Mike Konczal, fortunately, has two good posts on the topic: one a eulogy for plain vanilla, one on the underlying problems that plain vanilla would have helped solve. He also points out at least three ways the federal government can achieve some of the same goals through other means:

• Banning prepayment penalties on mortgages
• (Citing Alyssa Katz): using the government’s historically large and now even bigger influence in the secondary market to encourage plain vanilla mortgages
• (Citing Steve Waldman): a government charge card (think “public option”)

All of those posts are worth reading. If we’re not going to have plain vanilla, we need other new ideas about how to channel innovation into things that provide consumer benefit and put a floor under the quality offered by the private sector. More disclosure won’t work (that already failed).

Update: The Raven compares the Obama administration to the Johnson administration, each with its “devil’s bargain.”

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

“We’re proposing a new and powerful agency charged with just one job: looking out for ordinary consumers,” said the president on June 17^th.  The centerpiece of his proposed overhaul of the nation’s financial system, the Consumer Financial Protection Agency (CFPA), is designed to end what the president called “failure of…government to provide adequate oversight” by monitoring banking transactions, including mortgages, credit cards and checking and savings accounts. It did not take long for the predictable critics to denounce the agency with predictable rhetoric.  “It’s bad for the consumers,” said Steve Bartlett, president of the Financial Services Roundtable, a lobbying group for banks.  The institution will add “yet another regulatory layer” while advancing “the agenda of activist special interests,” according to the U.S. Chamber of Commerce.  The new agency represents “an unprecedented grant of power to mandate business practices” claims the American Bankers Association.

This is the language of conservative populism, a mainstay of the Republican party from Ronald Reagan to Newt Gingrich to Karl Rove. Conservative populism, wrote Jonathan Chait in the New Republic last year, “dismisses any inference that the rich and the non-rich might have opposing interests” and defines elites in cultural rather than economic terms as  “intellectuals and other snobs who fancy themselves better than average Americans.” Several decades of repetition have made this rhetoric familiar: federal efforts to help ordinary people–consumers–will inevitably hurt them; government is the problem rather than the solution; bureaucracy is “bumbling” (to use the words of a Crain’s New York Business poll about the proposed Agency); federal agencies designed to serve the public good actually serve narrow special interests.  It has been, in no small measure, through the ready deployment of this language that the Republicans have positioned themselves as simultaneously the party of big business and working Americans while denouncing Democrats as representing both intrusive government and elitism. This meme has been devastating for liberals since any expansion of government services can be dismissed with a quip–Bureaucrat!, Red Tape!, Nanny State!– rather than an argument. Recently, for example, Senator Lindsay Graham said that the American people would never tolerate the public choice option in health insurance because “you’ve got a bureaucrat standing in between the patient and the doctor.” For similar reasons, Senator Kit Bond dismissed the CFPA proposal as a “bad idea.”

To understand how Republicans have married free market homilies with the anti-elitist sympathies of ordinary Americans we must look back even before Reaganism to the 1960s and 1970s when policies favoring big business were first dressed up in the language of sympathy with ordinary folks.  One of the first successful efforts in this idiom was the battle against an earlier consumer protection proposal.  From 1969 to 1978 efforts to enact a Consumer Protection Agency (CPA) came tantalizingly close to passage in Congress.  With its leader appointed by the president, the CPA was to represent the consumer interest before federal agencies and courts and to serve as a clearinghouse for consumer complaints.  The CPA had widespread popular support and seemingly overwhelming Congressional support: the Senate passed a CPA bill 74-4 in the 91^st Congress (1969-1971); the House passed a similar bill 344-14 in the 92^nd Congress; and in the 94^th Congress both the House and Senate passed the bill but without a big enough margin to overcome an expected veto from President Gerald Ford.  Yet the CPA ran into a buzzsaw of lobbying and never became law.  This  fight against protection sheds light on the rise of a style of conservatism that continues to veil itself as populism today.

Obama’s efforts to reignite consumer protection suits the current  historical moment in which for the first time in two generations reflexive antiliberalism appears to have lost its rhetorical punch.  Passing consumer protection legislation may well be a way to advance and modernize the stalled and seemingly moribund liberal project.  Although President Obama stresses the twenty-first century nature of his proposals, the architect of the CFPA, the Harvard Law Professor Elizabeth Warren draws explicitly on the unfinished agenda of the earlier campaign for consumer protection. Her 2007 article that first proposed the agency was entitled, “Unsafe at any Rate.”  Not only did she take her title from Ralph Nader’s 1965 blockbuster, Unsafe at any Speed, Warren noted that the model for “such safety regulation is the U.S. Consumer Product Safety Commission,” the product of many consumer-friendly laws passed between the mid 1960s and mid-1970s.  Safe appliances came under the government’s mandate in the 1960s, Warren notes, and incorporating financial services fulfills the goals of consumer protection by expanding it to the less tangible but equally important category of family finances.

The lessons from past consumer battles are not only ideological but organizational.  Unwilling to be out-lobbied again, a coalition of 200 consumer groups has created Americans for Financial Reform, which will aim to influence Congress and vows to respond vigorously to the opponents talking points. President Obama has also indicated his willingness to take the offensive. “The American people sent me to Washington to stand up for their interests,” he said in his weekly radio address on June 20th. “And while I’m not spoiling for a fight, I’m ready for one.”

Such a fighting attitude may well be necessary if the earlier consumer protection battle is any indicator.   In the first fight against CPA legislation, conservative business leaders, lobbyists, and politicians successfully took aim at liberalism by first taking on the consumer movement. With a well-financed and well-coordinated campaign facilitated by an informal consortium of lobbyists called the Consumer Issues Working Group, CPA opponents described consumer protection as exemplifying the flaws of American liberalism and as standing in for the twentieth-century liberal project as a whole.

The revived consumer movement of the 1960s and 1970s was central to what the political scientist Jeffrey Berry has called “postmaterial liberalism,” a politics concerned not just with economic growth but with improving the quality of life.  “For half a century we called upon unbounded invention and untiring industry to create an order of plenty for all of our people,” as president Lyndon Johnson said in his “Great Society” speech in 1965, which exemplified this postmaterial view. “The challenge of the next half century is whether we have the wisdom to use that wealth to enrich and elevate our national life, and to advance the quality of our American civilization.” Consumer protection was to Johnson and many others central to that mission, and a variety of popular laws, including “truth in lending” and “truth in packaging” were enacted. in his administration and in the Nixon presidency that followed it . Consumers Union doubled in membership between 1966 and 1972 as it joined the battle against pollution and suburban sprawl to its mission of scientific product testing. Presidents of both parties from John F. Kennedy–who declared a “Consumers’ Bill of Rights” in 1962–to Johnson–who appointed a White House advisor on Consumer Affairs in 1964–recognized the political salience of appearing pro-consumer, to Nixon and Ford who also appointed consumer affairs deputies.  The high point came in Jimmy Carter’s campaign for the presidency in 1976 when he told an audience that he hoped to rival Ralph Nader “for the title of top consumer advocate in the country.” (It may be hard to recall today, in the wake of Nader’s unpopular actions in the 2000 election and beyond but throughout the 1960s and 1970s he consistently ranked as one of the most admired Americas.  When Carter wooed Nader to meet him in Plains it was seen as a coup for Carter’s effort to establish his liberal bona fides.)⁵ Between 1969 and the late 1970s consumer activists, notably Nader, and many Congressional leaders of both parties, including the Republicans Jacob Javits and Charles Percy, put their weight behind the plan for a federal agency to protect and promote consumer interests.  In 1973 the New York Times conveyed the conventional wisdom when it declared that “there is in the air the possibility that consumerism will become a mass movement of untold economic and political power.”   The CPA seemed the minimum achievable goal of that movement.

From its beginnings, however, the revived consumer movement alarmed opponents.  As early as 1964, the advertising trade journal, Printers Ink called it an “ominous phenomenon.” By 1967, the consumer affairs reporter Sidney Margolius noted that the “business backlash has been unusually sharp and surprisingly effective.”  Ever since the consumer movement began in the 1930s, business groups organized to weaken its power, creating counter-organizations, attacking the motives and personnel of consumer groups, and predicting the terrible consequences of consumer protection.  With the popularization of the consumer movement in the 1960s, business groups once again organized, and they shifted into high gear in 1969 when Benjamin Rosenthal (D-NY) sponsored legislation for the CPA.

Several key organizations played an especially prominent role in opposing consumer legislation, notably the U.S. Chamber of Commerce, the Business Roundtable, the Grocery Manufactures Association, the National Association of Manufacturers, and the American Enterprise Institute. These groups carried out what the veteran Congressional leader and future Speaker of the House Tip O’Neill called the most “extensive lobbying” he had witnessed in his quarter of a century in Washington. The anti-CPA lobby’s biggest success came in the promotion of a series of talking points which, in sum, amounted to a repudiation of American liberalism, and became familiar aspects of conservative discourse.  Outspending complacent pro-CPA forces by a huge margin, they ensured that their message would be heard through a series of press releases (often published verbatim in small-town newspapers throughout the country) and advertisements (“The Last Thing Consumers Need is Another Government Agency,” declared a full-page ad paid for the by US Chamber of Commerce in the New York Times in 1977. )

Although the proposed agency was relatively modest with an initial budget of $15 million/year, opponents depicted it as exemplifying a new and dangerous bureaucracy favored by overzealous liberals. According to critics, the authorization of a consumer protection agency would result in “big government,” a symptom of which was “red tape and lawyers,” as well as “onerous” and “mind-numbing” regulations.  The CPA bill would lead to “immense harassment of employers,” concluded the Nation’s Business, published by the U.S. Chamber of Commerce.         But the opponents went further than merely condemning the excessive paperwork the CPA might generate.  It represented a “bureaucratic nightmare,” according to James J. Kilpatrick who was one of many syndicated columnists–among them, Patrick Buchanan, William F. Buckley and George Will–to criticize the CPA in his columns, because the CPA was authorized with inappropriate and excessive powers, which would turn it into a “meddlesome” and “out of control” body, a “superagency,” even a “monster superagency.” Critics agreed that the CPA would hold what they variously framed as “irresponsible power,” “unbridled power,” “absolute power,” and “enormous power.”  The CPA would produce a group of potentially “despotic” and dangerous “super snoops.” According to the US Chamber of Commerce, the CPA bill marked “the most serious threat to free enterprise and orderly government ever to be proposed in Congress.”

The flip-side of bureaucratic arrogance and over-reach, according to the critics of the consumer movement, was the assumption of incompetence on the part of ordinary consumers. The very call for an agency on behalf of consumers was an expression of the bureaucrats’ lack of faith in the abilities of their countrymen and women.  Ronald Reagan, the ex-Governor of California, criticized the consumerists–whom he compared to Orwell’s “Big Brother,” in several op-ed pieces and radio commentaries in 1975–for “promoting the notion that people are too dumb to buy a box of corn flakes without being cheated.”  Reagan concluded that “professional consumerists are, in reality, elitists who think they know better than you do what’s good for you.”  A group of Senators who opposed the CPA also rejected the view, which they claimed was implicit in CPA legislation, “that all consumers are mental midgets who must look to Washington to find out how to manage their personal lives from some bureaucratic consumer `representative’ who will have neither the time nor the knowledge to shop for and cook a decent supper.”  According to the advertising executive, Arthur Fatt, the consumer movement sees “the typical consumer as a moron.” The celebration of the intelligence of ordinary Americans became a component of conservative anti-elitism and an element of its populism.  If consumer advocates were snobs condescending toward those they claimed to protect, it was easy to dismiss their proposal as tainted since, as the business journalist Mary Bennett Peterson wrote, “those the Movement is designed to protect can actually wind up as its victims.”

In time such dismissals of liberal proposals became rote but in the 1970s this was a new line of criticism, one that successfully consolidated conservative ideology.  As the CPA bill languished after its final defeat in 1978, conservative groups correctly foresaw the opportunity for what Jeffrey H. Joseph, of the U.S. Chamber of Commerce called a political and legislative “bonanza.”  And indeed the terms of that victory foreshadow the rhetorical (and electoral) victories of Reaganism and the concomitant delegitimation of liberalism.  The Wall Street Journal did not exaggerate when it noted that the CPA bill was “killed by words” and those words continued to resonate long after the once-popular federal consumer protection idea  faded from public memory.

In recent years the hold of this ideology has weakened, creating space for a renewal of liberal politics, such as that represented by the renewed call for consumer protection after a thirty year hiatus.  But this is no time for complacency. As Travis Plunkett, the legislative director of the Consumer Federation of America has observed, “the financial industry is sharpening its knives” against the CFPA idea.  Yet although the old rhetoric has been revived–regulation is always strangling, bureaucracy remains dangerous, and the free market is inevitably the friend of the little guy–opponents have gone out of their way to acknowledge the problems and to agree that some regulation might be in order.  Even though the Chamber of Commerce has recently launched a multi-million dollar defense of the free enterprise system, Tom Donohue, its president, has acknowledged that economic realities “certainly justified some out-of-the-ordinary remedial actions by government.” According to the Huffington Post, one opponent said, “Opposing a consumer protection agency sounds really terrible, no matter how you try to spin it.” This cautious response suggests in part the moderate nature of Obama’s proposal but also the exhaustion of the anti-liberal rhetoric which has sustained the Republic Party for the last forty years.  It also provides an opportunity to make consumer protection once again a linchpin of modern liberalism.

By Lawrence Glickman

…For the past five years, as home loans went to even Americans with poor credit and no proof of steady work, Ms. Todd couldn’t get a mortgage in spite of her good credit and low debt. Vermont banks told the self-employed landscaper that her income stream was unreliable. The 32-year-old changed careers, taking a permanent job as a teacher, to boost her chances.

Vermont’s strict mortgage-lending laws largely prevented the state’s residents from signing the types of dubious home loans written in other markets across the country. Its 1990s legislation made mortgage lenders warn customers when their rates were relatively high, and put the brokers who arranged loans on the hook if their customers defaulted. Now, by at least one measure, the state has the lowest foreclosure rate in the U.S…

These tendencies help explain how, in the 1990s, the state moved to rein in mortgage lenders based on just a few instances its chief regulator says raised red flags. According to Vermont’s Department of Banking, Insurance, Securities and Health Care Administration, one broker solicited customers through newspaper classified ads, charging up to $5,000 for referring customers to a lender. Another searched property records for owners’ tax liens, a town clerk reported, searching for what the department believes were people who could be desperate to borrow….

In laws passed between 1996 and 1998, Vermont required lenders to tell consumers when their rates were substantially higher than competitors’, with notices printed on “a colored sheet of paper, chartreuse or passion pink.” And in what officials believe is the first state law of its kind, Vermont declared that mortgage brokers’ fiduciary responsibility was to borrowers, not lenders. This left Vermont brokers partly on the hook for loans gone sour…

Vermonters didn’t see the same sharp rise in home ownership that swept much of America in recent decades, which, despite the bust, buoyed economic growth. And while part of the increase in U.S. home ownership reflected excesses in lending and borrowing, some of it represented real progress in the form of more Americans achieving the cherished goal of getting — and keeping — a home of their own. By 2007, the percentage of owner-occupied households as a whole reached 68.1%, up from 63.9% in 1990, according to U.S. Census data. Vermont started at a higher base but saw ownership rise just 1.1 percentage points in that span, to 73.7%.

Daniel Indiviglio follows up it with an in-depth comparison to Florida, while Tim Duy goes through the article and ends with this fantastic note: “according to the article, the ‘pitfalls’ amount to: Informed consumers, fewer foreclosures, healthier banks, higher rates of homeownership, and virtually no impact on average growth. Those are some ‘pitfalls’ – truly, greater consumer financial protection would spell ruin for us all.” Ha!

Two additional things:

Prepayment Penalties To go back to an old soapbox of mine, it’s worth noting that Vermont has outlawed prepayment penalties. Why is this important? My own thoughts, and the research is finding this as well, is that “lenders designed subprime mortgages as bridge-financing to the borrower over short horizons for mutual benefit from house price appreciation…Subprime mortgages were meant to be rolled over and each time the horizon deliberately kept short to limit the lenderís exposure to high-risk borrowers.” The prepayment penalty is what made these bad-faith loans profitable to the lenders, and with house prices increasing, prepayment penalties allowed lenders to bet directly on this housing appreciation.

To put it a different way, banks, instead of underwriting borrowers, were betting that house prices would increase, and paying consumers to sit in the houses. The fees and prepayment penalties were the payout that made this bet profitable (with that consumer getting what’s left over in housing appreciation). Banks don’t normally bet on house prices – they have exposures, but they are secondary exposures related to recoveries and risks – they bet on consumers. Getting rid of these prepayment penalties keeps them from taking that side bets. It also helps markets actually do their job, by allow borrowers to shop between outfits and products while reducing this transaction cost – and allow the innovation of interest rate risk management to make things a little easier for the consumer.

Texas Like Vermont, Texas has some of the strictest mortgage regulations on the books. No prepayment penalties, no balloon mortgages, etc., and as a result of the Homestead Act of 1839 and subsequent laws strict rules on Home Equity Loans (pdf).

I mentioned earlier in the year, that these consumer protection laws may have played a major role in keeping Texas from having a major housing bubble. I did not know at the time that there was a study at the Dallas Federal Reserve, Why Texas Feels Less Subprime Stress than U.S., that also came to the same conclusion:

Due to the state’s strong predatory lending laws and restrictions on mortgage equity withdrawals, a smaller share of Texas’ subprime loans involve cash-out refinancing, which reduces homeowner equity and makes default more likely when mortgage payments become unaffordable….

State data on subprime mortgage delinquencies suggest that housing prices and local economic factors are still the primary drivers of subprime default rates. Even so, mortgage characteristics also matter—from the incidence of ARMs to the purpose for which the loan was taken out. In general, cash-out refinancing loans are more prone to delinquency than loans for outright purchases.

Recent tightening of credit standards in the mortgage market has put a lid on the growth of subprime and exotic mortgages. Nevertheless, a sharply deteriorating economy, weak home sales and a continued downward trend in housing prices suggest that delinquencies and foreclosures will continue at a high level.

I find it very ironic that places like the AEI are using Texas as the role model for The Way States Should Conduct Themselves in the future, which is by association bootstrap-tugging laissez-faire financial capitalism. The research produced at the Dallas’ Federal Reserve, by economists on the ground, points out the exact opposite – consumer protection is a major reason why Texas isn’t Arizona or California or Florida. Consumer protection allows a baseline of financial safety, a net where the work of building our real economy can take place.

As opposed to specific practices, Levitin focuses on four key structural issues that are broken with our current system.

1. Consumer protection conflicts with, and is subordinated to, safety-and-soundness concerns.
2. Consumer protection is a so-called “orphan” mission.
3. No agency has developed an expertise in consumer protection in financial services.
4. Regulatory arbitrage of the current system fuels a regulatory race-to-the-bottom.

The first point is key and informs the rest of them. “Safety-and-soundness” means that regulators currently are focused on making sure the banking system is sound, part of which means that banks have lots of money. So if Americans are paying a mind-boggling $38.5 Billion dollars in overdraft fees a year (more than the GDP of Kenya, as a comparison) that just means regulators can sleep a little more soundly at the wheel.

If having giant banks dedicated to soaking and misleading consumers was creating a safer and more sound financial system, that would be one thing, though preliminary evidence says no:

Since protecting large banks at the expense of consumers is the current goal of the regulatory structure, other goals such as collecting data on actual experiences of consumers (something researchers have a difficult time finding, and have to use poor substitutes like aggregate consumption diaries), having in-depth knowledge locally on scene, and fighting regulatory arbitrage among the current 11 agencies that investigate this material fall by the wayside.

Levitin also brings up this point, mentioned again and again (and worth mentioning again): “Most consumer financial products differ in their class primarily on price, not functionality, but product pricing structure is designed to make comparison shopping difficult in order to avoid commoditization (and inevitably lower profit margins). Better disclosure should encourage commoditization and price competition, which should actually bring down prices.”

If you are in the business of reading or disseminating research papers, I’d recommend that Levitin paper. Though health care is rightfully focusing our minds and attentions these days, this is another piece of necessary reform that could get easily thrown under the bus.

Friends and contacts who work in the financial sector freely discuss their participation in activities they now regret.  But where is the mea culpa, of any kind, from a public figure – our “leadership”?

I suggest we divide the competition into three classes.

1. Policymakers who now admit that any of their actions or inactions contributed to the Great Credit Bubble.  Blaming China gets a person negative points; this may hurt Fed officials.
2. Private sector executives who concede they made mistakes or misjudged the situation so as to lose a lot of Other People’s Money.  Blaming Hank Paulson also earns negative points (too obvious).
3. Anyone charged with safeguarding consumers, in either public or private sector capacity, who now says that they or their organization did a completely miserable job.  My guess is that you will find precisely no one in this category.

You can award points for style, timing, and extent of the apology or near-apology.

Feel free to suggest other categories or to propose additional scoring rules.

By Simon Johnson

The Fed is a well-regarded institution in general and Bernanke is currently riding a wave of personal popularity and prestige, but are these claims vis-à-vis consumers plausible?

Not really.

The heart of the problem here lies with the Federal Reserve Act.  As it currently stands, the all-important Section 2A reads, “The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”

This is what the Fed does – in practice by trying to keep unemployment down (ideally around the 4-5% mark, although that can change over time) and inflation low (no more than 2%, roughly).

Formal objectives matter for central banks because they have to weigh trade-offs – “if we try to lower unemployment, what will that do to inflation?” etc – carefully in deciding where to set short-term interest rates and other dimensions of their support to the credit system.

Consumer protection is not in this mix and you can tell.  No one can seriously tell you what a great job the Fed has done protecting consumers.   For example, the Fed has dragged its feet for years on coming up with a sensible definition of the Annual Percentage Rate on loans, i.e., a measure that includes all costs.  As a result, many borrowers have been misled effectively by lenders.

More broadly, Alan Greenspan famously stood by despite being warned by his colleagues about the housing bubble and the associated abuses of consumers.  As the housing frenzy developed in 2003 and low income people got sucked in and – many of them – suckered, Ben Bernanke argued for a further lowering of interest rates on the basis of short-run macroeconomic considerations; apparently he was oblivious to the dangers that implied to consumer-as-borrowers.

As Rep. Barney Frank (D-Mass.) said at the height of the housing madness in 2007, “If I was going to list the top 87 entities in Washington in order of the history of their efforts on consumer protection, the Fed would not make it.”

What would happen if you tried to add formal protection of consumers to the top level of Fed priorities and to make it central to Bernanke’s job?

This would surely require amending the Federal Reserve Act, otherwise consumer protection would remain a second class citizen at the Fed.  The Fed is not a government department, it’s an independent entity.  If you don’t give the Fed specific legislative direction and detailed reporting requirements for a particular task, it won’t get done.

And even that may not be enough.  The Fed has plenty of powers to help consumers, but it just hasn’t used them.  The American Banker (subscription required) quotes Barney Frank on this also, “One of the greatest unused examples of power were the consumer protection powers we’ve given the Fed.”

Why? Again, Frank – as chair of the House Financial Services Committee – should know, “If you look at the Fed governors, their focus has been on the safety and soundness of the banking system, not consumers.”

The tip off here is that banks of all kinds want enforcement of consumer protection laws to stay with existing bank regulators where, John C. Dugan, Comptroller of the Currency claimed recently “it works well.” But he doesn’t mean that this arrangement protects consumers.  He means that it protects banks and the banking system – whenever necessary (like now) consumers can be squeezed to improve the banks’ bottom line.

The Federal Reserve never has and never will put consumers first.

By Simon Johnson

A slightly different version of this post originally appeared on the NYT.com’s Economix blog.  It is reproduced here with permission.  If you wish to repost this material in its entirety, please contact the New York Times. 

Officially measured interest rates are down from their height in the Great Panic of 2008-09 and the financial markets, broadly defined, continue to stabilize.  But are retail credit conditions, i.e., the terms on which you can borrow, getting easier or tougher?

On credit cards, there’s no question: it’s getting more expensive to borrow, particularly because new fees and charge are appearing.  Of course, lenders have the right to alter the terms on which they provide credit.  We could just note that this tightening of credit does not help the recovery and flies in the face of everything the Fed is trying to do – although it fits with Treasury’s broader strategy of allowing banks to recapitalize themselves at the expense of customers.  

But there is an additional question: will these changes in lending conditions be reflected in the disclosed Annual Percentage Rate (APR)?  Historically, the rules around the APR – overseen by the Federal Reserve - have not forced lenders to include all charges in this calculation.  Why is this OK?

It’s not OK.  This would be like cereal manufacturers including only some ingredients on their labels.  Or makers of children’s toys not telling you that some dangerous chemicals are involved.

Why has this been allowed to happen?  Essentially, because nobody watches out for the consumer of financial products.  Our regulation of financial institutions is byzantine and completely out of date; our banks game the system with impunity (e.g., nationally chartered banks are not subject to state usury laws; see this BusinessWeek article, section on payday loans).

Historically, the most powerful overseers of the system thought that this kind of detail didn’t matter – or that any changes in what banks did were a form of “financial innovation” that must naturally benefit everyone.  But this is exactly the attitude that brought us to subprime, Alt-A, and other ”exotic” (i.e., misleading rip-off) mortgages.

And it is, sadly, the attitude among existing regulators that still predominates today.  This implicit attitude towards consumers is in no way helpful, if we want an economic recovery, jobs, and a reasonably stable growth going forward.  But it’s what we appear to be stuck with.

Our financial regulatory system is a disaster.  The Obama administration should have called it by its proper name, proposed to close it down entirely, and argued to replace it with a more integrated and completely rationalized approach.  That at least would have moved the bargaining position of the regulators – they would now be too busy trying to save their jobs to oppose Treasury on substance.

If you think I am wronging credit card companies, lenders, or regulators in any way, post details below.  And if any representative of these institutions or their associated lobby groups is willing to debate these issues in public, just give me a call.

By Simon Johnson

And … there’s nothing there.

Here’s the summary version of the relevant section (Title 3, Section 311):

Creates an Office of Consumer Protection within the [Financial Institutions Regulator]. The Office of Consumer protection is responsible for all consumer protection rulemaking under the Consumer Credit Protection Act, and will coordinate with the other divisions of the FIR in enforcing consumer protection. Establishes a consumer complaint hotline for the timely referral and remedy of consumer complaints, regardless of charter type or regulatory structure. Requires the Office of Consumer Protection to use extensive consumer testing prior to the promulgation of new consumer protections. Requires a comprehensive review of consumer protection rules and regulations on a regular basis with reports to be issued to Congress based on inaction or action with regards to consumer protection standards.

Basically we get a hotline, a requirement that regulations have to be extensively tested, and periodic review.

Reading the draft bill, things get even weaker. 311(c) says rules of the Office of Consumer Protection (OCP) have to be approved by the board of directors of the Financial Institutions Regulator (FIR) – read John Dugan, Sheila Bair, etc. 311(e) mandates reviews, every seven (!) years, of disclosures … by the FIR itself. 311(g) requires, every seven years, a cost-benefit analysis of all consumer protection regulations to determine “if such regulation should remain the same or if such regulation should be revised.”

Cost-benefit analysis sounds good, but as I’ve previously written, this can have perverse effects when the costs are easily quantifiable but the benefits are difficult to quantify in monetary terms. A classic example is health – valuing the feeling of good health is notoriously difficult, although there are methodologies for it. Another classic example is tail risk, where you have to estimate the small probability of a very bad thing happening. Sound familiar?

Note also that the emphasis is on periodically pruning back regulation, rather than creating new regulations for new products and practices. In short, the effect if any of this plan would be to weaken consumer protection.

Now, this is not particularly surprising, nor is it particularly egregious behavior. The Republicans have zero chance of passing any bill that they author (although, for a party with forty senators, they have a surprising amount of influence on the Senate Finance Committee), so they are under no obligation to put forward responsible proposals to address real problems. And no one expects them to waste their time working on such proposals. But after Simon’s previous post, I thought we owed it to them to look at their “plan.”

By James Kwak

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

Now, the administration’s major remaining initiative is its version of a Financial Product Safety Commission - something that would be clearly beneficial for the public.  And the skepticism – and outright opposition – comes from the banking sector.

How does the administration’s effort compare, then vs. now?

As far as I can see, they are not pushing this new consumer protection/safety agency hard enough.

Some sources claim that Secretary Geithner is fully on board with the Agency, and certainly he has mentioned it in public.  But there is no sign of the frenzied effort that accompanied efforts to launch the PPIP – when, for example, almost every economist in the administration seemed pressed into service to call potential critics and ask them to “give it a chance.”

One symptom of this “effort gap” is that counter-arguments and disinformation about the proposed agency begin to gain the upper hand.  One senior executive recently told me that this agency would have unprecedented powers to determine the decision of individual products – “something not even the FDA can do.”

Of course, this is nonsense.  The new agency would be powerful – and thus it is feared by the industry – and presumably it would be able to prevent sufficiently toxic products from being sold.  Hopefully, it will also be able to require that all financial institutions also offer some vanilla products, to make consumers’ choices easier.  But the idea that an agency would design the details of all products for any sector is both implausible and a malicious rumor being spread by opponents (actually, it reminds me of the pushback from meatpackers, and others, early in the 20th century). 

If Treasury is so supportive of this new Agency, now is the time to launch public, high profile, and clever counterattacks.  By the time the legislation is being voted on, it will be too late.

And in this context, the administration should push hard on one of the great ironies here.  Financial sector executives like to stress the importance of “consumer confidence,” and they urge the government to take steps to restore this confidence (e.g., with a straight face, suggesting even more really cheap credit from the Fed to their favorite sector.)

But the same people completely reject the idea that consumers will feel more confident about financial products if there is finally some serious consumer protection around those products.  Whenever people learn – or just fear – that a particular food product is unsafe, they stop buying it.  When the stock market ripped people off in the late 1920s, it took legislation with real teeth to rebuild investor confidence – take a look at, for example, the Securities Exchange Act of 1934.  And the entire edifice of modern medicine is based on the idea that someone in government will make the call, right or wrong, on whether a compound can be regarded as a helpful drug – as opposed to colored water or something actually poisonous, which is what was sold as “patent medicine” 100-150 years ago.

If Treasury and the administration really wants a Consumer Protection/Safety Agency for finance, they need to kick their support campaign into much higher gear immediately.

By Simon Johnson

I’m in favor, although I don’t think it will be enough to simply make the vanilla offering available; in that case nothing would stop lenders from paying higher commissions to brokers in order to steer customers toward exploding mortgages.

By James Kwak

The first view is that Tim Geithner and Larry Summers have genuinely become radical reformers.  They see the error of the ways they pursued during the 1990s – both in terms of financial deregulation for the United States and in their advice to other countries, particularly through the capital market liberalization policies urged upon the IMF.  They now seek to put globalized finance back in its box and will pursue any sensible means possible to this end.

This view is not widely held.

The second view is the consensus: Geithner and Summers want a minimal degree of reform with a great deal of window dressing.  This interpretation is supported by the fact that most of the specifics with regard to large financial firms look like moderate technocratic tweaks, i.e., hardly what you’d expect in the aftermath of what the President himself called, “the worst financial crisis since the Great Depression”.

It’s true – and always pleasing to officials – that you can get a nice media bump with background briefings on all the effort that has gone into the proposals.  But honestly, what in the administration’s proposals is strong enough to have prevented this crisis, let alone preempt the next crisis which, by all indications, could be even larger – now that big financial players know for sure they are too big to fail?

The administration could have taken over Citigroup – e.g., placing it into negotiated conservatorship – at several points in the last nine months.  It did not.  Draw your own conclusions and think for a moment about how this will influence future actions in the financial sector.

The third view is more interesting and also controversial: Geithner-Summers have exercised an effective veto over measures that would have constrained large firms directly, but they are not at this time strong enough to prevent sensible consumer protection measures from also going forward.

In this view, someone (Cass Sunstein?) and his/her allies have managed – at least so far – to promote the idea of a consumer protection agency focused on financial products.  The details are not yet clear enough to see how what will emerge, and we also don’t yet know how vigorously Treasury will defend this idea against the financial sector lobbies.  But at least this is something new and potentially powerful in all the right ways.

Sunstein, of course, is known for the idea of a Nudge – pushing consumers ever so gently towards better decisions.  It’s a fine principle to guide thinking, but lobbies, opponents within the administration, and members of congress with their own agenda will not be moved through gentle means. 

This is going to be quite a fight.

By Simon Johnson

1. We need layers of protection against financial excess.  Think about the financial system as a nuclear power plant, in which you need independent, redundant back-up systems - so if one “super-regulator” fails we don’t incur another 20-40 percentage points in government debt through direct and indirect bailouts.  A consumer financial products protection agency should definitely be part of the package.  Update: The Washington Post reports that such an agency is now in the works; this is a big win for Elizabeth Warren, Brad Miller and others (add appropriate names below).
2. Congress will work on this.  The intensity of feeling with regard to the need to re-regulate is striking, and there is much that resonates across the political spectrum.
3. In the end, much of banking is likely to become boring again.  Special interests are convinced that they can fend off the regulatory challenge, but I find this increasingly unlikely.  Enough people have seen through what they did, how they did it, and what they keep on doing.  No doubt the outcomes will be messy and less than optimal, but at this point “less than optimal” is much preferable to “systemic meltdown”.

There is still much to argue about and, no doubt, there will be setbacks.  We’ll get a better or a worse system, depending on how the debate goes.  And if the external scrutiny slips away, so will point #3 above.  But this was still by far the most encouraging hearing I’ve so far attended.

The main points from my written testimony to the subcommittee are below.

1)      The U.S. economic system has evolved relatively efficient ways of handling the insolvency of nonfinancial firms and small or medium-sized financial institutions.  It does not yet have a similarly effective way to deal with the insolvency of large financial institutions.  The dire implications of this gap in our system have become much clearer since fall 2008 and there is no immediate prospect that the underlying problems will be addressed by the regulatory reform proposals currently on the table.  In fact, our underlying banking system problems are likely to become much worse.

2)      The executives who run large banks are aware that the insolvency of any single big bank, in isolation, could potentially be handled by the government through the same type of FDIC-led receivership process used for regular banks.  However, these executives also know that if more than one such bank were to fail (i.e., default on its obligations), this could cause massive economic and social disruption across the U.S. and global economy.  The prospect of such disruption, they reason, would induce the government to provide various forms of bailout.  They also invest considerable time and energy into impressing this point onto government officials, in a wide range of interactions.

3)      As an example of the ensuing bailouts, in its latest iteration the current administration has (a) run stress tests in which the stress scenario was not severe, (b) determined that banks are solvent, but some should raise small amounts of capital, (c) at the same time continued to provide large amounts of government subsidy through FDIC-guarantees on bank debt, large credit lines from the Federal Reserve, and cheap capital from the Troubled Assets Relief Program.

4)      The government strategy today is forbearance, as in the early 1980s, in which you wait for the economy to recover by itself and hope that this brings the banks back to financial health.  This is risky because: it may not work (depending on the defaults seen in “toxic” assets); it may lead the banks to engage in undesirable short-term behavior (with either too much or too little credit, depending on how exactly their incentives are distorted); and it rewards banks for previous irresponsible actions (and therefore encourages more of the same in the future).

5)      As a consequence of both this general failure to deal with big bank insolvency and the specific problems induced by current government policy, big bank executives have an incentive to reduce the probability that their bank fails for idiosyncratic reasons but they are much less concerned about their bank failing in a manner that is synchronized with other banks.  These bank executives have a strong incentive to copy the actions and policies of other big banks.

6)      By not changing incentives for powerful bank insiders, we are lining ourselves up for another big “moral hazard trade” – think of this as a bailout by the Federal Reserve of everyone, but especially banks.  Current and future bank executives will take risk again – but next time it will be risk with the public’s money.  A housing bubble led to the current difficulties but the meta-bubble is a rise in financial services as a share of the economy, which has been underway since the 1980s.  In the latest manifestation of the ensuing shift in economic and political power towards the financial sector, an unsustainable “Fed bubble” is potentially underway.  This may lead to outcomes that are considerably worse than what we have seen so far. 

7)      Everyone agrees that insolvent banks are a bad thing.  Since September 2008, we have learned about the additional difficulties that follow when no one knows if banks are insolvent are not. There are many manifestations of this problem, including: illiquid markets for toxic assets; accounting tricks, like the FASB rule change and the preferred-for-common stock conversion; and stress tests that turn out to be not very stressful, with outcomes that are apparently negotiable and mostly about public relations.

8)      There is a striking contrast between how we deal with small/medium-sized banks (using an FDIC intervention) and large banks – only the latter can obtain never ending bailouts.  The solution would be some kind of regulator able to take over any financial institution, but also better ways of measuring asset value, capitalization, etc.  In line with that general approach, Thomas Hoenig has a strong proposal for our current situation, which is to use negotiated conservatorship, as was done with Continental Illinois.  However, even his approach needs to be supplemented with quickly breaking up and selling off troubled banks; this is a daunting administrative task, but better than the alternatives.

9)      The critical weakness in our system is that bank executives get to keep their jobs and their money.  All key insiders should be fired when their banks become insolvent (as part of the government intervention and support process), irrespective of the reason for that insolvency.  They should also be subject to large fines, equal to or in excess of the value of their total compensation while leading the bank that failed.  As things currently stand, powerful insiders have learnt that they can gamble heavily and never lose personally or professionally.

10)  Our national debt will increase substantially as a result of direct bank bailouts and, more importantly, the discretionary fiscal stimulus needed to keep the economy from declining – as well as the standard deficit due to cyclical slowdown (a feature of the “automatic fiscal stabilizers”).  This will constrain our future actions as a nation.  For example, it may limit our options in terms of health care reform, with severe adverse social, economic, and budgetary implications.

11)  The costs to consumers from our broad and deep banking crisis come in many forms.  For example, in a period of financial confusion, it is easier to raise fees on consumers – they will have a harder time switching to other credit companies and many of them need the credit in order to survive.  Supporting consumption is a key part of our economic recovery, but we are letting credit card issuers hit consumers hard; this is evidence of prior uncompetitive behavior (i.e., limiting entry, in order to raise prices later).

The remainder of my testimony summarized the argument from “The Quiet Coup“, as published in The Atlantic.

By Simon Johnson

The basic notion behind this commission is that consumers were taken advantage of by unscrupulous lenders.  Of course, you could also say that consumers fooled themselves, but if that is pervasive and has systemic implications then we need to take it on.  In his recent testimony before the Joint Economic Committee, Joe Stiglitz emphasized the need for more consumer protection, and this idea is also strongly advocated by Elizabeth Warren - against the odds, she continues to make some progress.

On the other hand, perhaps we already have enough consumer protection-type agencies?  Would it be better to focus our efforts on overseeing and constraining the behavior of lenders and everyone else in the credit production and distribution chain?  There’s plenty of education and information available about financial products (or not), but somehow that doesn’t get through to people when they need it.  How should consumer protection be conceptualized, designed, and implemented in this space?

Over on The Hearing this morning, you can vote for or against the Financial Products Safety Commission – or send it back to Congress, the experts, and the lobbyists for more discussion.  Any opinions written up in your comments there (or here) may be taken down and used to construct a more sensible national debate.

By Simon Johnson