Consumer Financial Protection: The AEI vs. the Real World

by: The Baseline Scenario

By James Kwak

Peter Wallison of the American Enterprise Institute accuses the Consumer Financial Protection Agency of being a liberal plot to restrict good financial products to sophisticated elites. Mike at Rortybomb does a point-by-point takedown complete with actual data, so I can stick to the high level (not to be confused with the high road).

Wallison’s op-ed reads like a caricature of conservative ideology – all supposed moral principle and no real-world implications. His argument is basically that by imposing restrictions on complex products (Option ARM mortgages) that are not imposed on plain vanilla products (30-year fixed-rate mortgages), the CFPA is limiting choice for the poor and unsophisticated and preserving choice for the rich and sophisticated; since according to conservative ideology choice is always good in principle, the CFPA is discriminatory.

Where do we start?

First, this is exactly the way consumer protection is supposed to work. If you go to a convenience store, or wherever you can still buy cigarettes, you can buy lots of things that don’t have warning labels. The cigarettes have warning labels.

Wallison dismisses warning labels with a non-argument: “If the issue is whether the consumer understood the risks of the more complex product, strong warning labels or written ‘opt-ins’ simply raise the same question and will not be a defense for the provider.” Warning labels and written opt-ins are used all over the economy; every time you sign a piece of paper saying that you understand the risks of something and you agree not to hold the provider liable, you are opting in. It is true that these do not always hold up in court, but that’s a fact-specific question. In general, they certainly do protect service providers, although Wallison asserts the contrary.

Second, this is exactly the way securities regulation works today. The Securities Act of 1933 creates exemptions for securities that are only sold to “sophisticated” investors. This is how hedge funds escape most regulation; they only allow sophisticated investors in. The CFPA is extending this principle to a class of financial instruments that, in 1933, no one thought could be complex enough to be limited to sophisticated investors.

Third, the CFPA is simply broadening the concept of fiduciary responsibility, which already exists for various categories of service providers, such as lawyers, CPAs, and some investment advisors. Someone with a fiduciary responsibility has to put the interests of his client first. In a financial context, this would mean that you can’t put a client into a financial product that does not serve his interests. The purpose of the CFPA is similar: you can’t sell a product to someone without first making sure the he understands what you are selling him. Now, this is not exactly the same thing as a fiduciary responsibility; it’s actually considerably weaker. The point is that the idea that you should not treat your customers in ways that harm them is hardly liberal or elitist.

Fourth, Wallison asserts, without example or argument, that the more complex products are better.

So who will be able to get those more complex products and services? Not ordinary Americans, whose lack of financial sophistication will make the risks of selling to them too great for most providers. The more complex products, the ones that are better tailored to the needs of the particular consumer, will be offered only to the more sophisticated and better educated — in other words, to the nation’s elites.

“Better tailored to the needs of the particular consumer?” We’re talking about exploding mortgages and reverse convertibles here. Speaking as someone who could pass any test of sophistication, my personal opinion is that the CFPA regime would actually benefit the “unsophisticated,” because the “more complex products” are just higher-margin ways for banks to relieve rich people of their money. It’s a good thing that most people are not allowed to pay hedge funds 2-and-20 for the privilege of not being able to take their money out whenever they want. But that’s another topic.

Fifth, Wallison asserts that this is “not because the products or services are inherently dangerous, like drugs or explosives,” and hence need consumer protection. This completely ignores the biggest news story of the last two years (OK, maybe the second-biggest story after the election of an African-American president). We have millions of foreclosures – that’s people losing houses who either (a) would not be losing their houses if they had been given traditional mortgages that they would have qualified for or (b) would have been better off renting and not losing down payments, closing costs, refinance costs, and their credit ratings. Those foreclosures have negative externalities for their neighborhoods, including lower property values and higher crime. (Mike already nailed this in his now-famous “degenerate crackhead” example in this post.) And we have the biggest recession since the 1930s. How are complex financial products not inherently dangerous?

Sixth, what’s the alternative? The only one that Wallison mentions is disclosure.

Traditionally, consumer protection in the United States has focused on disclosure. It has always been assumed that with adequate disclosure all consumers — of whatever level of sophistication — could make rational decisions about the products and services they are offered. No more. . . .

Apparently, adequate disclosure will not be the answer to the provider’s dilemma. As outlined in the white paper, no amount of disclosure can adequately protect consumers against complexity.

Note that Wallison is clever enough to avoid saying that disclosure works – because it obviously doesn’t. But still he leaves it floating out there as his only alternative to the CFPA. So let’s avoid the clever rhetoric. Disclosure doesn’t work. If it did, we wouldn’t be where we are today. We tried it; now we need to try something else. And Wallison doesn’t suggest anything.

What ties these six points together? Let’s see, we have:

  1. ignoring the fact that warning labels and opt-ins are already used routinely in the economy;
  2. ignoring the fact that the “sophisticated investor” concept is already used in the financial industry itself;
  3. ignoring the fact that fiduciary duty, which is more restrictive than the CFPA approach, is already used for various classes of professionals;
  4. ignoring the very real possibility that complex financial products are not actually good for you;
  5. ignoring the fact that the financial products in question have just caused enormous harm to millions of people; and
  6. ignoring the fact that his implied alternative, disclosure, has resoundingly failed.

The genius of the modern conservative movement (not the traditional conservatism of Edmund Burke, for which I have a great deal of respect) has been its understanding that to win in politics, the facts of the real world – the “judicious study of discernible reality,” if you will – only slow you down. Wallison does the movement proud.