protecting consumers in the financial marketplace:...

Protecting Consumers in the Financial Marketplace:Thinking Outside the Boxes

James Gattuso, Todd Zywicki, Alex Pollock, and David John

Abstract: Do consumers need a new regulatory agency toprotect them in the financial marketplace? The questionhas been at the center of the ongoing congressional debateover financial services reform. But is such an agency reallynecessary, or will it do more harm than good? And if it iscreated, where should it be located, and—most critically—what powers should it have? A panel of experts discussesthese and other questions regarding consumer protectionand financial regulation.

JAMES GATTUSO: Location, location, location:Every real estate agent knows that those are the threemost important elements in evaluating a property forsale. Thus, it’s not surprising that the debate overfinancial reform, which has its roots in a real estatecrisis, should focus on location. In this case, it’s loca-tion of a proposed new agency for consumer financialprotection.

This idea of creating this agency has gone througha number of permutations. At first—and there’s stillsome support for this—it was supposed to be anindependent agency without any oversight by othertypes of regulators or policymakers. Then it wasmoved over to the Treasury Department. In its lastvariation, it’s supposedly going to be created withinthe Federal Reserve.

This last idea is clearly controversial. There is oneMember of Congress who pointed out, “We saw overthe last number of years when they took on consumerprotection responsibilities”—“they” being the Fed—

No. 1151Delivered March 11, 2010 April 2, 2010

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Talking Points• The proposed Consumer Financial Protec-

tion Agency would unhook consumer pro-tection from safety and soundness,competition, and all the other economicdynamics that are necessary for the marketto work properly. That would merely lay theseeds for the next crisis.

• The term “disclosure” implies that there’s ascheme the consumer is trying to discover.What we really should be concerned aboutis making sure that consumers understandessential information about the credit com-mitments that borrowers are making.

• Where the proposed CFPA is housed isimportant, but it would be a mistake to bedistracted by that question alone. The detailsof how its powers will be set up, what kindof interaction it will have with the prudentialregulator, are far more important than thequestion of its location.

No. 1151 Delivered March 11, 2010

“and the regulation of holding companies, it was anabysmal failure.” So, presumably, this Member,Senator Chris Dodd (D–CT), would be against theidea of moving the new agency to the Fed. Yet itlooks like that will be proposed in the new bill byChris Dodd.

Another potential location for this agency,which is my personal favorite, is to move it to theOffice of Thrift Supervision, which will itself like-ly be eliminated and would solve the problemrather neatly.

This debate over location is important, butthere’s a danger that it could obscure some evenmore important questions, particularly what pow-ers would this agency have? It’s less importantwhere it is than what it can do. And powers overwhom? Whom will it regulate, and whom will it notbe able to regulate?

Perhaps most important at all, would any of thishave any impact at all on the likelihood of anotherfinancial meltdown? There is precious little evi-dence that consumer fraud had much, if anything,to do with the crisis of 2008, and there is some argu-ment that perhaps an independent regulatoryregime for consumer protection that goes too farcould increase the possibility of another meltdown.

So there are lots of interesting issues here, and it’scertainly a timely discussion today with eventsmoving quickly on the Hill toward defining andimplementing some of these ideas. We have anexcellent lineup today of experts to discuss this issue.

Our first speaker is Todd Zywicki, who is theFoundation Professor of Law at George Mason Uni-versity. Todd is one of the leading commentatorsand analysts on the issue of financial consumer pro-tection; he has really been a leader in the debatesince it began over a year ago. He came to GeorgeMason from the Mississippi College School of Lawand had experience during 2003 and 2004 as Direc-tor of the Office of Policy Planning at the FederalTrade Commission. Todd received an M.A. in eco-nomics from Clemson University and his J.D. fromthe University of Virginia.

—James Gattuso is Senior Research Fellow in Regu-latory Policy in the Thomas A. Roe Institute for Econom-ic Policy Studies at The Heritage Foundation.

TODD ZYWICKI: I want to make three points.First, I want to make an argument for why I don’tthink consumer protection issues is what caused thefinancial crisis, even though that’s the linchpin ofthe argument for why we need some new govern-ment bureaucracy on steroids to deal with this.

Second, I’m going to talk about two differentapproaches to consumer protection, two paths thatsort of diverge in the woods, and urge us to thinkabout this differently from the way it has beenthought of.

Third, I want to talk about how making thewrong diagnosis of what caused the crisis and thewrong choice about how to respond to it wouldlikely make matters worse and lay the seeds for thenext crisis.

Let’s talk about the first point. It surely comes asa surprise to many for me to say that in my view,consumer protection problems did not cause thecrisis. I’m not saying that there wasn’t fraud by lend-ers against borrowers; certainly, in some neighbor-hoods, there seems to have been fraud. I’m notsaying that there wasn’t fraud by borrowers againstlenders; there was probably at least as much of thatas there was of lenders against borrowers. And I’mnot saying that there wasn’t fraud in the securitiza-tion market.

What I’m saying is that even if there were issuesof consumer fraud, that is not the financial under-pinning of what caused the crisis. What caused thecrisis was consumers rationally responding to mis-aligned incentives. When a consumer rationallyresponds to incentives, that is not a consumer pro-tection problem.

It is unquestionable that the banking industrymade a lot of incredibly foolish and stupid loans,but the reason those loans were foolish and stupidwas not because they relied on consumers beingtricked, but because of the structure of incentivesthat they set up for consumers, especially when the

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Consumer fraud…is not the financial underpinning of what caused the [financial] crisis. What caused the crisis was consumers rationally responding to misaligned incentives.

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housing market went south—in particular, thestructure of incentives that they set up for consum-ers to default on their mortgages and allow foreclo-sure when their houses fell in price.

The foreclosure and mortgage crisis is really astory about three different ways. The first way has todo with adjustable-rate mortgages (ARMs)—basi-cally, the Federal Reserve’s monetary policy overtime and, from 2001 to 2004, a downward bulge inwhat the Federal Reserve did with monetary policy.

What that did was create a strong incentive forconsumers to shift from 30-year fixed-rate mortgagesto adjustable mortgages by opening up a gap be-tween short-term and long-term interest rates. Fromabout 2001 to 2004, the 30-year fixed-rate mortgagestayed at about the same rate, but what we saw wasa dip in the rate for adjustable-rate mortgages.

What this shows is that the idea of adjustable-rate mortgages is not a new idea. Adjustable-ratemortgages go back at least to the mid-1980s, andthere were periods in the ’80s and ’90s when adjust-able-rate mortgages were as much as 40 or 50 or 60percent of the market. In the most recent iteration,it peaked at about 40 percent of the market.

Why does that matter? Consumers’ use of adjust-able-rate mortgages follows the spread betweenfixed and adjustable-rate mortgages. This is why, ifyou look back to the 1980s, as the gap betweenfixed and adjustable-rate mortgages gets larger, peo-ple flip over from fixed to adjustable-rate mort-gages. They respond to the incentives to do that.

So consumers switched from fixed to adjustable-rate mortgages. What happened next was, the Fedhad artificially reduced short-term interest rates andthen artificially brought them back up to where theyshould be. The effect is that what brought the ini-tial onset of the foreclosure crisis was adjustable-rate mortgages.

We’ve come to think of this as a subprime versusprime issue; I don’t think that’s right. The initialonset was an adjustable-rate versus fixed-rate issue.If you look at the foreclosure rate on subprimemortgages, subprime fixed-rate mortgages remainedat a relatively reasonable level, and it was subprimeadjustable-rate mortgages that took off.

But here’s where it gets interesting: If you look atprime mortgages, you see the same thing. Primeadjustable-rate mortgages skyrocketed; fixed-ratemortgages stayed constant. Consumers got side-swiped by the Federal Reserve’s monetary policy. Ifthey hadn’t been so exaggerated in the swings ininterest rates, my view is we never would have hadthis situation to begin with.

The other thing is that creating these very lowshort-term interest rates is what fueled the specula-tive fever and sucked investors into the market in alot of different areas, encouraged by that low accessto money.

The second phase was when this led to a fall inhousing prices. Over time, when housing prices fall,consumer foreclosures rise. Why is that? Basically,every month when you pay your mortgage, you havean option as to whether or not you want to continuepaying the mortgage or stop paying it and basicallygive the house back to the bank. Economic literaturegoing back 20 years says that consumers act on thisoption in a rational way, and that’s what we’ve seen:As housing prices have fallen, consumers have usedthis option to walk away from their houses.

What that leads to is the recognition that there wasan underwriting problem. For all the things you’veheard about the crazy mortgages that were made, itturns out that one thing matters: whether or not theconsumer had a product that caused them to haveequity in their house. No-down payment loans,interest-only loans, cash-out refinances—all thosethings are the core of where the problem arose,whether it was a prime or a subprime mortgage.

What that meant was, if you didn’t have equity inyour house, you weren’t as invested in your house,and those people are more likely to walk away,everything else being equal, but it also means yougo into the negative equity territory faster than youotherwise would have. This is especially the case in

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The Fed had artificially reduced short-term interest rates and then artificially brought them back up to where they should be…. [W]hat brought the initial onset of the foreclosure crisis was adjustable-rate mortgages.

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states where they have what are called anti-deficien-cy laws, which allow you to walk away from theloan without the bank being able to sue you for anydeficiency. Estimates are that that increases the fore-closure rate by about two to three times wheneverhouse prices fall.

The third phase we’re in now is macroeconomicconditions combined with negative equity. The fast-est-rising group of foreclosures now is prime fixed-rate mortgages—what we traditionally thought of asthe best mortgages.

So we’ve got three ways: adjustable-rate mort-gages caused by Federal Reserve monetary policy,falling house prices caused by consumers respond-ing to incentives, and now foreclosures risingbecause of macroeconomic conditions. None of thathas anything to do with consumer protection. Whatthat has to do with is consumers rationally respond-ing to the incentives that were presented to them.

Why does that matter, then? Well, it matters forthe way we think about consumer protection. Wecould think about consumer protection in two dif-ferent ways. We could think about it as what I callmarket-reinforcing versus market-replacing con-sumer protection. Market-reinforcing consumerprotection basically is focused on the idea of disclo-sure and competition and consumers being able toshop better. Market-replacing is basically a pater-nalistic view that says consumers can’t be trusted toknow what’s right for themselves, that they’re sortof gullible, hapless saps who get taken advantage ofby lenders.

My view is that the first model is the one we needto have for consumer protection. What this meansto me is, yes, there are reforms we need to make toconsumer protection laws. We need to get rid ofwhat a morass the Truth in Lending Act has become.It went from being a very simple mechanism that

would help consumers shop for things to being alawyer- and regulator-encrusted mound of paper. Ifanybody has bought a house, for instance, youknow that your disclosures aren’t very helpful. Wecan streamline disclosures, we can make marketswork better, and let’s focus on doing that.

Instead, the Consumer Financial ProtectionAgency (CFPA) notion that’s been presented by theObama Administration is based on the idea thatpaternalism is what matters, that products and con-sumer choice need to be regulated. I think that’s notonly incorrect, but also problematic for my thirdpoint, which is that I think it could make mattersworse. To the extent that we think of this as a con-sumer protection problem, we could end up enact-ing regulations that create new perverse incentivesfor consumers and lenders to lay the foundation forthe next crisis.

To give you an example, there are a number ofplaces in the Obama Administration white papersoriginally introduced about the ways in which theCFPA would ban unfair terms. The legislation itselftalks about so-called abusive loans. They would banpre-payment penalties on mortgages or regulatecredit card terms, regulate terms of payday lendingand all these sorts of things.

The reality is that a large number of the termsthat consumer protection people don’t like actuallyhave a risk-based justification in economics. If weban risk-based pricing in the name of consumer

protection, obviously, we’re going to get less accu-rate pricing. One of two things is going to happen:Either risk won’t be priced accurately or lenders aregoing to reduce their risk exposure by lending less,further exacerbating the credit crisis that we have.

The final point, then, is that those loans werefoolish. The crisis was caused by foolish loans. Wemight want to say you can’t make loans with no

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[State] anti-deficiency laws, which allow you to walk away from the loan without the bank being able to sue you for any deficiency…increase the foreclosure rate by about two to three times whenever house prices fall.

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The Consumer Financial Protection Agency (CFPA) notion that’s been presented by the Obama Administration is based on the idea that paternalism is what matters, that products and consumer choice need to be regulated.

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down payment, but that is a safety and soundnessissue. It is a safety and soundness issue because ofthe incentives it set up for consumers. That is not aconsumer protection issue.

I think CFPA is such a bad idea institutionallybecause it unhooks consumer protection from safe-ty and soundness, competition, and all the othereconomic dynamics that are necessary for the mar-ket to work properly. So the cornerstone, institu-tionally, needs to be combining consumerprotection with a safety and soundness and compe-tition framework and, second, reining in substan-tive things that could interfere with risk-basedpricing. What we’ve seen so far hasn’t done that,and if we don’t do that, we’re just laying the seedsfor the next crisis.

JAMES GATTUSO: Our next speaker is AlexPollock of the American Enterprise Institute. Alexserves as Resident Fellow at AEI. He joined AEI in2004 after 35 years in the banking industry, wherehe was President of the Home Loan Bank of Chica-go, President and CEO of Community Federal Sav-ings in St. Louis, and President of Marine Bank inMilwaukee. He certainly comes to the field withample credentials. He also has credit for developinga one-page mortgage form to help borrowers under-stand the mortgage system.

Alex has degrees from Princeton University ininternational relations, a bachelor’s degree fromWilliams College, and, most interestingly, a mas-ter’s degree from the University of Chicago inphilosophy.

ALEX POLLOCK: When I considered the Con-sumer Financial Protection Agency last spring, Igave some testimony entitled “One Good Idea and aNumber of Bad Ones,” and that is still my summaryof this proposal—except I would add now “andOne Possible Compromise.”

Starting with the bad ideas, it seems to me thatanybody looking at the proposal in its variousforms would agree that you would objectivelyexpect a large, very expensive, highly intrusivebureaucracy with rather undefined and probablyarbitrarily exercised powers, which would imposeheavy costs and requirements likely to conflict withother regulatory agencies.

Where the parties in the debate differ on thisproposal is that some people like such bureaucracyand some people don’t, like me.

When it comes to fraud, as Todd said, there wasof course some fraud against consumers and somefraud by consumers; fraud is known to attend everyfinancial bubble in history. The idea that you canmake a lot of money basically for free always givesrise to fraud. But that isn’t the main point.

When it comes to this proposed consumer pro-tection function, James mentioned location. Its orga-nizational location is very important, in my view, asTodd also suggested. If this were a stand-alone agency,its inevitable dynamic would be a vast expansion ofits regulatory activity: basically, telling people whatthey can and can’t do when it comes to financing.

As context, I’d like to suggest what our funda-mental philosophy toward risk in financial activityshould be. Needless to say, America is a nation ofrisk-takers. The risks those of us who have the greatadvantage of living in this wealthy society taketoday are nothing compared to those that our ances-tors took while they were conquering the frontier,but they’re interesting nonetheless.

Should Americans be able to take risk in theirfinancial decisions and, in particular, in financingthe buying of a house if they want to? My answer is,of course they should. Should Americans be able todecide, if they want to, that they’re going to have toeat oatmeal and hot dogs every day for five years tobuy the house of their dreams? Absolutely, but theyought to know what they’re doing. Should lendersbe able to decide to make risky loans which are like-ly to have high charge-off rates and heavy losses inbad scenarios? Sure they should, if they know whatthey’re doing.

It occurs to me that the opposite of consumerprotection is making people loans that they can’t

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CFPA is such a bad idea institutionally because it unhooks consumer protection from safety and soundness, competition, and all the other economic dynamics that are necessary for the market to work properly.

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afford. That’s the worst thing you can do, both toyourself as a lender and also to the borrowers.

Both sides of a credit transaction ought to knowand understand what it’s about and what its risksare. That brings me to the one good idea—and itreally is a significant idea—that’s embedded in allthis discussion, and it’s also a nonpartisan idea:clear, simple, straightforward, honest information,generally called “disclosure.”

Just as we ought to get rid of the term “entitle-ments” when it comes to budgeting because there isno spending of other people’s money which you areentitled to, we ought to get rid of the term “disclo-sure” because disclosure implies that there’s ascheme somebody has that you’re trying to discover.They may have such schemes, and you ought to dis-cover them, but what we really should be con-cerned with is key, essential information about thecredit commitments that you as a borrower aremaking and making sure that you understand them.

So what we’re really talking about is understand-ing by the borrower which allows the borrower toexercise personal responsibility in making financialcommitments. That, it seems to me, is the funda-mental, really good idea which is entangled in all ofthis debate and which we ought to make progress on.

As James was kind enough to mention, I pro-posed—it’s now almost three years ago—a mort-gage key information form. I did it because, as I saidto a congressional committee, “You should geteverything that a borrower really needs to knowonto one page.” Having said that, I needed to createsuch a form. It’s available on the AEI Web site if youwant to take a look at it.

I don’t insist on that particular form, but on pre-senting in straightforward language the key infor-mation elements so that people can understand in aclear way exactly the commitments they’re makingand can therefore decide for themselves how much

risk in their financial lives they wish to take. Thenwe can enable greater personal responsibility in theway the financial system functions. That, it seems tome, is a fundamental and extremely important thingto advance.

We talked about organizational location, and Imentioned a possible compromise. I do think that astand-alone Consumer Financial Protection Agency,for the reasons discussed a minute ago, is a reallybad idea. But, as we all know, the Members of Con-gress are busy discussing whether you might locatea consolidated consumer financial rules functioninside some existing regulatory body—perhaps theFederal Reserve. I think that this location questionis very important because if you’re going to do this,it is essential to maintain, as many others have said,a balance between the consumer protection func-tions and the safety and soundness functions.

This is especially important if the bureaucraticbehavior of consumer protection evolves as it isalmost certain to do. In a stand-alone agency, it isabsolutely, with 100 percent probability, going togrow into a credit-promotion as opposed to aninformation-assuring function. In the originalAdministration proposal, it was very clear theywanted this organization to promote, as they say,“access” to credit; that is to say, to promote the tak-ing of greater risk by lenders and investors.

If you’re going to promote that—I say if—youhave to have it balanced inside a safety-and-sound-ness, prudential risk-managing organization, andthat organization should be in charge. We have toreject a false compromise which would put such anagency theoretically inside a safety-and-soundnessorganization but really make it into an independentfiefdom. That is not a compromise and, in my view,is not acceptable.

I do think there is some argument for centraliz-ing the already existing consumer regulation underalready existing laws. For example, we have RESPA(the Real Estate Settlement Procedures Act), admin-istered by the Department of Housing and UrbanDevelopment. I imagine that in the mid-1970s theyhad higher hopes for the Department of Housingthan one might have today. We have TILA (the Truthin Lending Act), administered by the Fed. Anybody

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What we’re really talking about is understanding by the borrower which allows the borrower to exercise personal responsibility in making financial commitments.

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who follows this knows what a mess of consumerinformation—so-called disclosures—is made byhaving these two competing bureaucracies trying tocreate rules over the same mortgage transaction.

It seems to me there is an argument for consoli-dating these functions under existing statutes likeTruth in Lending and RESPA but making sure thatthey’re inside and subordinate to a financially pru-dent function. If that happened, by far the mostimportant project that this organization should takeon is clear, straightforward, key information—and,of course, honest information—to borrowers aboutexactly what commitments they’re making so theycan decide for themselves how much risk they wantin their financial lives.

JAMES GATTUSO: Our last panelist for the dayis David John, my colleague here at Heritage whoserves as Senior Research Fellow covering financialmarkets and regulation as well as retirement savingsissues. David has deep background in financial mar-ket issues and is a veteran of many financial legisla-tion wars, having served for some time on the Hillfor a number of Members of Congress and also asVice President of Chase Manhattan Bank in NewYork covering public policy issues, Director of Leg-islative Affairs at the National Association of FederalCredit Unions, and more. He is truly an expert onthis issue.

If I can add, he has a truly classical education,having received a number of degrees for studies inAthens, the University of Georgia in Athens.

DAVID JOHN: I think there are four mainpoints that need to be made and need to be remem-bered, especially as we go forward in the discussionhere. It appears, according to the latest news—andthat may change in the next 15 minutes or so—thatthe negotiations between Senator Dodd and SenatorBob Corker (R–TN) have foundered, and some ofthe reports suggest it was because of the CFPA.

It is important not to deny that there wereproblems with the way consumer regulationswere structured, the timing of when they cameout, and the way they were applied. Past experi-ence with consumer financial regulations has beenfar less than perfect. However, we do have theopportunity to make it worse, and I’m afraid that

is the direction that at least the Administration ismoving in.

I also have a very strong belief in disclosure, butit has to be, as Alex said, disclosure that you canunderstand. If you have a credit card, every yearyou’re going to get a disclosure that tells you howyour name, address, and other information is goingto be used for marketing purposes by the card issuerand its other subsidiaries. The disclosure is usuallyone large piece of paper that’s been folded into fourpieces and is filled with tiny type that might beunderstandable by one of Todd’s colleagues at lawschool, but certainly not by any normal individual.

So meaningful disclosure has to be very simple,and it has to be very carefully displayed. This isimportant. Those of us who have bought a car ontime may have noticed that there was a big boldblock in the middle of a long sheet of paper whichsaid basically, “You are going to make X payments ofX dollars for X months, which equals X dollars,which is how much you are paying for the car intotal. And by the way, this is the effective interestrate that you’re going to have.”

That is about as simple as you can make it,except for the fact that because it’s part of a longform, and because you’re writing your signatureand/or initials at least half a dozen—and sometimesmany more—times, it’s very easy for the sales per-son to point it out and say the proper legal terms,and you’ll never notice the disclosure at all. If youbuy a house, where you basically spend severalhours signing your name and writing a huge check,things become even worse. So disclosure is crucial,but disclosure is not enough. Disclosure has got tobe simple, like the one-pager Alex is talking about,and it has got to be stand-alone instead of part of alonger and more complex form.

In the debate about establishing a CFPA, wherethe agency is housed is important, but it would be ahuge mistake to get distracted by just answeringthat question. As Alex has already said, the last

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Disclosure is crucial, but disclosure is not enough. Disclosure has got to be simple…and it has got to be stand-alone.

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thing we need is a de facto independent agency thatis just tucked into another agency. The details onhow its powers will be set up, what kind of interac-tion it will have with the prudential regulators, andthe like are, if anything, far more important than thelocation question. I’m quite concerned that as thisdebate goes forward, in the effort to present a fairlysimple, easily understood argument to people, thisis going to be forgotten. There are other ways to pro-tect consumers than just to create a new agency,although Alex gives some very good reasons forconsolidating to an extent.

The big argument for a CFPA—especially, ironi-cally, by Chris Dodd and Barney Frank—is that theFed and other regulators failed to give consumerregulation the proper attention. We’ve got a paperout that discusses addressing these lapses by using acoordinating council structure instead of a new reg-ulator, one where the different existing regulatorswould meet on a regular basis. You could have aSenate-confirmed individual who heads this coun-cil. Members could include the state regulators inaddition to federal regulators so you don’t have anall-powerful federal regulator that takes control ofeverything.

This would solve the problems that supporters ofthe CFPA have come up with. It would give the con-sumer regulations more visibility. The coordinatingcouncil would have the ability to say this area isn’tbeing handled well enough, and the council couldhave a small research staff to assist it. But theresponse to problems with consumer financial reg-ulations doesn’t have to be a new agency with thegoal of trying to control the universe.

My last point, which I think is actually the mostcrucial point of all, is that if you look at the news-paper articles that have discussed the Corker–Dodd negotiations, the Shelby–Corker–Dodd nego-tiations, and others, they all, for the most part,focus on the CFPA. That’s an important issue, butit’s not the only one contained in a bill of more than1,000 pages.

What deeply concerns me is that there will be anagreement on the CFPA that somehow or other sat-isfies everyone, and the conservatives will also get

something—that says in essence, “There will neverbe another bailout, not now, not ever, absolutelynot”—and will treat as minor little issues whichactually are going to be far more important in thelong run: little things like a resolution authority.

The newspaper yesterday talked about an agree-ment to create a $50 billion pre-funded slush fundthat would be used to pay for part of the costs offuture failures. As we all know, Congress is constitu-tionally incapable of leaving money alone and notusing it for something. So supporters of this newfund can say initially, yes, this will only be for themost ultra-emergencies, but that’s not the way it’sgoing to work in the long run. As we’ve seen in theoperation of the federal Flood Insurance Programand so many other federal disaster programs, thedefinition of “disaster” greatly expands to reach thepoint of stubbed toes or splinters in your finger, andthat’s what’s going to happen here.

Keep in mind that $50 billion is only approxi-mately one-third—actually, it’s less than that—ofthe amount that the government sent to AIG alone,and that doesn’t count the many other major finan-cial companies out there that also received a federalbailout. There will be some sort of agency on sys-temic risk, and many of the proposals say that thisagency would have the ability to draft an unregulat-ed company into a regulatory system, and hypo-thetically, regulators at that point would be allowedto tell the company, “I’m sorry, you need to stop cer-tain product lines, you may need to sell off pieces ofyourself, or you may need to go out of business.”

An open-ended regulatory authority is bothexceedingly dangerous and a complete dropping ofcongressional responsibility. Congress is supposedto decide on a regular basis which companies aregoing to be regulated, why, and how and not justsimply hand that responsibility over to the regula-tors and say, “Do what you want guys, but if you fail,we’re going to blame you.”

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An open-ended regulatory authority is both exceedingly dangerous and a complete dropping of congressional responsibility.

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Last but not least, there are additional questionswhich are going to be answered by the legislationabout things like the regulation of derivatives andother types of similar products. The EuropeanUnion has just sent a rather nasty note to TreasurySecretary Geithner, who has not gone along withsome of their proposals to declare that all deriva-tives are the spawn of Satan and therefore need to bevery closely regulated.

These are all key issues. The CFPA is crucial. It’svery important, and it will be especially importantto consumers, but it’s not everything in the bill by along shot. So dealing with the Dodd draft properlyis not just a matter of having a priority list with threeitems on it and declaring victory and going home.This is a case of legislative language that we don’tknow or haven’t examined in detail and can reallyhurt us.

ALEX POLLOCK: Congressman Scott Garrett(R–NJ) has a bill to require Fannie Mae and FreddieMac to be put on budget. That would be anotherform of truth in legislation which we really need.

Questions & AnswersQUESTION: What is meant by fraud? Is it what

a lawyer or prosecutor would say—I can go to courtand send somebody to jail—or is it the more collo-quial sense of someone taking advantage of a lesssophisticated party? On one hand, it’s law enforce-ment, and on the other hand, it is kind of a pater-nalistic notion. I wonder which it is, or whether it’sboth.

TODD ZYWICKI: I think it is the kind of thingthat the Federal Trade Commission has done forev-er, which is fraud misrepresentation: basically mis-leading people about what was in their loandocuments, telling people that they had a fixed-ratemortgage when they actually had an adjustable-ratemortgage, or a 228 or a 327, those sorts of things. Ithasn’t really been defined very well.

But you put your finger on a more interestingpoint. I worked at the Federal Trade Commission. Iknow what fraud and deceptive practices look like.What’s interesting about the CFPA is that it’s not justtalking about fraud and deception; it’s also talkingabout abuse of lending. I have no idea what abuse oflending is. I don’t think anybody has any idea what

abuse of lending is, other than it is lending thatwhoever is the head of this bureaucracy after thefact will decide is too expensive or whatever the casemay be.

Certain types of lending might be called inher-ently abusive—payday lending, for example.Nobody could possibly know what that means, andI don’t see how anybody could possibly be willing tolend money in an environment where, after the fact,the regulators could say that your loan is not justfraudulent or deceptive but abusive, no matter howwell you disclose it.

You mentioned the idea about taking advantageof less sophisticated borrowers. A 2007 study doneby the Federal Trade Commission asked mortgageconsumers about their mortgages. What they foundwas that neither subprime nor prime borrowersactually understand their mortgages.

That goes back to the point about how bad thedisclosures are. The FTC came up with a whole listof very simple things that could be done in the reg-ulatory apparatus that would make it easier forprime and subprime borrowers to understand theirmortgages, and it seemingly has gone nowhere.Instead, HUD gets tangled up in all kinds of thingsinvolving yield spread premiums on mortgage bro-kers and all these sorts of sideshow activities.

Regulations are not written for human beingsright now. They’re written by lawyers and regulatorsfor lawyers and regulators. The FTC study asks,what would happen if we actually wrote disclosuresfor real human beings? It turns out consumers canunderstand their products a lot better if you justtake that simple step.

ALEX POLLOCK: When it comes to fraud,there are cases which are fraud pure and simple. Forexample, if a mortgage broker took the loan appli-cation and whited out the household income of$50,000 a year and put in $90,000 because heknew that’s what it would take to get the loan

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Regulations are not written for human beings right now. They’re written by lawyers and regulators for lawyers and regulators.

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approved, that’s outright fraud on the lender and onthe ultimate owner of the mortgage.

It’s equally clearly fraud if the borrower said theirincome was $90,000 when in fact it was $50,000.You might say the lender was stupid not to verify it,which is true; nonetheless, lying about your incomeas a borrower is out-and-out fraud.

Then there are less clear cases, which would bethe sort of thing the FTC might get involved in. I’veseen these myself in the case of option ARMs, whereyou’re able to make payments of less than the inter-est on the loan, with the interest rate being addedon to your principal. In advertising materials, thesewould get described as, “I can get you a 1.5 percentloan.” What it meant was your initial paymentcould be as little as 1.5 percent; the actual interestrate might be 5 percent or so, and the other 3.5 per-cent would be added on to your principal. Ofcourse, they worked on exactly how they said it,and maybe you found an asterisk that said “actualinterest may vary” or something. That wouldn’tcount as clear and straightforward disclosure.

QUESTION: It seems to me that we have socialideals being promoted in order to coerce or manip-ulate the marketplace. I’m thinking in particular ofthe Community Reinvestment Act, which offeredincentives and disincentives for abiding by thesesocial ideals, and then of course you had FreddieMac, Fannie Mae really offering implicit coveragefor these risky decisions.

Wouldn’t truth in lending be a lot more com-monsense to business practitioners if there weren’tthese perverse incentives? Wouldn’t it make sensefor them to have clearly agreed upon terms in whichboth lender and borrower were protected if theseincentives were not involved?

TODD ZYWICKI: I’m personally not that con-vinced that the Community Reinvestment Act orFannie Mae was a big part of this story. The fore-closures and defaults that spawned the financialcrisis are not lending to poor-risk and inner-cityneighborhoods. What they are is gigantic tracts ofbrand-new houses built in the suburbs and exurbsof Phoenix, Las Vegas, and the Inland Empire ofCalifornia.

If you look at FICO scores, for instance, ofsubprime borrowers over the run of the housingboom, you see they remain the same or perhapseven went up a little; what deteriorated was every-thing else. In particular, what deteriorated werethese requirements of putting money down, putmore cash out refinancing, those sorts of things.

Basically, the national banking crisis is really alocalized foreclosure crisis in a handful of states,primarily with respect to newer houses and thingshaving to do with real estate markets, exacerbatedby things like anti-deficiency laws in states like Cal-ifornia and Arizona, which are basically get-out-of-jail-free cards if your bet doesn’t pay off.

In my view, Fannie is probably a part of this storybecause it created a market where these poorlyunderwritten loans could go. CRA is a very badidea, and we should get rid of CRA regardless, but Idon’t think it’s necessarily a big part of this story.

ALEX POLLOCK: We had a bubble in houseprices and a bubble in credit extension. The ques-tion rightly focuses on the political pressure to low-er lending standards.

One of the most important parts of that was pres-sure to reduce down payment requirements. Toddrightly said there are some key regularities in mort-gage finance, and one of them is the very strongrelationship between down payments, or theirinverse, the loan-to-value ratio, and loan perfor-mance. The lower the down payment and the high-er the loan-to-value ratio, the greater the defaultsand delinquencies will be. That’s as close to a law ofnature as you’ll get in finance.

I’d like to contrast this with the ideas of a fewgenerations ago, of the old savings and loan associ-ations. It’s very interesting to read how theydescribed what they were doing. They were aboutimprovement in the lives of what we would now callmodest- or low-income people, and they said,“Thrift and savings and self-discipline will allowyou to better your role in the world.” They wereclear that they were on a program of social improve-ment through, in the first place, thrift and, in thesecond place, becoming a homeowner, a propertyowner, with a stake in society. So they had savings


and loans, but they never forgot about the savingspart of it.

One way to look at the evolution of Americanmortgage finance is that we completely forgot aboutthe savings part—in fact, politically, purposefullysuppressed the savings part, which is the down pay-ment, in favor of all of the emphasis going on theloan. That was a big mistake.

DAVID JOHN: That was a huge mistake. You’vegot to remember also, CRA has been around forabout 30 years or so, and what that means is thatmost financial institutions found a way to deal withCRA about 25 years ago. I remember going to theAmerican Bankers Association with an idea havingto do with small-business retirement savings. Wesaid, “We could give these accounts CRA credit,”and they looked at me and said, “Well, that’s all verynice, but we figured out how to deal with CRA adozen years ago. We don’t really care if you add it tothe definition or don’t add it to the definition; it’sjust not a big deal.”

But part of what we forget—and that people overin that domed building and the regulators who tryto figure out what those legislators were talkingabout forget—is that there is a huge differencebetween what seems like a commonsense idea andactually putting it into regulation and law.

One that we haven’t talked about is the Truth inSavings Act. The Truth in Savings Act came aboutbecause a member of the House Banking Commit-tee was walking down K Street one day. It used tobe, as you walked by all the different financial insti-tutions, that you’d see a little pressboard in everywindow showing how much that bank paid on dif-ferent savings products, and he noticed that therewere some differences as they went along. Then hediscovered that how the individual financial institu-tion defined a one-year CD might be vastly differentfrom the way another institution did.

So he came back to Congress and started to workon something called the Truth in Savings Act, andby the time it passed, everybody thought, “Oh,that’s a really good idea.” The final law, as I recall,was somewhere in the 10- to 12-page range—which frankly is nothing, especially given that thefinancial reform that we’re talking about today isgoing to be somewhere in the neighborhood of1,000 to 1,500 pages or so—and they sent it to theFederal Reserve and said, “Implement this, please.”

What came out of the Federal Reserve was some-thing that was about 1,000 pages thick, and itincluded a disk, which had the first-ever computerprogram that was part of a financial regulation.When the Fed attorneys sat down and looked athow savings rates are set, they realized that this sub-ject was vastly complex, and in order to get a legaldefinition of each savings product, they had to coverevery conceivable eventuality, and the result turnedout to be a nightmare.

One of the things that you come up with in vir-tually any law and regulation in financial services isthe law of unintended consequences. We’ve had atremendous amount of that already, and we’re likelyto have even more.

TODD ZYWICKI: I want to add one point toAlex’s observations, which I thought were veryinsightful. On the promotion of home ownership,it’s a very, very interesting example of the hubris ofeconomic planning. As everybody has remarked,expanding home ownership has been a bipartisangoal for decades.

In retrospect, it seems foolish, and obviously itwas foolish, but at the time it actually made sense.There was a huge volume of empirical research thatshowed that home ownership was correlated withthe good things in life—wealth accumulation, bet-ter results for kids, better neighborhoods, lowercrime, all these sorts of things—and people justassumed that the causal link was that if you boughta home, you became more responsible.

What we’ve subsequently found out is thatresponsible people like to buy homes and creategood neighborhoods and take care of their kids andthat sort of thing. By artificially promoting homeownership, we brought in a new class of people

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Part of what we forget…is that there is a huge difference between what seems like a commonsense idea and actually putting it into regulation and law.

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buying homes for different reasons. It didn’t makethem more responsible. They were irresponsiblepeople who were coming in to speculate. They wereshort-term owners; they weren’t as invested in theneighborhood. What we found is that these werethe people who were much more responsive to theincentives, for instance, to walk away from their

homes when their houses go underwater; they weremore likely to take these exotic mortgages and thesesorts of things.

It’s a very interesting story about how the causa-tion was actually the opposite of what we hadunderstood and had been basing policy on for along time.

protecting consumers in the financial marketplace:...

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