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Tuesday, July 14, 2009

Consumer Protection Elitists? Hardly

Richard Green takes on Peter Wallison's arguments against establishing a Financial Product Safety Commission:

Peter Wallison calls Consumer Protection Elitist: He writes:

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. If the administration's plan is adopted, many consumers will be told that they cannot have particular products or services because they are not sophisticated, educated or perhaps intelligent enough to understand what they have been offered.

Conservatives have always argued that liberals are elitists who do not respect ordinary Americans; this legislation seems to prove it. For example, the administration's plan would allow the educated and sophisticated elites to have access to whatever financial services they want but limit the range of products available to ordinary Americans.

This unprecedented result comes about because, under the proposed legislation, every provider of a financial service (a term that includes organizations as varied as banks, check-cashing services, leasing companies and payment services) is required to offer a "standard" product or service -- to be defined and approved by the proposed agency -- that will be simple and entail "lower risks" for consumers. These standard products are called "plain vanilla" in the white paper that the administration circulated in advance of the legislation.

Such protection is actually not unprecedented. For example, people must be deemed to be "accredited investors" or (for more complicated products) "qualified purchasers" in order to invest in certain types of hedge funds. And stock brokers have an obligation to make sure their clients' investments are "suitable."

But beyond the issue of precedence, there is a broader issue of safety. We reasonably forbid or require a variety of actions in the interest of safety. We require people to wear seatbelts. Be don't allow people to buy certain type of narcotics over the counter. Perhaps Mr. Wallison thinks such protections are a bad idea too, in which case he is consistent, if not also ridiculous. Mortgages can be dangerous products. Let's turn it over to Richard Thaler:

Fast forward to 2008, and the world of mortgage shopping had become a much more complicated place. Borrowers were quoted low initial “teaser” rates that would jump later to some higher level, depending on market interest rates at the time, and there were prepayment penalties for paying off the loans early. For such mortgages, an A.P.R. was no longer an adequate measure of the loan’s cost.

How can we help people make sense of all this?

One extreme approach would be to ban complex mortgages entirely: we could just go back to the world of uniform fixed-rate mortgages. But the cost of simplicity is an end to innovation. ...

A better approach is to strive for maintaining diverse options but helping consumers make smart choices and avoid the most common pitfalls. ... As the administration plan describes it, lenders could be required to offer some mortgages they call “plain vanilla,” with uniform terms. There might be one vanilla 30-year, fixed-rate mortgage and one five-year, adjustable-rate mortgage. The features of these plain mortgages would be uniform, much as in a standard lease used in most rental agreements.

Lenders would also be free to offer other exotic mortgages — perhaps called “rocky road” mortgages? — along with the vanilla variety, but these offerings would receive more intense scrutiny from regulators.

I am not sure what is so elitist about this, other than the fact that those who are hostile to regulations tend to like to use elitist as an epithet for their opponents. So I guess I have two questions for Mr. Wallison:

(1) If I gave him an HP12C calculator, assumptions about an interest rate path, and the terms of an option-ARM mortgage, would he be able to tell me the payment on that mortgage in, say, month 62? Perhaps he could, but I don't know too many lawyers (and he is a lawyer) who could do that calculation. ... The point is ... to emphasize a fact--most of us do not have the equipment to make informed judgments about complex financial products.

(2) I am curious how often Mr. Wallison hangs out with those who are not elite. Does he socialize with, say, median income people? ... Perhaps he does, in which case he is entitled to refer to "the elite" as an other. But I have my doubts.

I would be hesitant to endorse this banks weren't "free to offer other exotic mortgages," but that's not a problem.

Why make these products identical, i.e. why have a plain vanilla option? Have you ever tried to compare the price of mattresses at different stores? It's almost impossible - intentionally - to find matching model numbers and exactly identical products, so you are never quite sure which is the better deal. That uncertainty gives the stores pricing power. If stores were required to offer two or three identical mattresses, such comparison shopping would no longer be a problem and you'd expect competition to drive the price down its minimum level. There would still be exotic mattresses at each store, nobody would make you purchase the standard option, you would still have choices. But even if you aren't a mattress expert and hence have little idea if the exotic mattresses are worth the price, at least there would be two or three choices where you could be sure that the mattresses were priced fairly and that they adhered to particular quality and safety standards.

Of course, since such a proposal would take away pricing power of firms selling mattresses, and they would be opposed to such a requirement. It's no different for financial firms, and Simon Johnson doesn't think the administration is being aggressive enough in countering efforts to undermine and weaken the proposed consumer protection legislation:

Waiting For The Big Push: Selling The Consumer Protection Agency For Financial Products. by Simon Johnson: ...[T]he administration’s major remaining initiative is its version of a Financial Product Safety Commission - something that would be clearly beneficial for the public.  And the skepticism – and outright opposition – comes from the banking sector. ...

As far as I can see, [the administration is] not pushing this new consumer protection/safety agency hard enough. Some sources claim that Secretary Geithner is fully on board with the Agency...  But there is no sign of the frenzied effort that accompanied efforts to launch the PPIP – when, for example, almost every economist in the administration seemed pressed into service to call potential critics and ask them to “give it a chance.”

One symptom of this “effort gap” is that counter-arguments and disinformation about the proposed agency begin to gain the upper hand.  One senior executive recently told me that this agency would have unprecedented powers to determine the design of individual products – “something not even the FDA can do.”

Of course, this is nonsense.  The new agency would be powerful – and thus it is feared by the industry – and presumably it would be able to prevent sufficiently toxic products from being sold.  Hopefully, it will also be able to require that all financial institutions also offer some vanilla products, to make consumers’ choices easier.  But the idea that an agency would design the details of all products for any sector is both implausible and a malicious rumor being spread by opponents (actually, it reminds me of the pushback from meatpackers, and others, early in the 20th century). 

If Treasury is so supportive of this new Agency, now is the time to launch public, high profile, and clever counterattacks.  By the time the legislation is being voted on, it will be too late.

And in this context, the administration should push hard on one of the great ironies here.  Financial sector executives like to stress the importance of “consumer confidence,” and they urge the government to take steps to restore this confidence...

But the same people completely reject the idea that consumers will feel more confident about financial products if there is finally some serious consumer protection around those products.  Whenever people learn – or just fear – that a particular food product is unsafe, they stop buying it.  When the stock market ripped people off in the late 1920s, it took legislation with real teeth to rebuild investor confidence – take a look at, for example, the Securities Exchange Act of 1934. ...

If Treasury and the administration really wants a Consumer Protection/Safety Agency for finance, they need to kick their support campaign into much higher gear immediately.

Consumers have a big information disadvantage when it comes to mortgages and understanding which product fits their needs without exposing them to unnecessary risk, and in some cases they may not even be presented with the full spectrum of mortgage products that are available when they apply for a loan. And though it's better than it used to be, it's also difficult to shop around due to the transactions costs involved. The information problem combined with the difficulty in comparison shopping give brokers the opportunity to steer people toward products that are more profitable, but not as good a fit for the borrower. Having a few common options that are available across brokers makes comparison shopping easier and helps to overcome the information problem.

Update: More at Rortybomb.

Update: Tim Fernholz disagrees with Simon Johnson:

Simon Johnson writes that the administration isn't supporting the proposed Consumer Financial Products Agency enough. Since I wrote a piece arguing the exact opposite last week, I thought I'd respond, though I do agree with Simon in so far as he administration could never do too much to support the creation of the agency.

    Posted by on Tuesday, July 14, 2009 at 01:20 AM in Economics, Financial System, Regulation | Permalink  Comments (33)


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