggest recession since the 1930s. How are complex financial products not inherently dangerous?

Sixth, what’s the alternative? The only one that Wallison mentions is disclosure.

Traditionally, consumer protection in the United States has focused on disclosure. It has always been assumed that with adequate disclosure all consumers — of whatever level of sophistication — could make rational decisions about the products and services they are offered. No more. . . .

Apparently, adequate disclosure will not be the answer to the provider’s dilemma. As outlined in the white paper, no amount of disclosure can adequately protect consumers against complexity.

Note that Wallison is clever enough to avoid saying that disclosure works – because it obviously doesn’t. But still he leaves it floating out there as his only alternative to the CFPA. So let’s avoid the clever rhetoric. Disclosure doesn’t work. If it did, we wouldn’t be where we are today. We tried it; now we need to try something else. And Wallison doesn’t suggest anything.

What ties these six points together? Let’s see, we have:

  1. ignoring the fact that warning labels and opt-ins are already used routinely in the economy;
  2. ignoring the fact that the “sophisticated investor” concept is already used in the financial industry itself;
  3. ignoring the fact that fiduciary duty, which is more restrictive than the CFPA approach, is already used for various classes of professionals;
  4. ignoring the very real possibility that complex financial products are not actually good for you;
  5. ignoring the fact that the financial products in question have just caused enormous harm to millions of people; and
  6. ignoring the fact that his implied alternative, disclosure, has resoundingly failed.

The genius of the modern conservative movement (not the traditional conservatism of Edmund Burke, for which I have a great deal of respect) has been its understanding that to win in politics, the facts of the real world – the “judicious study of discernible reality,” if you will – only slow you down. Wallison does the movement proud.

By James Kwak

26 responses to “The AEI Versus the Real World

  1. There is a large and rapidly growing literature from conservative, libertarian, and business sources blaming the financial crisis on … you guessed it… the government. Peter Wallison has been a major promoter of this view:

    Peter J. Wallison , “Cause and Effect :Government Policies and the
    Financial Crisis”, Posted: Wednesday, December 3, 2008, FINANCIAL
    SERVICES OUTLOOK, (American Enterprise Institute) AEI Online,,
    Publication Date: November 25, 2008

    Peter J. Wallison, “The True Origins of This Financial Crisis”, The
    American Spectator, February 2009

    In almost every financial crisis following putative deregulation conservative, libertarian, and business sources have aggressively blamed the government. It seems essential to comprehensively challenge and rebut these claims in the current financial crisis for there to be any hope of real progress.



  2. I wonder whether Wallison believes gambling and recreational drugs should be legal.

  3. DesolationRow

    While I’m no fan of the modern conservative movement, I can see there being issues with limiting choice for a certain category of people. In this case however, the real-world repercussions probably make it worth it. For example if you want to go sky diving non-tandem, you have to take a full day class and prove you know and are able to execute your parachute…and then an experienced jumper still jumps with you. And even with all these precautions, there are still a ton of discloures. Common sense.

  4. As to your second point, I tend to think that “sophisticated investor” in the SEC context is a little bit too broad. Under the regulations, a sophisticated investor can be someone who has a million dollars. It doesn’t matter their actual sophistication, just their net worth. This Forbes article has more.

    As to your third point, fiduciary responsibilities are broader, and apply widely between principals and agents, between employers and employees. It may be better to say, we would like those who are selling financial products to act like they had fiduciary duties towards their customers, duties of loyalty, good faith, and due care, something more than just the morality of the bare marketplace where caveat emptor is the rule.

    As to disclosure, that is usually the solution to many problems with investments. However, disclosure cannot solve the problem of a lack of transparency, of being able to see the whole picture. Mortgage markets can often have huge information asymmetries between mortgagor and mortgagee. Complex instruments widen this gap, but even disclosure can only do so much. With these complex instruments, even if you have the information disclosed, it may not be enough to be transparent, which is what most consumers need. Investors who bought RMBS got plenty of disclosure most of the time. Reams and reams of paper disclosure were sent – but disclosure without the information being humanly accessible is useless.

  5. Good point. Government is going to cause the next crisis. The current one is all private sector.

    It seems my life will be ruled either by big government or by big business. Decisions, decisions…

  6. One of my rare disagreements, and it is limited to your point about foreclosures:

    People took on exotic mortgages for the simple reason that they could not take a conventional mortgage AND occupy the house they wished to occupy. It may be that they did not understand the details of the instrument, but they surely understood its intended function.

    The increase in nominal buying power afforded by the exotics was a straight transfer of wealth from the UNDERWRITER to the seller. The “buyer”, assuming he ultimately was foreclosed, gained the utility of occupying a house he otherwise would not have had. He also had the option (not exercised, but valuable at closing) that if house prices continued to appreciate he could benefit financially from the thin capitalization.

    The foreclosure externality argument is not amazingly convincing. At its core, it is an argument against abandoned housing. But there are all sorts of reasons for houses to be abandoned for long stretches of time; during the height of the bubble houses on Nantucket or Southampton were regularly empty for nine months at a clip. No one complained, because the maintenance/taxes were still being paid. Similarly, there is no rule forcing someone who moves to sell his house for the immediate market-clearing price; owners are free to wait as long as they wish for their price. As long as the title holder pays the costs of the property, how is foreclosure especially harmful?

    I like the idea of consumer safety and would be happy to have restrictions on the types of mortgages available. But whatever the mortgage type, there will still be the issue of people overextending themselves in an attempt to get specific assets, and some of these people will be foreclosed. A house with a mortgage is a highly concentrated LBO, and any private equity manager who chases returns long enough will be able to point to one that didn’t work.

  7. >>Good point. Government is going to cause the next crisis. The current one is all private sector.<<

    Was it the private sector that set the trajectory of monetary policy in a fashion that let NGDP expectations plummet in Q42008?

  8. This post was good for comic relief (though the basic demagogic trend isn’t funny at all).

    The basic idea is, anyone chooses to live either in a mansion or under a bridge, so to impose any extra regulation on mansion-dwellers will be unfair to someone currently living under a bridge who decides to go live in a mansion.

    Of course, the new anti-regulatory lie being served up here directly contradicts the old one. They used to argue that sophisticated investment vehicles didn’t need special regulation precisely because it was only sophisticated (“elite”) investors who were involved with them.

    Now it turns out that was wrong. Now it goes: more stringent regulation will set up barriers vs. the unsophisticated non-elite investor who wants to enter the casino.

    Wouldn’t it be great to be able to force each of these pigs to choose one lie he’d have to stick with for the rest of his life?

    As for explosives being inherently dangerous, aren’t these the same guys who argue that guns are NOT “inherently” dangerous, but only dangerous when people abuse them?

    Of course, these complex financial products are inherently dangerous when used as intended. When was the golden time when CDSs were being used responsibly and constructively? If such a time did briefly exist, it was enforced only by regulation, and filled up and shortened by anti-regulatory activity.

    The real measure of reckless behavior and abuse isn’t absolute but relative. If everyone in the biz wanted to be what an outside observer would call abusive, then they really weren’t “abusing” but using according to how the culture decreed what the baseline should be. So an insider ideologue like Wallison is simply lying when he tries to pretend to draw any dsitinction between proper use and abuse. These complex instruments are what Buffet called them, and they are a clear and present danger to public health. They are by definition to be abused, and no one can be trusted with them.

    Which leads to the real question, which of course Wallison and his ilk intentionally obscure:

    Why should these things exist at all?

    Their alleged macroeconomic benefits have proven to be so much vapor. America hasn’t even ahd any real “growth” in a decade, only debt- and bubble-puffed fictional growth, which has now all vaporized, while wages have continued to decline.

    The ONLY benefits have accrued to a handful of criminals and parasites.

    Of course the harms are obvious and legion.

    So zero benefit, infinite harm…Why are we even still debating this? Smash the infamous thing. Get rid of the globalized “finance industry” completely.

  9. I knew this would happen. I knew that eventually the conservatives/libertarians would re-write history to say that:

    1. the crisis of 2007-2009 wasn’t really a crisis, that it was overhyped

    2. that the crisis that never happened was the fault of prior government interference in the economy, not the failure of the free market


    3. any recover from the supposed crisis happened naturally, in spite of the government rescue not because of it

    I just didn’t think they’d start spouting this idiocy so soon, while the actual events were still fresh in everyone’s memories.

  10. Please do not misunderestimate the integrity of the AEI’s financial types when they get into heavy analysis. Wallison’s Feb 2005 seminar on receivership powers for GSE regulators ( ) was excellent.

    One of the most important historical records of the present crisis is Alex Pollock’s twice-yearly subprime series, which among other things did much to popularize the views of Professor Nouriel Roubini. Just today we at Doom have released our new unauthorized transcript of Part III (March ’08), which contains some pretty deep insight, including some truly amazing thoughts on derivatives by Desmond Lachman.

    In an ideal world, AEI’s banking types, and their associates like Bert Ely and Tom Zimmerman, would have sat down years ago with the heavy military planners like Tom Donnelly and Fred Kagan and informed them that recent adventures like Afghanistan and Iraq (heck, even the 700+ oversees bases) had long since become unaffordable. That missed opportunity was tragic.

    But of course guys like Peter do tend to get a bit Manichean over D/R politics. Seems they’re in good company, though ;-)

  11. Well, yes. That’s the main subtext of the Aleynikov affair.

  12. @ John and RuetheDay,

    While it is an overstatement to say the government was the sole element responsible for the crisis, to say it was just the market/private sector is just as blind.

    Fannie Mae and Freddie Mac (didn’t they hold several trillion dollars worth of mortgages?), incredibly loose monetary policy, liquidity from foreign central banks reserves (that may have otherwise been invested outside of the US if it weren’t for official policy), etc. surely had an effect as well.

    The culprit is somewhere in between, but I’ve had enough of the view that ridicules anyone suggesting positive government policy may have been at least partly responsible.

  13. @RueTheDay

    Conservative, libertarian, and business sources began to aggressively blame the government as far back as the original “sub-prime” crisis in the summer of 2007. The attacks went into overdrive in September/October of 2008 coincident with TARP I.

    This is not unusual. In other crises, like the California electricity market deregulation fiasco of 2000, as soon as things go bad, conservative, libertarian, and business sources will switch (within days) from extolling how the latest putative deregulation has gotten the government out of the way, ushering in a free market utopia of prosperity (also known as a bubble), to blaming the crisis on massive government intervention in the market!

    I use the term “putative deregulation” deliberately since the putative deregulation often turns out on close examination to be a change in policy or regulations that benefits certain companies, not textbook deregulation.

    Conservative, libertarian, and business sources do not wait. They attack immediately and aggressively churning out op-eds, video appearances, scholarly papers, books, and so forth in volume blaming the latest fiasco on the government.



  14. I use the term “putative deregulation” deliberately. On close examination, the putative deregulation often turns out to be a change in policy and/or regulation that favors certain companies.

    Conservative, libertarian, and business sources try very hard, usually successfully, to frame the debate on the latest crisis in terms of the putative private sector or free market versus the government. This keeps the debate away from specific policies or regulations that benefit (or harm) certain companies.
    It also enables them to seize the moral high ground by claiming that they are supporting a neutral “hands off” government policy that does not favor any company, rather than policies that benefit certain companies or groups of companies.

    Progressives, liberals, and leftists almost always take the bait and frame the debate in terms of the private sector/free market versus the government. For a number of reasons, they are setting themselves up to lose. Because the putative deregulation often in fact involves government intervention in the putative free market, the conservative, libertarian, and business sources can simply point with shock and dismay at the government intervention buried in the fine print of the policies that they previously supported as “free market”, thus proving once again that it is all the government’s fault.

    On the other side of the aisle, conservatives, libertarians, and business people who are actually harmed by the policies will actually embrace them because the issue is framed in terms of the “private sector” versus the “government”. For example, many businesses in California embraced the electricity market “deregulation” in the belief that it would lead to lower electricity rates through greater competition. Aggressively blaming the government and environmentalists diverted the ire of the business community with ease even though they lost a lot of money.

    Dean Baker at CEPR is an example of a progressive economist who is usually very careful in his language about the private sector versus government. He will for example refer to the putative deregulation as “selective deregulation”.

    In the current financial crisis, most conservatives, libertarians, and businesses are not benefiting from the actual policies. They are losing money, laying off people, getting laid off, and so forth. Blaming the government and framing the issue as private sector versus the government shifts attention and blame away from specific policies and regulations that are benefiting only a small group of companies and people.



  15. But I think the point is that the CFPA will limit people’s ability to buy houses which will end up in foreclosure. People will still want them, but the financing won’t be there.

    I also think that houses that sit empty for long periods of time represent an inefficient allocation of capital, in addition to the economic and social costs to the people being foreclosed upon.

  16. I have to disagree with your statement that people only took on ARMs because they couldn’t afford their house otherwise. A lot of lenders DID steer people who were eligible for conventional prime mortgages into ARMs, somehow convincing them they were “better”. The borrowers were stupid to fall for it, sure, but the fact is that a lot of them did.

  17. I’m surprised the meme about the Community Reinvestment Act didn’t somehow get incorporated into the op-ed. I guess everyone needs a day off once in awhile.

  18. That may or may not be true from the underwriter’s perspective, but I would bet virtually every customer was told “if you select this exotic product, you will have lower payments per dollar of debt than with a traditional mortgage.” The customer took the exotic INTENDING to increase his leverage.

    There is no commandment “thou shalt put twenty percent down.” The conventional mortgage is just that: conventional. In an area such as 2004 San Diego, where nearly 80% of the population cannot afford a median house, all a conventional mortgage would have achieved is foreclosure with a larger equity contribution from the customer. The only answer that would have avoided inversion was not buying.

    Unless, of course, you believe that exotics contributed to the high prices, in which case I would think you would take my point that people were borrowing exotic to pay prices they could not have otherwise…

  19. John,

    I can’t help but feel that you’re being incredibly partisan on this.

    Conservative/libertarian/business may be too quick to jump all over the government, but what about those on the left who jump all over “free market ideology” for problems that blatantly stem from private interests chanelling postitive state action on their behalf? For an extreme example, Naomi Klein’s recent thesis attributes such things as the Iraq War and Haliburton’s successful rent-seeking to Milton Friedman’s neoclassical economic theory.

    In the end, you’re right that the market/government dicotomy is less than helpful. Efficient markets require well designed policies to complement them. The right needs to recognize this. But the left equally needs to recognize that government policies and regulation can be just as prone to failure as unregulated markets.

  20. A clear distinction should be made between the theoretical free market and policies labeled as “free market” (or “private sector”, “market based”, “market friendly”, “pro-business”, several alternate labels are used today).

    Conservatives, libertarians, and business people often embrace policies labeled as “free market” or something similar without critical scrutiny, even where the policies turn out to be harmful to them.

    The left frequently fails to make the distinction between the theoretical free market and the policies labeled as “free market” by their promoters and/or beneficiaries. This often turns into a trap as the government intervention buried in the fine print can be denounced after the policies fail to perform as originally advertised.

    There was widespread opposition to TARP I across the political spectrum — hardly surprising since it benefits very few people — but this has been diverted and diffused by confusing the issue with constant invocations of the private sector versus government debate and aggressive blaming of the government.



  21. The CFPA is a bad idea not for the reasons stated by the AEI. It is a bad idea because bureaucracies are bad ideas when simpler methods exist and incrementalist approaches pale in effectiveness to broad measures. If you want to stop people from taking on too much debt, or being charged too much for it, stop them from taking on too much debt and stop lenders from charging too much for it. Don’t leave it to some bureaucracy to ponder whether every “financial product” is or isn’t “safe” whatever that means. It may be safe for one person and not for another and the latter may have absolutely no clue, no matter how much disclosure and advice you give them. Just write a simple, clear usury law and a simple clear law that says you have to have a 20% equity in your house, and car and other big ticket items, and write a simple clear law that caps the amount of debt you can have as a multiple of your income. This law is a bad idea because iterative, case by case regulation off of vague legislation just spawns bureaucratic waste, litigation, and is ridiculously inefficient.

  22. bayardwaterbury

    Ah, the neo-conservative, a greedy, plutarch-oriented, amoral, nay-saying bigot who wants a perpetuation of society desecration for the sake of profits at any cost. I used to be a conservative in the more traditional sense, but my “old” party, the GOP has lost its way. Sad to say, but these, and more, arguments are a last ditch attempt to save the elitist shell game, which, inspite of its worst intentions and best arguments has put us in the current predicament. Time to work towards a real egalitarian social universe.

    The crisis is not over, and there will be chances to move there, if we keep pluggin. Thank you, James, for your strident debunkery!!!

  23. John, there is a small business/ big business fissure among supposed free market types.

    Small business rarely has influence and access to the political class, and is often hurt disproportionately by regulation simply because they don’t often have the legal or accounting staff to deal with burdensome regulation. New regulations rarely benefit them, and most often significantly hurt small business.

    Big Business, on the other hand, which often poses as free market oriented when convenient, often favors regulation because it drives the smaller competition out of business. Large corporations are bureaucratic by nature, so their very nature allows them to deal with government bureaucracy. Additionally Big Business, particularly Wall Street, can much more easily corrupt and /or influence politicians because they have a tremendous amount of wealth and power.

    The California energy market “deregulation” and the latest games on Wall Street were pushed by the Big Business Crony Capitalists posing as free marketeers. These “market reforms” were often welcomed by politicians on the left as well particularly when huge buckets of campaign cash were in the offing.

  24. i marvel at these separate entities you all describe,
    government versus private enterprise,

    where can i find these things in the real world please?

  25. California Mike

    My response will be limited to Mr. Wallison’s comments as they relate to Option ARM mortgages. For disclosure to contribute to market efficiency, consumers have not only to be shown facts about a financial instrument, they have to understand how it operates and how their obligations change over time and in differing interest rate environments. Option ARMs were highly complex instruments that were poorly understood by nearly all, from consumers to even Board members of companies which originated them. The continued confusion in the press between resets and recasts even today illustrates how poorly they are understood as does a lack of any consensus as to when the spike in recasts is expected to take place.
    Amortizing mortgages were developed in the 1930s to help prevent the problems associated with non-amortizing bullet mortgages that were popular prior to the depression. Somewhere along the line, blinded by the expectation that home prices could only rise, interest-only and then negative amortization loans became popular. Consumers were sold on the notion that if they could not afford the payments when payments spiked at recast, they could refinance the loan or sell the home at a profit. Until of course they couldn’t. And unfortunately, when they couldn’t, neither could anybody else and the bubble imploded.
    The history of Option ARMs is that they pose a substantial risk to the financial health of borrowers and that they create, as Russ points out, large negative externalities. The fact that there may be a borrower somewhere in Greenwich or Beverly Hills whose wealth, financial understanding and discipline benefited is really irrelevant. We don’t permit people to own hand grenades even though it may make fishing easier for some.