Issue #5, Summer 2007

Unsafe at Any Rate

If it’s good enough for microwaves, it’s good enough for mortgages. Why we need a Financial Product Safety Commission.

It is impossible to buy a toaster that has a one-in-five chance of bursting into flames and burning down your house. But it is possible to refinance an existing home with a mortgage that has the same one-in-five chance of putting the family out on the street–and the mortgage won’t even carry a disclosure of that fact to the homeowner. Similarly, it’s impossible to change the price on a toaster once it has been purchased. But long after the papers have been signed, it is possible to triple the price of the credit used to finance the purchase of that appliance, even if the customer meets all the credit terms, in full and on time. Why are consumers safe when they purchase tangible consumer products with cash, but when they sign up for routine financial products like mortgages and credit cards they are left at the mercy of their creditors?

The difference between the two markets is regulation. Although considered an epithet in Washington since Ronald Reagan swept into the White House, the “R-word” supports a booming market in tangible consumer goods. Nearly every product sold in America has passed basic safety regulations well in advance of reaching store shelves. Credit products, by comparison, are regulated by a tattered patchwork of federal and state laws that have failed to adapt to changing markets. Moreover, thanks to effective regulation, innovation in the market for physical products has led to more safety and cutting-edge features. By comparison, innovation in financial products has produced incomprehensible terms and sharp practices that have left families at the mercy of those who write the contracts.

Sometimes consumer trust in a creditor is well-placed. Indeed, credit has provided real value for millions of households, permitting the purchase of homes that can add to family wealth accumulation and cars that can expand job opportunities. Credit can also provide a critical safety net and a chance for a family to borrow against a better tomorrow when they hit job layoffs, medical problems, or family break-ups today. Other financial products, such as life insurance and annuities, also can greatly enhance a family’s security. Consumers might not spend hours pouring over the details of their credit card terms or understand every paper they signed at a real estate closing, but many of those financial products are offered on fair terms that benefit both seller and customer.

But for a growing number of families who are steered into over-priced credit products, risky subprime mortgages, and misleading insurance plans, trust in a creditor turns out to be costly. And for families who get tangled up with truly dangerous financial products, the result can be wiped-out savings, lost homes, higher costs for car insurance, denial of jobs, troubled marriages, bleak retirements, and broken lives.

Consumers can enter the market to buy physical products confident that they won’t be tricked into buying exploding toasters and other unreasonably dangerous products. They can concentrate their shopping efforts in other directions, helping to drive a competitive market that keeps costs low and encourages innovation in convenience, durability, and style. Consumers entering the market to buy financial products should enjoy the same protection. Just as the Consumer Product Safety Commission (CPSC) protects buyers of goods and supports a competitive market, we need the same for consumers of financial products–a new regulatory regime, and even a new regulatory body, to protect consumers who use credit cards, home mortgages, car loans, and a host of other products. The time has come to put scaremongering to rest and to recognize that regulation can often support and advance efficient and more dynamic markets.

Do You Have Credit Problems?

Americans are drowning in debt. One in four families say they are worried about how they will pay their credit card bills this month. Nearly half of all credit card holders have missed payments in the past year, and an additional 2.1 million families missed at least one mortgage payment. Last year, 1.2 million families lost their homes in foreclosure, and another 1.5 million families are likely headed into mortgage foreclosure this year.

Families’ troubles are compounded by substantial changes in the credit market that have made debt instruments far riskier for consumers than they were a generation ago. The effective deregulation of interest rates, coupled with innovations in credit charges (e.g., teaser rates, negative amortization, increased use of fees, cross-default clauses, penalty interest rates, and two-cycle billing), have turned ordinary credit transactions into devilishly complex financial undertakings. Aggressive marketing, almost nonexistent in the 1970s, compounds the difficulty, shaping consumer demand in unexpected and costly directions. And yet consumer capacity–measured both by available time and expertise–has not expanded to meet the demands of a changing credit marketplace. Instead, consumers sign on to credit products with only a vague understanding of the terms.

Credit cards offer a glimpse at the costs imposed by a rapidly growing credit industry. In 2006, for example, Americans turned over $89 billion in fees, interest payments, added costs on purchases, and other charges associated with their credit cards. That is $89 billion out of the pockets of ordinary middle-class families, people with jobs, kids in school, and groceries to buy. That is also $89 billion that didn’t go to new cars, new shoes, or any other goods or services in the American economy. To be sure, the money kept plenty of bank employees working full-time, and it helped make “debt collector” one of the fastest-growing occupations in the economy. But debt repayment has become a growing part of the American family budget, so much so that now the typical family with credit card debt spends only slightly less on fees and interest each year than it does on clothing, shoes, laundry, and dry-cleaning for the whole family.

Nor are all costs associated with debt measured in dollars; not surprisingly, the effect on family life is considerable. Anxiety and shame have become constant companions for Americans struggling with debt. Since 2000, families have filed nearly 10 million petitions for bankruptcy. Today about one in every seven families in America is dealing with a debt collector. Mortgage foreclosures and credit defaults sweep in millions more families. How do they feel about their inability to pay their bills? The National Opinion Research Council asked families about negative life events, on a ranking of one thorough 100: Death of a child (94.3) and being forced to live on the street or in a shelter (86.7) topped the list, but filing for bankruptcy ranked close behind (83.5), more serious than death of a close friend (80.8) or separating from a spouse (82.1). About half won’t tell a friend their credit card balances, and 85 percent of those who file for bankruptcy are struggling to hide that fact from families, friends, or neighbors.

Why do people get into debt trouble in the first place? People know that credit cards are dangerous, all the more so if the customer carries a balance. Mortgage financing is a serious undertaking, with reams of documents and papers; any consumer who signed papers without reading carefully or seeking legal assistance should not be surprised if terms come to light later that are unfavorable to the consumer. Payday lenders have a bad reputation for taking advantage of people; no one should expect to be treated well by them. Car lenders, check-cashing outlets, overdraft protection–the point can be repeated again and again: Financial products are dangerous, and any consumer who is not careful is inviting trouble. And yet, dangerous or not, millions of Americans engage in billions of credit transactions, adding up to trillions of dollars every year.

Some Americans claim that their neighbors are drowning in debt because they are heedless of the risk or because they are so consumed by their appetites to purchase that they willingly ignore the risks. Surely, in such circumstances, it is not the responsibility of regulators to provide the self-discipline that customers lack. Indeed, there can be no doubt that some portion of the credit crisis in America is the result of foolishness and profligacy. Some people are in trouble with credit because they simply use too much of it. Others are in trouble because they use credit in dangerous ways. But that is not the whole story. Lenders have deliberately built tricks and traps into some credit products so they can ensnare families in a cycle of high-cost debt.

To be sure, creating safer marketplaces is not about protecting consumers from all possible bad decisions. Instead, it is about making certain that the products themselves don’t become the source of the trouble. This means that terms hidden in the fine print or obscured with incomprehensible language, unexpected terms, reservation of all power to the seller with nothing left for the buyer, and similar tricks and traps have no place in a well-functioning market.

How did financial products get so dangerous? Part of the problem is that disclosure has become a way to obfuscate rather than to inform. According to the Wall Street Journal, in the early 1980s, the typical credit card contract was a page long; by the early 2000s, that contract had grown to more than 30 pages of incomprehensible text. The additional terms were not designed to make life easier for the customer. Rather, they were designed in large part to add unexpected–and unreadable–terms that favor the card companies. Mortgage-loan documents, payday-loan papers, car-loan terms, and other lending products are often equally incomprehensible. And this is not the subjective claim of the consumer advocacy movement. In a recent memo aimed at bank executives, the vice president of the business consulting firm Booz Allen Hamilton observed that most bank products are “too complex for the average consumer to understand.”

Creditors sometimes explain away their long contracts with the claim that they need to protect themselves from litigation. This ignores the fact that creditors have found many other effective ways to insulate themselves for liability for their own wrongdoing. Arbitration clauses, for example, may look benign to the customer, but their point is often to permit the lender to escape the reach of class-action lawsuits. This means the lender can break the law, but if the amounts at stake are small–say, under $50 per customer–few customers would ever bother to sue.

Legal protection is only a small part of the proliferating verbiage. For those willing to wade through paragraph after paragraph replete with terms like “LIBOR” and “Cash Equivalent Transactions,” lenders have built in enough surprises in some credit contracts that even successful efforts to understand and assess risk will be erased by the lender’s own terms. So, for example, after 47 lines of text explaining how interest rates will be calculated, one prominent credit card company concludes, “We reserve the right to change the terms at any time for any reason.” Evidently, all that convoluted language was there only to obscure the bottom line: The company will charge whatever it wants. In effect, such text is an effort for lenders to have it both ways. Lenders won’t be bound by any term or price that becomes inconvenient for them, but they will expect their customers to be bound by whatever terms the lenders want to enforce–and to have the courts back them up in case of dispute.

Even worse, consumers wary of creditor tricks may look for help, only to rush headlong into the waiting arms of someone else who will fleece them–and then hand them over to the creditors for further fleecing. In the mortgage market, for example, consumers may respond to advertisements for “a friend to help you find the best possible mortgage,” “someone on your side,” and “access to thousands of mortgages with a single phone call–do all your comparison shopping here.” When they call a mortgage broker, they may believe they will receive wise advice that will guide them through a dangerous thicket. Some mortgage brokers will do just that. But consumers are just as likely to encounter a broker who is working only for himself, taking what amounts to a bribe from a mortgage company to steer a family into a higher-priced mortgage than it could qualify for, all the while assuring the family that this is the best possible deal. For example, a family that might qualify for a 6.5 percent fixed-rate, 30-year mortgage could easily end up with a 9.5 percent mortgage because the broker can pocket a fee (what the industry calls a “yield service premium,” or YSP) from the mortgage company to place the higher-priced loan. High YSPs helped drive the wild selling that led to the recent meltdown in the subprime mortgage market.

Despite the characterization of YSPs by one Fannie Mae vice president as “lender kickbacks,” the practice of taking these fees is legal. Under pressure from the mortgage-broker industry, Congress and the regulatory agencies have generally approved of YSPs. In fact, mortgage brokers face few regulatory restrictions. It is no surprise, then, that mortgage brokers originate more than half of all mortgage loans, particularly at the low-end of the credit market. YSPs are present in 85 to 90 percent of subprime mortgages, which implies that brokers are needlessly pushing clients into more expensive products. And the costs are staggering: Fannie Mae estimates that fully 50 percent of those who were sold ruinous subprime mortgages would have qualified for prime-rate loans. A study by the Department of Housing and Urban Development revealed that one in nine middle-income families (and one in 14 upper-income families) who refinanced a home mortgage ended up with a high-fee, high-interest subprime mortgage. Of course, YSPs are not confined to subprime mortgages. Pushing a family who qualifies for a 6.5 percent loan into a 9.5 percent loan and pocketing the difference will cost the family tens of thousands of dollars, but it will not show up in anyone’s statistics on sub-prime lending.

Issue #5, Summer 2007
Post a Comment

Jim Flanagan's Response You Missed the Mark:

To compare a mortgage, an instrument used to purchase, secure and collateralize a piece of Real Estate, one of the main avenues used to create and build long term wealth in a short time, running neck and neck only with the stock market for vehicles to create millionaires and billionaires. It is the only way someone with nothing can secure the American Dream and enter an arena with so much potential. When a college degree, the school you went to and it’s ALUMNI, no longer matter. The educationally challenged home schooled degree of hard knocks is OK. They can play they are now in the game and on the field and can compete. I fail to see how this matches up against a broken toaster that can burn down a house, building, and block. Also kill yourself the kids and the neighbors, maim and/or steal unlimited lives or the microwave that can cook your brain rendering you, your college degree’s life experience useless. The fact that there is no age limit on shopping in the mall, online, catalogs, mailers and the HOME Shopping Network’s, minors can buy and CHILDREN whether supervised or left home alone can and would play with and injure or kill themselves and/or countless others, to a mortgage payment to a subprime lender from a family that was paying 1,500.00 a month RENT supporting his Real Estate investor landlord and now is paying equal to or LESS for his own home which he just bought, that he now gets his tax shelter on his mortgage interest, closing costs, home structure depreciation and appreciation in value driving up his net worth and are now getting a shot at the American Dream of home ownership and success. Because, the subprime bank (of private investors) gave him the money because the conventional lenders would not take the risk with the odds being too great. Tell that family that a subprime mortgage and a broken toaster made in and imported from China are the same. Even if he lost the home in FORECLOSURE, if it was the apartment, he did not own, it would have been called GETTING EVICTED either way the family is in a shelter no one really cares if he got there from an eviction with a subprime lender taking the investors payment, collecting the rent to repay his subprime mortgage on the same home 2 scenarios. Why is it on one we care and one no one hears about? This is nothing more than an opportunity for a platform to promote a future political adgenda and you the author, with a degree from “The Most Prestigious University in the entire World, “HARVARD LAW SCHOOL” an Ivy League school and you just drafted an article in laymen terms with a catch phrase of a crooked politician, meant for the masses of the laymen educationally challenged and threw statistics in there that they wouldn't have read anyway according to the credit card portion, I don’t get it. You insult the intelligence of your audience, which could use solid advice from someone of your caliber and print non-sense. You referred to scare tactics and yet you use the same ploy it in your headline with big bold font. You learned researching the subprime thieves. You want to protect the consumer put a CAP on the payments and Rate spikes. Allow the borrower the chance to be forgiven a grace period when forgetting the anniversary date of the payment adjustment, notify them 6 months prior so they can refinance the mortgage out. Sell the info to other banks so they can call the guy with offers and get him out of trouble before the credit scores drop. Because now there are no more sub prime lenders left, OPTIONS are gone. At least they had the shot, sometimes people have to be given the opportunity to fail. AS for the credit card portion, why it was there this was a mortgage slogan and topic and you should have saved it for another article the credit cards are a totaly different animal. Maybe the schools should have educated kids on real life like business, real estate, money and marriage years ago instead of pumping out real world morons and illiterates like cattle that can’t balance a check book or read financial statement. In the end that’s all the ANY Lender Cares about anyway isn’t it. Someone with your knowledge and background can really make a difference. You sold yourself and your readers short today. That topic could have had some serious impact, articulated properly, by you Professor. With an article like this who would you recommend, running this committee, which blundering pile of ineptitude would volunteer and generously offer their 2 cents worth of their 1 cent opinions, without having a pulse on how this really started and how to fix it without directly crossing lines into other agencies and free markets. Remember always start with the end in mind and from the local ranks to complicate things will be.......

The Financial Product Safety Commission LOL

P.S. Aren't they still selling bootlegs and knockoffs all over

Thats because rules restrict the good guys and the bad guys never played by them in the first place

Forgive me if I was harsh.

Professionally Yours,

Mr. Jim Flanagan

Jun 23, 2007, 7:30 PM
Nancy Seats:

Thank you for this outstanding analysis of the financial markets industry. Everyone in the nation should read it, but most partiularly, CONGRESS.

One thing that you may not be aware of -- the product safety commission does an outstanding job on the issues that they cover, but did you realize that HOUSES are NOT coverd by anyone regarding the safe and sound construction of them? Houses are considered real estate, NOT a product. CRAZY?? You bet!

Today Consumer Reports says the 17% of new homes built each year have two or more serious defects yet there is NO consumer protection for the largest purchase a family ever makes.

SO we not only have predatory/fraudulent lending leading to foreclosure, we also have serious structural defects. Most builders have binding mandatory arbitration clauses naming the arbitration service that must be used -- builders are repeat users and arbitrators who are on the list to choose from know where their bread is buttered. Not only that homeowners who go through this kangaroo court nearly always get a gag order so that they can't warn others about the bad builder OR the horror of arbitration.

Thanks again for writing this paper. I am sending it to everyone I know.

Sep 9, 2007, 1:30 AM
Diane R:

Thank you. Excellent idea - I fully support it.

Mar 24, 2009, 3:59 PM

"President Obama appointed Elizabeth Warren to establish the new Consumer Financial Protection Bureau–“€”an agency that Warren first proposed in the Summer 2007 issue of Democracy.

The creation of the new bureau was a key provision of the financial regulatory reform bill that President Obama signed into law this summer. Warren will serve as Assistant to the President and Special Advisor to the Secretary of the Treasury to get the new agency started."

That's all very well and good, but why are we congratulating ourselves that

1). Warren is merely advisor and not official head of the agency?

2). this alleged "consumer protection agency" is housed internally at the federal reserve BANK?

3). you're so far behind the curve that "Democracy: A Journal of Ideas" is effectively lying to the public?

I'm taking a very long term view here. The 2010 election is over and you're coming out of it looking like a delegitimized tool to me.

Sep 20, 2010, 2:07 PM

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Mar 17, 2011, 1:41 PM
Dr. Paul G. Scheurer:

Discussions as to who it right or wrong about anything is a waste of ones time.
For example, there is an ongoing lawsuit which concerns the restoration of our NE fishery. What is important is not the lawsuit but How the fishery is to be restored - the solution to the problem, not the political solution but the real solution based on scientific evidence, a real plan of action that promises to succeed if followed with diligence.

In all the years I have been reading the Gloucester times, I have not read one comment as to any solid scientific plan to restore the fishery.
I can shake one our of my sleave. Am I so different from anyone else when it comes to doing simple things which make sense.

Worse, no one seems willing to come together and discuss the problem - our problems.

Mar 30, 2011, 5:57 PM

It is all but impossible today to identify a legitimate creditor because of the changing nature of business, and the "identity hats" worn by "instant companies, and fly-by-nights" that are here today and gone tomorrow."

40% of companies in the top rankings of the Fortune 500 in 2000 were not there in 2010, as reported by business analysts.

Who's kidding whom?

May 24, 2011, 9:53 AM

Road to the Truth can be found at the following address:
(attention, it is not the ad of the site - it is the ad of the Truth).

Jun 22, 2011, 1:25 AM

An economic thought for today. Eighty percent of the Fortune 500 companies have off shore accounts, the Fortune 500 hire twenty percent of the work force and make eighty percent of the profit-so long small business and hello to higher unemploymet. And yes, good bye Elizibeth Warren. How dare her to do what should of been done years ago, take away the punch bowl now that the corporate party is coming back. Regulation, it's the cross that corportate vampairs hate. Not all but some companies, banks, and financial institutions are " cooking the books". Some but not all buyers, put the wrong information on their mortage application. "Man, they are break'n the law, break'n the law". Our politians, big business and labor unions think that "the road goes on for ever and the party never ends". Soon our foriegn investors will be talking to the IMF. No, make that screaming to the IMF. You don't like Dr. Warren's kind of regulation and micro-management skills? Wait and see what China does. Mao Zedong once said-"to get a cat to eat chilli powder you put it on its bottom. When the cat feels its bottom burn it would happily lick it off". If things get bad enough, we'll do what ever we are told and that is the reality of economics. Dr. Warren is looking sweeter by the minute compared to unchecked corporate America.

Jul 18, 2011, 9:37 PM

@ JTFaraday asked,

why are we congratulating ourselves that
1). Warren is merely advisor and not official head of the agency?

Elsewhere I read that this happened because if she were made head of the agency she'd need Senate confirmation, another circus! and this way she got to spend the time trying to form the agency so it could do its job instead of schmoozing with senators.

Aug 2, 2011, 2:22 PM
Stephen Watkins:

Two quotes apply here:

"Power corrupts and absolute power corrupts absolutely."

"It's all about the money, Honey!" (From a prostitute to a longtime customer)

Dec 7, 2011, 1:21 AM

really an excellent post. I have been advocating for control over the 90 mortgage problem for years, and its great to see people doing things along the same line.

Feb 20, 2012, 7:51 PM
nothappy :

if you have been in this postion for this long (2007) why are we still having a porblem, & still using tax payers money to bail every one out

Aug 25, 2012, 11:20 AM

The financial services industry argues that without the right to take suckers capitalism cannot succeed. It believes that this unwisely unwritten constitutional freedom is what makes this country worth fighting for. It provides and opportunity for the incompetent and dishonest to make a living with the expectation that consumers are free agents capable of making irrational decisions on their own and educating them to all the tricks and traps that await them under a free market are necessary for them to mature and become cynical users as those who used them. Taking advantage of the vulnerable. unsuspecting and naive' is free market capitalism. Honesty in lending, purchasing and investing would come to a halt without the sacred right of those who are experienced to exploit the inexperienced. This assumption stems from the idea that victims only need to learn from being used so that they can become users who in turn can then prey on the current generation of suckers. Such is the upside-down, inside-out world a generation has been taught to accept.

Nov 8, 2012, 3:34 AM

Big government doesn't care about the little guy. The only solution is not to buy in the first place.

Allowing the rich to tax the rich is the kindest method of having to come face to face with the fraud they perpetuate.

Until fraud formation and passing the buck of fraud is cured, America can't come back economically.

Feb 26, 2013, 9:48 AM

To compare a a home to a toaster is a bit of a stretch. If a free market as well as free from Stock Market Speculation Real Estate appreciates while personal property depreciates. Home may burst into flames, thus insurance, there will always be home buyers to feed the machine, as long as Banks refuse to turn real estate into slot machines and due-diligence to prevent fraud. Please Wath my Video: Orange County Realtor

Feb 26, 2013, 11:13 PM

You guys (especially Jim Flanagan) need to get more in-tune with how the 2008 financial crisis actually happened. Read The Big Short by Michael Lewis and you guys will quit being so objective.

Oct 3, 2013, 9:57 PM

Or just look up collateralized debt obligation and credit default swaps

Oct 3, 2013, 10:03 PM

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