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The Credit Market is Broken, but the CFPA Won't Fix It

|Includes: BAC, C, JPMorgan Chase & Co. (JPM)

As Chair of the Congressional Oversight Panel, which has been charged with reviewing the current state of financial markets and the regulatory system, Harvard professor Elizabeth Warren has been quite vocal in her support of the administration’s proposal for a Consumer Financial Protection Agency (CFPA).  The CFPA would be the regulatory body that ensures that financial institutions provide clear and simple disclosures, which would ostensibly deter consumers from opting for risky and “exotic” financial products, and would be the eighth agency involved in consumer credit regulation.  While I agree that there has been little effectiveness in the regulatory system as far as consumer financial protection is concerned, this is no reason to create yet another agency.  The CFPA, which was actually conceived by professor Warren several years ago, would separate the regulation that provides consumer financial protection from the regulation that ensures the banks that serve these consumers are solvent, and do not introduce toxic products to the market.  If our hope is for a solid financial system, then it must be understood that these two areas of regulation go hand-in-hand.  Warren is right, “the credit market is broken,” but she herself proves that the CFPA won’t fix it.

Warren lays out her arguments for the CFPA in two articles that appeared recently in Business Week and in The Baseline Scenario.  While she is spot on in her analysis of the nature of the problems that plague our financial system, her solutions do not address the problems that she identifies.  It’s true, traditional financial products cannot compete with “exotic” products whose terms seem attractive up front, but hide surprises and changes that are revealed only after the consumer has committed.  Further, the more complex these “exotic” financial products become, the less able consumers are to make comparisons.  Right now our financial system lacks a level-playing field, transparent in its operation, which encourages competition, and also engenders product innovation.

I am in agreement with Warren about the backwardness of our current regulatory system, which is most ineffective because it is structured by business type rather than financial product type (i.e. credit cards, home loans, etc.), and allows financial institutions to essentially choose their own regulators, simply by changing their organizational structure.  There is also a conflict of interest in the current system that is perpetuated by the fact that the regulatory budget comes, in large part, from the financial institutions that need regulation.

Warren insists that the solution to these problems, which again she has correctly identified, is the CFPA.  This new agency would promote clear disclosure of the risks and costs for everything from mortgages to credit cards, from payday loans to bank overdraft fees.  Disclosure – this is the lion’s share of Warren’s argument for the CFPA.  She believes that, if people were aware of the facts surrounding financial products, they would make rational decisions concerning which product to choose.  This is simply not the case.

For instance, in the case of the housing market, it’s easy to say that all of the people that took out subprime loans were victims who had no idea what they were getting into, but the reality of the situation is that many of these people got caught up in a bubble economic mentality.   They believed that they could sell their homes at inflated prices, if they became unable to afford their mortgage payments once they doubled.  This segment of consumers failed to weigh risk properly, because they assumed that housing prices would continue to appreciate.  The core of the problem was extensive speculation on the parts of both lenders and borrowers, and not insufficient disclosure.  

The truth is that regardless of the thoroughness of disclosure, consumers aren’t always realistic about their home’s future success on the housing market, or their ability to consistently make payments on their credit card accounts on time.  It’s human nature for people make decisions that are unrealistically optimistic.  Full disclosure won’t fix this problem.

Moreover, the proposed CFPA fails to address the problem that lies at the core of the misfortunes our financial system faces, and that is product structure and underwriting standards.  As a result of her belief that the marketing of and disclosure around financial products can be separated from the design of the products themselves, Warren’s conceived CFPA would allow banks and other lenders to continue offering complicated or risky products, so long as the risks are disclosed so that consumers can reasonably understand them.  These kinds of products simply should not be allowed to exist.  Plans for the CFPA fall short because mandating full disclosure does nothing to mitigate the danger for both banks and consumers that exotic financial products represent.  

Continuing to allow complex financial products to be sold on the market will, by necessity, imply some complexity in terms and contracts, making “clear disclosure” an extraordinarily subjective term.  Additionally, the same regulators who are to be responsible for the terms of disclosure should also responsible for the structure of financial products.  In the financial products market these two things are intrinsically intertwined.

Disclosure: No positions