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.
Other creditors have their own techniques for fleecing borrowers. Payday lenders offer consumers a friendly hand when they are short of cash. But hidden in the tangle of disclosures is a staggering interest rate. For example, buried in a page of disclosures for one lender (rather than on the fee page, where the customer might expect to see it) was the note that the interest rate on the offered loan was 485.450 percent. For some families, the rates run even higher. In transactions recently documented by the Center on Responsible Lending, a $300 loan cost one family $2,700, while another borrowed $400, paid back $3,000, and was being hounded by the payday lender for $1,200 per month when they gave up and filed for bankruptcy. In total, the cost to American families of payday lending is estimated to be $4.2 billion a year. The Department of Defense identified payday lending as such a serious problem for those in the military that it determined the industry “undermines military readiness.” In fact, the practices were so outrageous that Congress banned all companies from charging military people more than 36 percent interest. This change in the law will protect military families from payday lenders, but it will leave all other families subject to the same predatory practices.
For some, Shakespeare’s injunction that “neither a borrower nor a lender be” seems to be good policy. Just stay away from all debt and avoid the trouble. But no one takes that position with tangible consumer goods. No one advocates that people who don’t want their homes burned down should stay away from toasters or that those who don’t want their fingers and toes cut off should give up mowing the lawn. Instead, product safety standards set the floor for all consumer products, and an active, competitive market revolves around the features consumers can see, such as price or convenience or, in some cases, even greater safety. To say that credit markets should follow a caveat emptor model is to ignore the success of the consumer goods market–and the pain inflicted by dangerous credit products.
Indeed, the pain imposed by a dangerous credit product is even more insidious than that inflicted by a malfunctioning kitchen appliance. If toasters are dangerous, they may burn down the homes of rich people or poor people, college graduates or high-school dropouts. But credit products are not nearly so egalitarian. Wealthy families can ignore the tricks and traps associated with credit card debt, secure in the knowledge that they won’t need to turn to credit to get through a rough patch. Their savings will protect them from medical expenses that exceed their insurance coverage or the effects of an unexpected car repair; credit cards are little more than a matter of convenience. Working- and middle-class families are far less insulated. For the family who lives closer to the economic margin, a credit card with an interest rate that unexpectedly escalates to 29.99 percent or misplaced trust in a broker who recommends a high-priced mortgage can push a family into a downward economic spiral from which it may never recover.
The Traditional Solutions Have Hit Their Limits The credit industry is not without regulation; credit transactions have been regulated by statute or common law since the founding of the Republic. Traditionally, states bore the primary responsibility for protecting their citizens from unscrupulous lenders, imposing usury caps and other credit regulations on all companies doing business locally. While states still play some role, particularly in the regulation of real-estate transactions, their primary tool–interest rate regulation–has been effectively destroyed by federal legislation. Today, any lender that gets a federal bank charter can locate its operations in a state with high usury rates (e.g., South Dakota or Delaware), then export that states’ interest rate caps (or no caps at all) to customers located all over the country. As a result, and with no public debate, interest rates have been effectively deregulated across the country, leaving the states powerless to act. In April of this year, the Supreme Court took another step in the same direction in Watters v. Wachovia, giving federal regulators the power to shut down state efforts to regulate mortgage lenders without providing effective federal regulation to replace it.
Local laws suffer from another problem. As lenders have consolidated and credit markets have gone national, a plethora of state regulations drives up costs for lenders, forcing them to include repetitive disclosures and meaningless exceptions in order to comply with differing local laws, even as it also leaves open regulatory gaps. The resulting patchwork of regulation is neither effective nor cost-effective. During the 1970s and early 1980s, for instance, Congress moved the regulation of some aspects of consumer credit from the state to the federal level through a series of landmark bills that included Truth-in-Lending (TIL), Fair Credit Reporting, and anti-discrimination regulations. These statutes tend to be highly specific. TIL, for example, specifies the information that must be revealed in a credit transaction, including the size of the typeface that must be used and how interest rates must be stated. But the specificity of these laws works against their effectiveness, trapping the regulations like a fly in amber. The statutes inhibit some beneficial innovations (e.g., new ways of informing consumers) while they fail to regulate dangerous innovations (e.g., no discussion of negative amortization). What’s more, these generation-old regulations completely miss most of the new features of credit products, such as universal default, double-cycle billing, and other changes in credit.
Any effort to increase or reform statutory regulation of financial products is met by a powerful industry lobby on one side that is not balanced by an equally effective consumer lobby on the other. As a result, even the most basic efforts are blocked from becoming law. A decade ago, for example, mortgage-lender abuses were rare. Today, experts estimate that fraud and deception have stripped $9.1 billion in equity from homeowners, particularly from elderly and working-class families. A few hearty souls have repeatedly introduced legislation to halt such practices, but those bills never make it out of committee.
Beyond Congress, some regulation of financial products occurs through the indirect mechanism of the Federal Reserve, the Office of the Comptroller of the Currency (OCC), and the Office of Thrift Supervision. Each agency, for example, has some power to control certain forms of predatory lending. But their main mission is to protect the financial stability of banks and other financial institutions, not to protect consumers. As a result, they focus intently on bank profitability and far less on the financial impact on customers of many of the products the banks sell.
The current regulatory jumble creates another problem: Consumer financial products are regulated based, principally, on the identity of the issuer, rather than the nature of the product. The subprime mortgage market provides a stunning example of the resulting fractured oversight. In 2005, for example, 23 percent of subprime mortgages were issued by regulated thrifts and banks. Another 25 percent were issued by bank holding companies, which were subject to different regulatory oversight through the federal system. But more than half–52 percent, to be exact–of all subprime mortgages originated with companies with no federal supervision at all, largely stand-alone mortgage brokers and finance companies. This division not only creates enormous loopholes, it also triggers a kind of regulatory arbitrage. Regulators are acutely aware that if they push financial institutions too hard, those institutions will simply reincorporate in another form under the umbrella of a different regulatory agency–or no regulatory agency at all. Indeed, in recent years a number of credit unions have dissolved and reincorporated as state or national banks, precisely to fit under a regulatory charter that would give them different options in developing and marketing financial products. If the regulated have the option to choose their regulators, then it should be no surprise when they game the rules in their own favor.
Unfortunately, in a world in which the financial services industry is routinely one of the top three contributors to national political campaigns, giving $133 million over the past five years, the likelihood of quick action to respond to specific problems and to engage in meaningful oversight is vanishingly slim. The resulting splintered regulatory framework has created regulatory loopholes and timid regulators. This leaves the American consumer effectively unprotected in a world in which a number of merchants of financial products have shown themselves very willing to take as much as they can by any means they can.
The Financial Product Safety Commission
Clearly, it is time for a new model of financial regulation, one focused primarily on consumer safety rather than corporate profitability. Financial products should be subject to the same routine safety screening that now governs the sale of every toaster, washing machine, and child’s car seat sold on the American market.
The model for such safety regulation is the U.S. Consumer Product Safety Commission (CPSC), an independent health and safety regulatory agency founded in 1972 by the Nixon Administration. The CPSC’s mission is to protect the American public from risks of injury and death from products used in the home, school, and recreation. The agency has the authority to develop uniform safety standards, order the recall of unsafe products, and ban products that pose unreasonable risks. In establishing the Commission, Congress recognized that “the complexities of consumer products and the diverse nature and abilities of consumers using them frequently result in an inability of users to anticipate risks and to safeguard themselves adequately.”
The evidence clearly shows that CPSC is a cost-effective agency. Since it was established, product-related death and injury rates in the United States have decreased substantially. The CPSC estimates that just three safety standards for three products alone–cigarette lighters, cribs, and baby walkers–save more than $2 billion annually. The annual estimated savings is more than CPSC’s total cumulative budget since its inception.
So why not create a Financial Product Safety Commission (FPSC)? Like its counterpart for ordinary consumer products, this agency would be charged with responsibility to establish guidelines for consumer disclosure, collect and report data about the uses of different financial products, review new financial products for safety, and require modification of dangerous products before they can be marketed to the public. The agency could review mortgages, credit cards, car loans, and a number of other financial products, such as life insurance and annuity contracts. In effect, the FPSC would evaluate these products to eliminate the hidden tricks and traps that make some of them far more dangerous than others.
An FPSC would promote the benefits of free markets by assuring that consumers can enter credit markets with confidence that the products they purchase meet minimum safety standards. No one expects every customer to become an engineer to buy a toaster that doesn’t burst into flames, or analyze complex diagrams to buy an infant car seat that doesn’t collapse on impact. By the same reasoning, no customer should be forced to read the fine print in 30-plus-page credit card contracts to determine whether the company claims it can seize property paid for with the credit card or raise the interest rate by more than 20 points if the customer gets into a dispute with the water company.
Instead, an FPSC would develop precisely such expertise in consumer financial products. A commission would be able to collect data about which financial products are least understood, what kinds of disclosures are most effective, and which products are most likely to result in consumer default. Free of legislative micromanaging, it could develop nuanced regulatory responses; some terms might be banned altogether, while others might be permitted only with clearer disclosure. A Commission might promote uniform disclosures that make it easier to compare products from one issuer to another, and to discern conflicts of interest on the part of a mortgage broker or seller of a currently loosely regulated financial product. In the area of credit card regulation, for example, an FPSC might want to review the following terms that appear in some–but not all–credit card agreements: universal clauses; unlimited and unexplained fees; interest rate increases that exceed 10 percentage points; and an issuer’s claim that it can change the terms of cards after money has been borrowed. It would also promote such market-enhancing practices as a simple, easy-to-read paragraph that explains all interest charges; clear explanations of when fees will be imposed; a requirement that the terms of a credit card remain the same until the card expires; no marketing targeted at college students or people under age 21; and a statement showing how long it will take to pay off the balance, as well as how much interest will be paid if the customer makes the minimum monthly payments on the outstanding balance on a credit card.
With every agency, the fear of regulatory capture is ever-present. But in a world in which there is little coherent, consumer-oriented regulation of any kind, an FPSC with power to act is far better than the available alternatives. Whether it is housed in a current agency like the CPSC or stands alone, the point is to concentrate the review of financial products in a single location, with a focus on the safety of the products as consumers use them. Companies that offer good products would have little to fear. Indeed, if they could conduct business without competing with companies whose business model involves misleading the customer, then the companies offering safer products would be more likely to flourish. Moreover, with an FPSC, consumer credit companies would be free to innovate on a level playing field within the boundaries of clearly disclosed terms and open competition–not hidden terms designed to mislead consumers.
The consumer financial services industry has grown to more than $3 trillion in annual business. Lenders employ thousands of lawyers, marketing agencies, statisticians, and business strategists to help them increase profits. In a rapidly changing market, customers need someone on their side to help make certain that the financial products they buy meet minimum safety standards. A Financial Product Safety Commission would be the consumers’ ally.
A Well-Regulated Market
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