This guest post was contributed by Norman I. Silber, a Professor of Law at Hofstra Law School, and Jeff Sovern , a Professor of Law at St. John’s University. They were principal drafters of a statement signed by more than eighty-five professors who teach in fields related to banking and consumer law, supporting H. 3126, which would create an independent Consumer Financial Protection Agency. Some of the research on which this essay is based is drawn from an article by Professor Sovern.
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.