Financial Product Safety

As our nation's economic crisis spreads and trillions of dollars are disbursed to keep the banks afloat, it's easy to forget that the catastrophe began with the peddling of a toxic retail-credit product: adjustable-rate sub-prime mortgages. Fueled more by demand from Wall Street than by demand from homebuyers or homeowners, a vast army of unregulated mortgage brokers barreled through down-on-their-luck neighborhoods offering salvation via cash-out refinancing in the form of exploding adjustable-rate mortgages. Contrary to popular perception, the majority of these mortgages weren't taken out by speculative investors or even by middle-class families fulfilling their aspirations for ever-more home on an ever-shrinking income. In many cases, the mortgages were sold to existing homeowners, who were duped into trading their affordable fixed-rate mortgage for an ultimately unaffordable adjustable one. According to The Wall Street Journal, more than half of all sub-prime loans went to people with credit scores that could have qualified them for traditional mortgages.

As early as 1998, legislative hearings on predatory lending featured testimony from advocates, government officials, and Congress members voicing concern about the dramatic increase in sub-prime loans. The warnings were steady and consistent, but regulators failed to act.

Why? First, agencies were fragmented and afflicted with conflicts of interest. The Office of Thrift Supervision and the Office of the Comptroller of the Currency are both funded through money paid by the very institutions they regulate. Second, agencies focused almost exclusively on the "safety and soundness" of the banks they regulated. If they sold off the sketchy loans (the case with nearly all sub-prime mortgages), the bank's own portfolio was safe and sound. Third, agencies had authority they failed to use. The Federal Reserve could have acted--it had the authority through the Home Ownership and Equity Protection Act--but Chair Alan Greenspan showed very little interest in consumer protection.

By contrast, a Financial Products Safety Commission (FPSC), an idea first proposed by Harvard law professor Elizabeth Warren, would surely have yanked these mortgage products and the brokers who sold them from the market--preventing the whole complicated chain of events that resulted in the collapse of our economy. In the pending bill introduced by Sen. Dick Durbin and Rep. William Delahunt, the commission would have the power to "ban abusive, fraudulent, unfair, deceptive, predatory, anticompetitive, or otherwise anticonsumer practices, products, or product features." Had the FPSC, modeled after the Consumer Product Safety Commission, existed prior to the current crisis, it would have been the first stop for consumer advocates, mayors, attorneys general, and consumers themselves to file complaints or raise concerns about predatory sub-prime loans. The FPSC would have investigated. Having found widespread evidence of loans being deceptively marketed, shoddily underwritten, and loaded with features that would eventually make them unaffordable, the FPSC would have forced the equivalent of a recall, converting sub-prime adjustable-rate mortgages into affordable fixed-rate loans. The agency would then likely have issued new quality standards, clearly specifying the underwriting necessary to ensure home-owners could afford the payments under the highest rate-adjustment scenario. It also would likely have issued rules prohibiting the use of kickbacks to brokers for originating loans with interest rates higher than the consumer qualified for.

Moreover, toxic financial products have been aggressively marketed to communities of color. As a result, African Americans and Latinos have suffered disproportionately under deregulation. A survey commissioned by De'mos found that low- and middle-income Hispanic and African American households carried credit-card debt twice the total value of their financial assets, while white households had financial assets worth more than the amount of their credit-card debt. United for a Fair Economy has estimated that households of color have lost between $164 billion and $213 billion as a result of sub-prime loans taken out during the past eight years. Many of these borrowers qualified for prime-rate products.

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A Financial Products Safety Commission could monitor marketing campaigns to see if similarly situated borrowers are being offered different products depending on their community of residence or their race or ethnicity. By extending the collection of race data from mortgages to credit cards, auto loans, payday loans, and so on--the commission could better police the industry's racial targeting.

As the idea of a Financial Products Safety Commission gains momentum (the White House was considering the idea as this issue went to press), questions arise about whether the new agency should have direct authority or whether it should serve in an intervenor function, working with existing regulatory agencies. The current bill would give the agency direct authority. While arguments can be made for either form, if the goal is to elevate consumer protection in the regulatory scheme, creating an agency that doesn't have direct authority to regulate financial products seems poised to produce lukewarm results.

Critics contend that we don't need a new agency because safety and soundness and consumer protection are two sides of the same coin. This idea is conventional wisdom now but was considered naive for the last decade. It's not difficult to imagine a time, say a decade from now, when the interests of consumers are again viewed as pesky nuisances standing in the way of bank profits. The current patchwork system of regulators overseeing consumer financial products--some 10 altogether--are ill-equipped, even ill-designed, to do the job of protecting consumers. Their primary clients are banks, not consumers. Historically, much consumer protection was provided through state law and oversight. But beginning in the late 1970s, usury protections and other credit regulations were all but nullified by legal rulings and several pieces of congressional legislation that preempted state laws. In addition, none of the agencies have the resources to tackle consumer protection adequately.

Millions of families have lost their home, jobs, retirement savings, college aspirations--as a result of toxic products pushed by unregulated mortgage lenders and brokers, who often had the full backing of capital from august financial institutions and the full approval of existing regulatory agencies. It remains to be seen if this lesson will lead to transformative change such as the establishment of a Financial Product Safety Commission, or if the lingering power of the banking industry will leave us with mere tinkering at the margins.

Further Reading on the Financial Products Safety Commission idea:

Leading academics and policy experts present their case for why our nation is in need of a regulatory body for financial products - and what powers that body would require in order to do its job:

Katherine Porter (Associate Professor of Law, University of Iowa) argues that a consumer financial products regulatory body should look to the FDA's regulatory process for pharmaceuticals to develop a nuanced approach to testing, approving, and monitoring the use of financial products, as well as to balance the benefits of their use against the risks.

Daniel Carpenter (Freed Professor of Government and Director of the Center for American Political Studies, Harvard University) makes the case for a financial products regulator that would hold veto power over market entry for some products, proposing that such a power would create real incentives for a firm to produce good information about the purpose of its product and how the product will serve that purpose with minimal safety hazards.

Robert Litan (Senior Fellow, Economic Studies, Brookings Institute and Vice President for Research and Policy, Kauffman Foundation) proposes post-market scrutiny of financial products rather than a pre-approval process, arguing that the latter setup would slow innovation, raise costs to consumers, and come up against the difficulty of running meaningful "clinical trials" for proposed financial products.

Elizabeth Warren, chair of the Congressional Oversight Panel and the Leo Gottlieb Professor of Law at Harvard University, challenges three myths about the consumer financial product agency.

Adam Levitin, a professor at Georgetown University, discusses the Consumer Financial Product Agency's potential.

Travis Plunkett (Legislative Director, Consumer Federation of America) identifies current structural shortcomings in the regulatory process that a financial products regulatory body would remedy - including the failure of federal regulators to prioritize consumer protection over competing (and often financial) incentives to keep standards weak.

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