Senator Sam Brownback has been pushing an amendment in the Senate that would exempt auto dealers from regulation by the Consumer Financial Protection Agency. The auto dealer exemption has gotten a lot of press. The House version of the exemption was the focal point of a Huffington Post story back in December on how the House Financial Services Committee was loaded with moderate Democrats who are weak on financial reform. (That amendment was introduced by John Campbell, a former auto dealer who is no longer an auto dealer but who owns real estate that he rents to auto dealers.)

The argument for the exemption is that regulating auto dealers will — you guessed it — reduce access to credit.* The arguments against are: (a) auto loans are a major source of financing for consumers, along with mortgages and credit cards, so people need to be protected; (b) auto loans provide even more opportunities for ripping off customers than most bank loans, because of the auto dealer’s privileged market position and its ability to shift money back and forth between the sale price and the loan fees;  and (c) if you open up this loophole, you will have regulatory arbitrage.

Anyway, to support his amendment, this is what Brownback wrote in a letter to the under secretary of defense.

“CNN Money on May 13 reported that ‘Raj Date, executive director of the Cambridge Winter Center for Financial Institutions Policy, agreed that the additional [CFPA] regulation might cause some dealers to stop arranging loans.’”

This is the full passage from the CNN Money story that Brownback cited.

“Raj Date, executive director of the Cambridge Winter Center for Financial Institutions Policy, agreed that the additional regulation might cause some dealers to stop arranging loans.

“‘There will be some dealers who say “If I have to play by an honest set rules, then I can’t be in this business anymore,”‘ Date said. ‘I’m not going to shed any tears for these dealers.’”

Date’s point is that insofar as credit will be less available, it will be less available because dealers won’t be able to screw customers anymore and with stop offering financing. That’s a good thing.

Now, Brownback certainly didn’t write that letter; some staffer of his did. That staffer knew that he was citing Date to support a point that is the opposite of what Date was actually saying, but did it anyway. That’s the kind of thing you do in a college paper, not something you should be doing in Congress.

Of course, it’s possible to make an honest mistake, like if you only read the abstract of a paper and not the whole thing (though it’s still a mistake). But in this case, the staffer only had to read one more sentence. That’s not an honest mistake.

* There is another “argument” for the exception, which is that auto loans didn’t cause the financial crisis. But this is not really an argument, since there is no rule that says that a bill can only be passed if it directly responds to a cause of a crisis that occurred within the past twenty-four months.

One battle in Washington — the one that has been in the news this week — is over resolution authority and the supposed “bailout fund” attacked by Mitch McConnell. Another battle will be over the Consumer Financial Protection Agency, which Republicans are likely to try to cripple behind the scenes. While most of the reviewers of 13 Bankers have seized on the call to break up big banks, few have discussed the first part of that chapter, which argues for strong consumer protection. Simon and I wrote an op-ed in The Hill to reiterate the point and warn against some of the tactics opponents may use.

A couple of weeks ago, Max Abelson got some investment bankers who used to work at Lehman to say what they really think about ordinary people:

“[Lehman]’s just not that big of an event. But that’s not what people want it to be, so they’ll make it not that way if they can. They just want to be mad and don’t know what they’re talking about and want to be outraged.”

“When I read this, I giggle a little bit. Because $50 billion is a s—load of money, but in the grand scheme of things, $50 billion is a drop in the ocean.”

“Yappers who don’t know anything.”

Well, the commercial bankers are not taking this lying down. They are out trying to prove that they can be just as offensive.

Speaking of the proposed Consumer Financial Protection Agency, bank president Robert Braswell had this to say, according to the News & Record of Greensboro:

“The consequences to the consumer will be equal or worse than what they’re trying to legislate away,” said Robert Braswell, president of Greensboro-based Carolina Bank. . . .

Banks, he said, will pass on added costs to consumers or stop offering some services, such as free checking. Braswell said when he has been on lobbying trips to Washington on behalf of bankers groups, congressmen and congressional staffers did not seem receptive to points made by those in the industry.

“There is no consideration to (whether it’s duplicative); there’s no consideration as to cost,” he said. “Those who are behind this legislation are absolutely ill-informed and under-educated . . . They refuse to consult with anyone who does possess the requisite knowledge.”

This isn’t even worth a point-by-point rebuttal. Insofar as the CFPA is duplicative, it duplicates powers that existing regulators didn’t use; and it also extends consumer protection to the nonbanks, which were not regulated at all. If free checking only exists because banks are gouging other customers, then free checking shouldn’t exist. Oh, and Tim Geithner, Michael Barr, and Elizabeth Warren are “under-educated”? I guess I am, too.

I would be encouraged by Braswell’s claim that congressmen and their staffers are not receptive to points made by the industry . . . except that it’s not true. Anyone who knows what is going on in Washington knows that the bank lobbyists have been punching holes in the legislation successfully for the past seven months. Maybe they’re not receptive to Braswell, but there are plenty of industry spokespeople doing a much better job — and not talking about it in public.

By the way, on the subject of Lehman and yappers, John Hempton has some good evidence that, yes, other banks were doing it, too. The main evidence is that Bank of America’s end-of-period assets were consistently lower than their average assets, which implies that they were doing something at the end of every quarter to massage the size of their balance sheet down. (Hempton also found matching imbalances in a specific counterparty’s balance sheet.) We had a brief exchange about whether there might be some business reason for this consistent imbalance (for example, in high-ticket sales businesses, most of the sales are clumped at the end of each quarter — but that’s an income statement thing, not a balance sheet thing), and he is pretty certain that there is no other explanation.

With the financial reform bill out of the Senate Banking Committee last week (another good thing that happened while I was away) and fresh off of victory in the health care war, the Obama administration is upping the rhetorical pressure to pass financial reform. This was most obvious in Deputy Treasury Secretary Neal Wolin’s speech at the U.S. Chamber of Commerce last week, in which he called out his hosts with fighting words: “the Chamber of Commerce – funded, no doubt, with a good deal of your money – has launched a lavish, aggressive and misleading campaign to defeat the proposed independent agency.”

Elizabeth Warren, who has never minced words when it comes to enemies of consumer protection, steps up today with an even more withering attack on the flip-flopping of the American Bankers Association, which was for the separation of consumer protection from prudential regulation before it was against it. As Warren says:

“ABA lobbyists now aggressively insist that separating consumer protection and safety and soundness functions would unravel bank stability. Yet just a few years ago, they heatedly argued the opposite—that the functions should be distinct.

“In 2006, the ABA claimed to act on principle as it railed against an interagency guidance designed to exercise some modest control over subprime mortgages.  It criticized the proposal for ‘combin[ing] safety and soundness guidance with consumer protection guidance, creating confusion that is best addressed by separating them.’”

Huh? To understand the ABA’s position in 2006,  you need to realize that it was arguing against a proposal by the major regulatory agencies to make consumer suitability (the appropriateness of a mortgage product for a consumer) an element of safety and soundness regulation. And so the ABA argued that consumer issues and safety-and-soundness were two separate things. But this is what it really cared about (from the 2006 ABA comment, page 9):

“In discussing underwriting, the Agencies should be focusing on risk levels of default and loss and creditworthiness of borrowers rather than ‘appropriateness.’ We are concerned that the Agencies are creating a new ‘appropriateness’ or ‘suitability’ standard that we are very reluctant to see applied in lending, if ‘suitability’  is to mean something other than creditworthiness.”

In other words, the ABA’s bottom line is that it does not want regulators worrying about consumers at all, and it will use whatever argument happens to be handy at the moment. In 2006, it was for separating prudential regulation from consumer protection. Now that the threat is an independent consumer protection agency, it is for unifying consumer protection with prudential regulation (because that would preserve the existing set of regulatory agencies, none of which is primarily responsible for consumer protection).

The ABA’s current argument is that if you split consumer protection from prudential regulation, the consumer protecters will write rules that will make it hard for banks to make money, thereby weakening the banks. While this argument seems to make sense, it has two independently fatal flaws. First, the implication is that if banks can’t survive without screwing their customers, then they should be allowed to screw their customers. Second, it flies in the face of the lessons of the past few years, when, as Warren says, “it was the lack of meaningful, independent consumer protection that helped bring down the entire banking system and cause the current crisis”; the banks nearly failed (would have failed without government support) because their customers couldn’t pay off their toxic mortgages.*

Of course, the ABA is a lobbying organization, and some (like a majority of the Supreme Court in Citizens United) might say that this is how politics is supposed to work: corporations that have certain interests should be able to give money to lobbying organizations that will do whatever it takes to advance those interests, and being constrained by things like logical consistency or even a sense of shame would be a dereliction of duty for those organizations. So maybe the ABA is just doing its job. But that doesn’t mean that the members of the United States Senate have to fall for it.

(By the way, did you know that Elizabeth Warren also wrote, “If you want to understand how Wall Street captured Washington and how it tenaciously hangs on to that power, read 13 Bankers“?)

* Yes, I know this is a bit complicated, because many of the toxic mortgages were originated by nonbank mortgage lenders, who then sold the mortgages to banks, who packaged them into mortgage-backed securities and CDOs and held onto some of the tranches of those CDOs, which were what blew up the banks (in part — Lehman also added a healthy dose of explosive commercial real estate). But the banks were largely responsible for the originations in the first place, both because they provided the demand for the toxic mortgages and because in many cases they provided the funding for the nonbank mortgage lenders.

Update: Shahien Nasiripour has more.

The National Association for Business Economics does a semi-annual Economic Policy Survey of its members, who are primarily private-sector economists. The March 2010 survey isn’t up on their site yet, but this is what it has to say about the Consumer Financial Protection Agency:

“A key point of discussion in Congressional deliberations on financial services regulatory reform has been the establishment of an independent agency focused on consumer financial protection. Fifty-four percent of survey respondents feel that creating such an agency would not impair safety and soundness regulation; 25 percent believed it would be detrimental.  On a related issue, 43 percent of respondents indicate that a consumer financial protection agency would not impair access to credit while 39 percent believed it would.”

The financial sector has been demanding that any new consumer protection agency be made subservient to the traditional safety and soundness regulators, and has also been threatening that greater regulation will make credit harder to come by. Apparently the business community–a group that is pretty skeptical about government, judging by some of the other survey responses–isn’t buying it.

Did under-regulated lending to consumers play a big part in destabilizing the financial system? Many knowledgeable people say yes, but Professor Todd Zywicki disagrees. (“Complex Loans Didn’t Cause the Financial Crisis,” Wall Street Journal, February 19, 2010).  He claims that the present troubles resulted from the “rational behavior of borrowers and lenders responding to misaligned incentives, not fraud or borrower stupidity.”

Professor Zywicki’s argument enjoys, at least, the modest virtue of technical accuracy, because many objectionable misleading sales practices and agreements that lenders used were, and continue to be, unfortunately, quite legal.  Lending practices may have been regularly misleading and confusing and reckless-but fraudulent?  Well, no, usually not unlawful by the remarkably low standards of the day.   But that in itself is an argument for saying consumer protection laws failed.

Professor Zywicki’s case for denying that better consumer protection rules would have mattered quickly becomes technical and rather disingenuous, hinging as it does on the difference between denying that there were inadequate restraints on imprudent lending, on the one hand, and insisting that there were definitely “misaligned incentives,” on the other.  If the lassitude of the government agencies who were responsible for financial consumer protection is not to blame, then who was responsible for all the euphemistic “misaligning”?  Zywicki manages to blame the financial crisis on “extraordinarily foolish loans” that created incentives for borrowers to borrow unwisely, but absolves the regulators who could have prevented those foolish loans from being made.

Zywicki’s research leads him to conclude that the onset of the foreclosure crisis “was [initially] a problem of adjustable-rate mortgages, whether prime or subprime.”  It might have been useful if he recalled that even if true, it was still the case that inadequate disclosure of the implications of potentially exploding adjustable-rate mortgages was a matter of serious concern to consumer groups.  In the second phase, he says, “falling home prices provided incentives for owners . . . to walk away from their houses.” It might have been useful to recall that if the carrying cost of mortgages had been more closely supervised as a matter of consumer protection, the problems would not likely have been as severe.

And so the broad claim that the financial crisis has nothing to do with fraud or consumer protection dissolves in the face of the facts: the crisis can be attributed to failures of consumer protection, including those that enabled lenders to make the loans Zywicki decries. Consider the following examples of consumer protection failures:

First, lenders made loans that virtually invited default.  Thus, Countrywide’s manual approved the making of loans that left consumers as little as $550 a month to live on, or $1,000 for a family of four.  And lenders qualified borrowers for loans based on a temporary low teaser rate even though they knew that borrowers would not be able to make the higher payments required when the teaser rate expired.   Of course, when loans became unaffordable, lenders could anticipate that borrowers would refinance, triggering a new round of fees for lenders-but they gave too little attention to the possibility that the loans could not be refinanced.  Consumer protection laws failed to prevent this disaster-in-the-making.

Second, the Federal Reserve’s disclosure rules made it impossible for adjustable rate mortgage borrowers-and 80% of the subprime loans were adjustable–to understand the risks they faced. Since the eighties, the Fed has mandated that the disclosures for such loans state figures for monthly payments that are simply wrong.  That may have led consumers to believe their loans would be more affordable than they were.  One of us recently presided over a survey of mortgage brokers that revealed that many borrowers spent little time reviewing those disclosures and never changed what they did because of them-something that ironically makes sense when the disclosures are misleading.  Better consumer protection laws would have enabled borrowers to know when they risked getting in over their heads.

A third consumer protection failure connects to Zywicki’s claim that borrowers “rationally switched to adjustable-rate mortgage when their prices fell relative to fixed-rate mortgages.”  The problem is that many adjustable-rate borrowers did not realize that their loans were adjustable.  Thus, a study of borrowers in certain Chicago zip codes found that “the overwhelming majority” of those who received adjustable-rate loans had thought their loans were for fixed rates.  The authors explained that “In every case where borrowers were surprised to be told they were receiving an adjustable rate loan, the Loan Originator had told the borrower that the rate was ‘fixed’ but neglected to mention that the terms for which the rate was ‘fixed’ was limited to 12 to 36   months.”  It was not until 2008 that the Fed reined in this practice.

These problems could have been forestalled by an agency focused on consumer protection. Why weren’t they?  We believe that Zywicki is right to focus on incentives but wrong to ignore the incentives faced by regulators themselves.  The economic crisis was caused in part by incentives built into our consumer regulatory structure that encourage regulators not to protect consumers.  A CFPA would have different incentives.

For example, in 1994 Congress gave the Federal Reserve the power to bar unfair or deceptive mortgage loan practices and abusive lending practices in connection with mortgage refinancing-powers that would have enabled the Fed to prevent the foolish loans Zywicki complains about, and the practices described above.  Yet the Fed did not use that power until 2008, long after the subprime loans had tanked.   And it was only last summer that the Fed proposed to change its misleading adjustable-rate mortgage disclosures. Perhaps the reason lies in the fact that the Fed is primarily an agency devoted to monetary policy, where consumer protection is reportedly seen as a backwater.  The leaders of the Fed are chosen not because of their expertise in consumer protection, but because of their mastery of economic policy.  Thus, the Fed’s incentive is to focus on monetary policy.  An agency with protecting consumers as its sole mission would surely not have waited almost twenty years to act while lenders provided borrowers with false and useless disclosures.

A second problem with the current structure of consumer protection regulators stems from the fact that because lenders have some power to  choose which agency will regulate them, agencies have an incentive to go easy on consumer protection regulation to avoid chasing lenders to other agencies.  For example, four days after the Connecticut Banking Commissioner examined one Connecticut lender, the lender notified the Commissioner that it was becoming a subsidiary of a national bank, thereby excusing it from compliance with Connecticut banking law.  The incentive to retain lenders to regulate is especially strong for regulators, like the OCC, that depend on fees provided by their lenders to finance their operations.   That may explain why the OCC took the position that state anti-predatory lending laws did not apply to the lenders within its jurisdiction-laws which might have prevented some of the lending that led to the subprime crisis.  But if lenders could not choose their regulator, regulators would lose the incentive to compete to protect lenders from consumer protection laws.

Zywicki is right that we need “simplified and streamlined regulation.” The problem is that the existing structure, with consumer protection split among an alphabet soup of agencies, such as the OCC, OTS, NCUA, FDIC, HUD, FTC, and, of course, the Fed, among others, is not likely to produce simplified and streamlined anything.  We share Professor Zywicki’s concern that the Truth In Lending Act needs pruning, for example.

The best way to attain simplified and streamlined regulation is to simplify and streamline the agencies that produce it-by reducing them to one.  Doing so would concentrate consumer protection expertise in one place and enable accountability.   And, we assert, if it had been done a few years ago, the financial crisis might have been averted.

Paul Krugman begins this morning’s column this way:

“So here’s the situation. We’ve been through the second-worst financial crisis in the history of the world, and we’ve barely begun to recover: 29 million Americans either can’t find jobs or can’t find full-time work. Yet all momentum for serious banking reform has been lost. The question now seems to be whether we’ll get a watered-down bill or no bill at all. And I hate to say this, but the second option is starting to look preferable.”

Krugman says he would be satisfied with the House bill, but that the need to bring moderate Democrats and at least one Republican on board in the Senate could lead to a severely watered-down bill, in particular one without a Consumer Financial Protection Agency. Instead of accepting such a deal, he says:

“In summary, then, it’s time to draw a line in the sand. No reform, coupled with a campaign to name and shame the people responsible, is better than a cosmetic reform that just covers up failure to act.”

Krugman recognizes that this is structurally different from what he said about health care reform. In Larissa MacFarquhar’s recent profile of him in The New Yorker, discussing health care, he said, “There’s a trap I’ve seen some people fall into — you let your vision of what should be get completely taken over by what appears possible right now — and that’s something I’m trying to avoid.” Now he’s avoiding it.

I generally enjoyed that article. For one thing, I remembered that Krugman and I had a similar perspective on the 2008 Democratic primary (Obama was the most conservative of the major candidates and spouted a lot of “feel-good stuff about hope and dialogue and reconciliation”); both of us supported Edwards, although he switched to Clinton when Edwards dropped out and I switched to Obama.

For another, there’s something else we have in common. Explaining why, after the fall of the Berlin Wall, he didn’t set out to consult to post-Communist or developing countries, Krugman says, “I know what Jeff [Sachs] does and I couldn’t do it. Taking transport planes, living on yak meat for days — no. But I do write faster than anybody. You’ve got to figure out what you should be doing.”

Anyway, getting back to this morning’s column — I’m with Krugman. There are certainly things that would probably make it into a compromise bill that are better than nothing. Resolution authority would be better than nothing, although far from a perfect solution. Systemic risk regulation would be better than nothing — though perhaps not much better, depending on who is in charge of it. But frankly without the CFPA and without a real solution to banks that are too big to fail, it seems to me we will have avoided solving the biggest problems.

If we want change, someone has to be willing to stand up for it. If you want to win a negotiation, you have to be willing to walk away. If you can’t do that, you will get rolled on every issue. The Democrats need to force the Republicans to make a public choice on the CFPA, instead of negotiating against themselves and taking the issue off the table. Voters will be upset if Congress does nothing about the financial system, but the Democrats should have the courage to point out why they couldn’t pass anything. Taking a stand on consumer protection should not be that hard a position to take.

“A Consumer Financial Protection Agency can be the vehicle that restores consumer confidence in our products, our services and our institutions. The customers we serve will always need credit and other banking products . . . What they want is simple, clearly explained products and the comfort that someone is looking out for their best interests when financial products are developed and marketed. . . .

“In every existing agency, consumer protection is a secondary or tertiary responsibility, after safety and soundness. Consequently, it is often a regulatory afterthought.

“If we expect attention to be paid to consumer protection and product simplification these functions must be consolidated into a functional entity with rulemaking and enforcement authority. . . .

“For a good portion of my banking career, I have been involved with products registered under the supervision of regulators who continually examine, write rules and look for wrongdoing. It has not always been easy, but my experience has taught me that vigilant, well designed regulations and agencies are the best structure for protecting me as a businessman and the consumers I serve.”

Wade’s main request is that the industry work with Congress to “improve” the CFPA rather than simply dig in its heels and try to kill it. I’m not thrilled about more rewriting of the legislation by the banking lobby. It’s already been “improved” plenty in the House, which took out the plain-vanilla requirement and also exempted the vast majority of banks from direct CFPA examinations (the CFPA will set the rules, but examinations will be done by the primary safety and soundness regulator). But practically speaking it’s better than all-out opposition. And Wade is right: the industry will be better off if customers actually trust it, because otherwise they will switch into cash, which doesn’t help the banking industry.

The problem is that the Republican Party, traditionally the political vehicle of the banking lobby, has its own, separate reasons for wanting to kill the CFPA. My guess is that even if the ABA and the ICBA went to the Republican leadership (Michael Steele? Mitch McConnell? Richard Shelby? John Boehner? Sarah Palin? Is that an oxymoron?) and asked for a constructive attitude toward the CFPA, the Republicans would turn them down, because they see more political value in following the Frank Luntz line and demonizing regulation.

The big banks face a choice. They can agree to sensible reforms that protect consumers and rein in the excesses of the past decades. Or they can simply decide to screw customers, but do it openly this time, since they have so much market share it almost doesn’t matter what customers think. How else do you explain, say, Citigroup’s concocting a new credit card “feature” explicitly to get around a new requirement of the Credit CARD Act? Or Jamie Dimon saying that financial crises are something to be expected every five to seven years, so we should just get over it?

A year ago, it might have been possible to twist the banks’ arms hard enough to get them to agree to new ways of doing business (such as a CFPA), because they needed government support so badly. Now it’s too late. So the solution has to come from the other kind of arm-twisting–pressure from the president, the administration (that means you, Tim Geithner), and ordinary voters. If people feel screwed by the financial sector–and many of them should after the past decade–then they should want the CFPA.

But last month, Republican political consultant Frank Luntz wrote a memo laying out how Republicans could kill financial regulatory reform. “Ordinarily, calling for a new government program ‘to protect consumers’ would be extraordinary popular,” he wrote. “But these are not ordinary times. The American people are not just saying ‘no.’ They are saying ‘hell no’ to more government agencies, more bureaucrats, and more legislation crafted by special interests.” The goal is simple: to make Americans think that the CFPA is their enemy, because it’s part of the government, and that the banks are nice cuddly ewoks by comparison.

This is absurd.

We like to make fun of government in this country, but really, what are you and a few of your buddies going to do to fight JPMorgan Chase on your own? For all of our beloved rugged individualism (and our individual right to handguns), it doesn’t do much good when you’re up against your credit card issuer. There is no Chicago-school free market solution to an oligopoly that, on top of all its other advantages, has an implicit government guarantee that gives it a major funding cost advantage over its competitors. One of the purposes of government is to protect ordinary people from forces (hurricanes, terrorists, monopolies) against which free market forces do not provide adequate protection. This is why we need a Consumer Financial Protection Agency. And this is what Frank Luntz wants to trick people into forgetting.

By James Kwak

Levitin, using some assumptions, estimates the effective APR (including fees) of the current card at 112.3% and of the new card at 104.9%. So, a few observations:

1. The card with the 79.9% APR may actually be better for consumers. (It depends mainly on how long you use it, because you can then amortize the up-front fees; although once you’ve paid your bills for a year, presumably the goal is to establish credit to get a better card that doesn’t have $132 in ongoing fees per year.)

2. This may demonstrate the benefits of disclosure, since consumers may be deterred by the 79.9% APR. On the other hand, they may think that they are going to pay off the balance on time so the APR doesn’t matter, but some of them will miss their payments because of misfortune or accident, and then they’re stuck.

3. Most important, I think it shows the need for a Consumer Financial Protection Agency that has broad power to set new rules as the industry invents new tricks to get around the old rules. Last year’s card bill was passed in an environment of violent antipathy toward the financial services industry that has already faded and is unlikely to return soon. So two years from now, when the dust has settled and the card issuers have figured out new ways to make money through deception, I don’t have confidence that Congress will be able to respond appropriately. Last year’s bill should have been stronger in various ways. Failing that, we need the CFPA. Yes, it made it through the House, but as with health care and climate change, the Senate is likely to be tougher.

Should the new card exist? Maybe. If the pricing is transparent enough, so people understand the true cost of credit, then maybe they’ll choose it for a year to establish a credit history. Maybe with transparency the new card will simply fail in the market. But even if some people want the card, I’m still skeptical that this would show a competitive free market. What kind of assumptions do you need to justify 79.9% as the real price of the risk the issuer is taking on, especially when the issuer has pocketed $75 right off the bat (and, no doubt, is still charging late fees and the like)? The break-even default rate must be astronomical.

Appendix on price and marginal cost: The current First Premier Card has a $3.95 fee to enable Internet access to your account and a $7 fee for direct debits that you initiate over the phone or the Internet. Because, you know, mailing you bills and processing your checks is so much more cheaper than having you log in and pay using a computer. There are only two reasons I can think of for these fees, neither of them good: (1) Internet access and payment is something customers value, so we’ll charge them for it (even though it lowers the issuer’s costs), since in this segment they’ll find it hard to find another provider; (2) Internet access and payment make it more likely that customers will pay their bills on time, so we want to deter that.

By James Kwak

Over the past several months, Congress has debated ways to strengthen and rationalize consumer protection in financial services.  Central to that debate is the proposed creation of a new agency focused exclusively on this issue, the Consumer Financial Protection Agency (the “CFPA”).

Even among proponents, however, there are varying conceptions of the scope and function of the CFPA.  For example, the CFPA as envisioned by the House Financial Services Committee would exclude auto dealers from the CFPA’s coverage.  The Administration’s original proposal would have included them.  Starting this week, the Senate Banking Committee will have to wrestle with the same question.

They shouldn’t have to wrestle long:  Even by the low analytical standards applied to hastily arranged, crisis-driven corporate welfare initiatives, the exemption of auto dealers from the CFPA appears profoundly ill conceived.  Exempting auto dealers would simultaneously be bad for consumers, bad for industry stability, and bad for what remaining sense of free-market integrity we still have.

First, and most obviously, exempting auto dealers from the CFPA would be a big step in exactly the wrong direction on consumer protection.

One the central premises of the CFPA is that it would provide comprehensive rule-making — that is, regardless of what a firm chooses to call itself (bank, thrift, finance company, ILC, investment bank, broker — whatever), if it sells financial products, then it should be subject to the same rules of the road as every other competitor.  Absent the same rules applying to all players, the marketplace becomes a “race to the bottom”:  all participants migrate to the most permissive system of rules, and customer practices degrade to the lowest common denominator.  (And then one day you wake up, and everyone is marketing teaser-rate option-ARMs).

So by that logic, if auto dealers are selling loans, then they should be subject to the same rules as everyone else.

And auto dealers are certainly selling loans.

Dealers are not a niche part of some obscure and immaterial market; they are the single largest channel (with 79% market share) in the origination of auto loans and leases, a business that (at more than $850 billion in outstandings) is larger than the entire U.S. credit card industry.

Not only are dealers a giant part of auto lending, but auto lending is a giant part of dealer economics.  Over the past ten years, gross profit per new car has plummeted by a third.  That would seem catastrophic in what was, even a decade ago, the brutally thin-margin business of selling cars.  But dealers, somehow, still were profitable in 2008.  The main reason:  Over this same period, dealers were able to double their amount of higher-margin finance and insurance income.

Moreover, auto finance is demonstrably susceptible to unfair and deceptive practices, and those practices are demonstrably not held in check by private market forces alone.  Just like mortgage brokers during the bubble, auto dealers have the opportunity to mark up interest rates; they routinely and confusingly cross-subsidize finance pricing and vehicle pricing; they can and do add “garbage” fees and add-ons of questionable provenance and dubious value.  (Can I interest you in undercarriage coating?  How about paint protection?).

So auto dealers are in the business of selling loans — a lot of loans — and their business model is susceptible to abuse.  This is not a close call; they should be subject to the same rules as other players.

But this problem goes beyond consumer protection; it goes to the stability of the system.

The auto finance market consists of two basic distribution channels:  the dealer (or “indirect”) channel, which is generally funded by a handful of large national banks and Wall Street capital markets platforms; and the retail (or “direct”) channel, which generally consists of credit unions and community banks.  By artificially distorting the auto finance market in favor of the dealers’ distribution channel, the exemption encourages the primacy of Wall Street funding sources over traditional bank deposit funding.  As evidenced by the crisis, intentionally chasing businesses from traditional banks and credit unions into Wall Street funding models creates the real potential for disruptive volatility over time.

Finally, the exemption also offends even the most basic principles of regulatory fairness.  Free-market adherents should be dismayed by the notion of specially permissive regulatory treatment for some classes of politically powerful market participants.  We should not be stacking the deck in favor of the already-dominant players with the most dubious customer practices (auto dealers and the captive finance companies and Wall Street houses that fund them), and thereby discriminating against competitors with more transparent, customer-friendly business models (community banks and credit unions chief among them).

By Raj Date

This reminds me of something that Andrew Lo said in his Congressional testimony back in November, of which I’ve discussed other aspects in the past. Lo recommended creating a Capital Markets Safety Board modeled on the National Transportation Safety Board:

“[T]he financial industry can take a lesson from other technology-based professions. In the medical, chemical engineering, and semiconductor industries, for example, failures are routinely documented, catalogued, analyzed, internalized, and used to develop new and improved processes and controls. Each failure is viewed as a valuable lesson, to be studied and reviewed until all the wisdom has been gleaned from it, which is understandable given the typical cost of each lesson.

“One successful model for conducting such reviews is the National Transportation Safety Board (NTSB), an independent government agency whose primary mission is to investigate accidents, provide careful and conclusive forensic analysis, and make recommendations for avoiding such accidents in the future. In the event of an airplane crash, the NTSB assembles a team of engineers and flight-safety experts who are immediately dispatched to the crash site to conduct a thorough investigation, including interviewing witnesses, poring over historical flight logs and maintenance records, and sifting through the wreckage to recover the flight recorder or ‘black box’ and, if necessary, reassembling the aircraft from its parts so as to determine the ultimate cause of the crash. Once its work is completed, the NTSB publishes a report summarizing the team’s investigation, concluding with specific recommendations for avoiding future occurrences of this type of accident. The report is entered into a searchable database that is available to the general public (see http://www.ntsb.gov/ntsb/query.asp) and this has been one of the major factors underlying the remarkable safety record of commercial air travel.”

Lo was talking more about financial crises than about individual bankruptcies, but the analogy still holds. If a regulator notices that a lot of people are dying in a particular kind of accident in a particular kind of car, it will investigate to find out what is going on.

Now, the statistics could actually be a bit tricky. It’s entirely possible that the most toxic products on the market will not be the ones that are involved in the most bankruptcies and foreclosures. Most bankruptcies are (I believe) caused by illness, job loss, or divorce, which strike people independently of whatever mortgage they happen to have. If we just count up the mortgages of people who go bankrupt, we might find that more had 30-year fixed mortgages than had option ARMs, simply because more people in general have 30-year fixed mortgages than option ARMs. But for now I will make a bold assertion that these statistical problems could be addressed — it doesn’t seem like the world’s most complicated model to estimate.

The Grayson/Clay/Miller amendment attempts to sidestep the banking industry’s main contention, which is that the CFPA will have a “chilling” effect on financial innovation. It also plays a kind of “sweeper” position (“free safety” is the American football metaphor) in that it can catch products that do not on their face seem all that bad, but turn out to be homewreckers later. The common-sense argument for it is that no one could reasonably oppose a provision that simply asks the CFPA to investigate existing problems and clean up after them. Still, the industry will no doubt come up with arguments against it. That, at least, is what Felix Salmon assumes, reading the overall trends.

By James Kwak

A recent ad taken out by the “The Center for Consumer Freedom” marks the latest assault by business lobbyists and conservatives on the idea of consumer protection.  This organization’s motto — Promoting Personal Freedom and Protecting Consumer Choice — defines consumer freedom as “the right of adults and parents to choose how they live their lives, what they eat and drink, how they manage their finances, and how they enjoy themselves.”

Like other critics of consumer protection, this organization (“supported by over 100 companies,” according to its website) speaks in the name of freedom and depicts consumer protection as an assault not only on the liberty but on the intelligence of ordinary people. The ad begins with the following rhetorical question, “Are you too stupid…to make good personal decisions about foods and beverages”?  Arguing against the “campaign to demonize soda” the advertisement blasts “food cops and politicians” for “attacking food and soda choices they don’t like.”  Another of their ads warns about “Big Brother” in the “Big Apple” because New York City is considering taxes on junk foods and sugar-laden sodas. [The group's print ads can be seen here.]

A nearly identical line of criticism is currently being deployed against President Obama’s proposed Consumer Financial Protection Agency.  Richard Shelby, the Republican Senator from Alabama, finds the proposal “disturbing and somewhat offensive” because it relies on the “concept of the intellectually deficient consumer.” Jeb Hensarling, a Congressman from Texas, worries that “un-elected bureaucrats” might “decide if we can have a credit card.” Scott Garrett, his fellow Republican colleague from New Jersey, is worried about the “Orwellian, government-bureaucrat-knows-best mentality” evinced by the proposal.

Opponents of consumer protection have long spoken in the name of individual liberty.  They have done so by misconstruing the nature of human agency and freedom in the modern world.

At least as far back as the Progressive era, many Americans noted that industrial society–in which consumers did not produce their own food and drink and often lived far from such sites of production–called for federal regulation and protection to insure that the food we bought was safe. This was the essence of the landmark 1906 Pure Food and Drugs Act and it was the meaning of presidential candidate Woodrow Wilson’s statement in 1912 that “freedom today is something more than being let alone. The program of a government of freedom must in these days be positive, not negative merely.”  Wilson and other progressives–-including members of the Republican Party, such as Theodore Roosevelt–-recognized that extending freedom in the twentieth century required a federal government capable of regulating business. In Wilson’s view, federal regulation of the sort provided by the 1906 Pure Food law did not substantially restrict the freedom of individual Americans. It instead instilled confidence that the market for food and drugs would be stripped of poisonous and dangerous goods.

The freedom that is restricted by consumer protection laws is the freedom of businesses to sell dangerous or even poisonous goods.  By preserving confidence in the marketplace, such regulations allow consumers the freedom to make choices, and therefore esteem the intelligence of the American people.

Of course, regulation can become excessive and Americans need to balance individual autonomy with federal protection. (So too can federal assistance go in the other direction: one of the reasons businesses ply Americans with unhealthy food is that subsidies to agribusiness make possible the cheap production of high fructose corn syrup. Thus, these defenders of the free market ignore the inconvenient fact that the playing field is not truly level.) The claims of business lobbyists that common sense regulation amounts to incipient totalitarianism, however, demonstrate their unwillingness to accept what has become over the last century a fundamental part of the social contract, and which makes tangible true freedom of choice.

By Lawrence Glickman

John Pottow (hat tip Mike Konczal) agrees on the small bank point. His main argument is that the CFPA should lower fixed regulatory costs by making it easier to get approval for basic products. He also adds this point:

“The current credit market, with its indecipherable multi-page contracts, is not competitive. Actually, that’s not true: It’s perniciously competitive — the competition focuses on better hiding fees in small print. Burying terms in legal documents is an activity where larger banks again hold the advantage. By contrast, a true plain vanilla market would remove the obfuscation and refocus the competition on price. Once more, smaller lenders would benefit from this increased transparency and leveled playing field.”

Now, Stephen Ranzini, an executive at a small bank did write in with this comment on Pottow’s article:

“Since the penalty for offering any product that isn’t ‘plain vanilla’ will be severe if that product is ‘after the fact’ found to be not to the liking of these new CFPA bureaucrats, only plain vanilla products will be offered. Since large banks can leverage economies of scale and a lower compliance burden per dollar of assets to outprice smaller banks and we won’t be able to compete anymore by crafting niche products to serve niche needs, we will be screwed (as will our customers). Gov’t needs to better regulate the non-banks. Michigan has only 15 bank examiners for all the mortgage firms in the state. These non-banks created 95% of the toxic exotic mortgages because they aren’t effectively regulated.

Now, there’s a fair amount of hysteria and blame-the-other-guy in here. First, he throws in the insult of calling CFPA regulators “bureaucrats,” while later in the comment he says there should be more regulators – to regulate non-banks, not him. Note that he doesn’t call those other regulators “bureaucrats;” he calls them “bank examiners.” I agree that non-banks need more regulation, but I don’t agree with the implicit assumption that this can be done by traditional prudential regulators; we’ve already seen where that got us. Also, blaming subprime lending on “non-banks,” is disingenuous, although they did play a major role. Not only did the top 25 subprime lenders include banks such as Citi, Wells, Wachovia, Chase, HSBC, IndyMac, and National City, but most of the others were supported by large banks that provided financing by buying up their mortgages.

Still, though, if the commenter is right that the small bank strategy is “niche products to serve niche needs,” then he may have a point. I’m still skeptical, because his entire argument rests on the premise that regulation will be so severe that it will be chilling to the market – and when have we seen that in the last thirty years? – but there could be something there.

By James Kwak

The opponents of the CFPA – not only banks, but the head of just about every current financial regulatory agency – argue that consumer protection should be combined with prudential regulation, so that one agency should be both making sure that a bank doesn’t collapse and that it isn’t abusing its customers. Many people have pointed out the flaws with this argument: first, consumer protection invariably slips down on the priority list; second, regulators become hesitant to crack down on abusive practices because those abusive practices generate the profits that make the bank “healthy” to begin with.

In addition, this combination makes the fundamental mistake of regulating financial institutions rather than financial functions, and therefore lets abusive practices simply escape to unregulated institutions. Banking regulation in the U.S. has historically been focused on making sure that banks don’t collapse, so depositors can get their money back (without bankrupting the FDIC). The result was that non-bank mortgage lenders and consumer finance companies were notoriously under-regulated. This created another opportunity for regulatory arbitrage: as Warren writes, “the Center for Public Integrity found that 21 of the 25 largest subprime issuers leading up to the crisis were financed by large banks.” In other words, banks outsourced their abusive practices to unregulated entities that they financed. How can that be a good thing?

The CFPA is many things, but it is also an example of regulating a financial function rather than a financial institution, and therefore makes regulatory arbitrage that much harder; to get outside its reach, you have to define the thing you are doing as not a financial service. (Although I think it has a weird exception for insurance products, which could turn out to be a big problem.) Since regulatory arbitrage seems to have been a core business strategy of many financial institutions over the last decade, that seems to be a good place to start.

By James Kwak