Zwicki: Why Change The Financial System? We Had One Little "Mishap"

It's time to mock Todd Zwicki! He devotes a column in the WSJ to arguing against a consumer financial protection agency

Regulatory reform that can improve competition and consumer choice in financial services is long overdue. But no new federal bureaucracy such as the Obama administration's proposed Consumer Financial Protection Agency (CFPA) is needed to bring that about.

Of course not. The agencies that we already have in place, such as the Federal Reserve and the Treasury, which are owned by the financial services sector, are doing such a fantastic job that only 2.8 million Americans lost their homes in foreclosure last year.

Also, there's no evidence at all that Todd Zywicki's home was one of those, so I think everything is just fine.

More importantly, the administration is incorrect in claiming that such an agency would have prevented the present financial crisis and is necessary to prevent the next crisis. On the contrary, such an agency might be the first step toward more problems.

Who has made this claim? It would certainly have helped mitigate it somewhat, but the reason to have a consumer financial protection agency is because the financial services sector employs thousands of lawyers and "innovators" who dream up better and better ways to scam the public, most of whom are too busy doing productive things like inventing real products, or teaching children, or well, pretty anything other than writing up seven pages of legalese designed to obscure the fact that your credit card interest rate is going to triple if you forget to fill out a form opting out of the rate increases you were promised you wouldn't get.

During the housing boom bankers made a raft of extraordinarily foolish loans. Some were the result of lenders defrauding borrowers; probably at least as many were the product of borrowers defrauding lenders. But there is no evidence, as Elizabeth Warren (a champion of CFPA and chair of the TARP Congressional Oversight Panel) recently asserted on these pages, that lender fraud was the overriding cause of the crisis.

And since lender fraud was not the overriding cause of the ongoing Great Recession, well, let's just not worry about it. Is that the plan, Todd?

And Todd - borrowers were not defrauding lenders; they were encouraged by lenders to submit applications that were less than truthful. Why? Because as soon as those loans were signed, they were packaged up by the big banks, disguised as good securities,  and sold to investors. (Pension funds for retirees, for example.)

Let's get this straight right now: lenders were not defrauded. Lenders, who knew better, actively sold these loans to homeowners who may or may not have known better. And Todd either knows this and is lying about it, or he doesn't and he's incompetent.

The bank loans were not foolish because borrowers didn't realize what they were doing. They were foolish because of the incentives they created for borrowers, especially when housing prices turned south.

Actually, the bank loans weren't foolish at all, at least not from the standpoint of the banks. They quickly sold them and make tons of money doing it.

There were three distinct stages of the housing crisis. In the first, the Federal Reserve's extremely low interest rates from 2001-2004 induced consumers to switch from fixed to adjustable rate mortgages and drew short-term speculators and house-flippers into the market in certain cities. The Fed's increase in short-term interest rates over the next two years increased homeowner payments and precipitated a round of defaults.

Also, there was a completely unregulated financial sector which was making a killing by turning mortgages into CDO's. And these guys needed more mortgages to feed into the money making machine, which led them to do everything possible to convince homeowners to refinance, or for unqualified borrowers to buy homes.

My own research confirms the analysis provided by University of Texas economist Stan Leibowitz on these pages last July: The initial onset of the foreclosure crisis was a problem of adjustable-rate mortgages, whether prime or subprime. It was not initially a subprime problem.

Oh. Well, maybe we should look into these adjustable rate mortgages. Maybe a consumer financial protection agency could do that?

In the second phase, falling home prices provided incentives for owners whose mortgages were under water to walk away from their houses. 

Because, in the absence of a consumer financial protection agency, people who couldn't afford it were allowed to buy homes with no money down and interest only loans, which meant that ANY drop in home prices would leave them underwater and give them an incentive to walk away.

And in the third phase, which we are now experiencing, traditional macroeconomic factors like unemployment led to more foreclosures—especially where homeowners' mortgages are already underwater. Reflecting this situation, the Mortgage Bankers Association reports that the fastest-rising segment of foreclosures in recent months has been traditional prime, fixed-rate mortgages.

So now the problem is worse, and this...is an argument against a consumer financial protection agency?

None of this analysis has anything to do with fraud or consumer protection problems. Consumers rationally switched to adjustable-rate mortgages when their prices fell relative to fixed-rate mortgages—a pattern that has repeated itself numerous times since the 1980s.

Why was this rational? It's only rational if people wrongly believed that taking out adjustable rate mortgages which they didn't understand was a good idea. And a consumer financial protection agency might have helped, no?

And when housing prices fell, underwater homeowners rationally responded by walking away from their houses. The proliferation of mortgages with minimal downpayments, interest-only or even negative amoritzation terms, and cash-out refinances meant that many consumers fell into negative equity territory much more rapidly than they would have otherwise.

Again, these are exactly the kinds of loans that a consumer financial protection agency would discourage.

Regulators may want to limit mortgages that provide so many borrowers with such strong incentives to walk away when housing prices fall. They may want to prohibit lenders from making loans with minimal downpayments or interest-only loans that result in consumers having minimal equity in their homes. But that's an issue of safety and soundness, not protection against fraud. 

What regulator is going to do this? The Fed and the Treasury have shown no interest because they are owned by the banks.

With respect to ARMs, the obvious solution is a less-erratic Federal Reserve interest rate policy. 

Yes, in a perfect world, the Fed would never change interest rates, and I would have a pony. In the real world, it happens all the time.

ARMs have been in widespread use for 25 years (and are common in the rest of the world) without mishap like in the current cycle.

Other than this slight mishap (the greatest recession in 70 years, tens of millions out of work, massive government bailouts of rich people, and the greatest wealth transfer from the middle class to the rich in the history of the world), things have worked out just fine. And the funny thing is, no one is even talking about banning ARMs.

So the problem isn't consumer gullibility or ignorance. Borrowers have shown they understand, and act on, the incentives they face all too well.

No, Todd. Borrowers have shown that they are just smart enough to realize after the fact that they made a mistake. But that's a little late, isn't it? What if we could find a way to prevent them from making the mistake in the first place? Maybe a consumer financial protection agency could help.

It is worth remembering that, although the banking crisis was a national crisis, the foreclosure crisis is concentrated in four states—Arizona, California, Florida and Nevada—that comprise almost half of the mortgages in foreclosure. Even within those states, foreclosures are concentrated within a handful of hot-spots such as Las Vegas, Miami, Phoenix and the Inland Empire region of California. It is unlikely that borrowers in these cities are more gullible than borrowers elsewhere. Evidence does suggest, however, that there were a larger number of speculators and home-flippers in those cities than elsewhere.

Do you know how bubbles work, Todd? They feed on themselves. It is completely predictable that there would be hot spots. Are you saying that the fact that some places were hurt worse than others is somehow a reason to oppose consumer financial protection?

This is not to deny that we are overdue for a comprehensive reform of consumer credit regulation.

Todd isn't going to deny that we need it. He's just saying that he doesn't want it, because his banking buddies don't like it.

Over the years, federal laws governing disclosures have become encrusted with an ever-thickening coat of litigation- and regulation-imposed barnacles.

Right. Even though in the real world, the financial services sector has succeeded in dismantling much of the regulatory system over the past 20 years, has literally written many of the regulations that we have, and actively does everything in it's power to avoid the little that's left, in Todd's fantasy land there is too much regulation.

One example, according to Federal Reserve economists Thomas Durkin and Gregory Elliehausen in a book to be published this year, involves the Truth in Lending Act, which has grown from a simple effort to standardize disclosures on consumer credit to a morass.

This morass has been largely created by the industry itself, which craves complexity, because it can afford to understand complex things, and consumers cannot. Also, you'll have to excuse me if I don't just take the Fed's word that the Truth In Lending Act caused the crisis. That is just blatant blame-shifting.

Regulatory mandates and lawsuit fears are largely responsible for the mind-numbing length of a typical credit-card agreement and monthly statement. The most recent mandate-induced clutter requires the monthly statement to disclose how long it would take to repay the balance by making the minimum payment while making no new charges. According to a Federal Reserve Study by Mr. Durkin, only 4% of consumers would even consider this option.

No, no, and no. Credit card statements which are designed so that only a lawyer can understand them are designed that way because banks know that most people don't have lawyers, and therefore can't understand them. And just because most people aren't going to just make the minimum payment doesn't mean that they shouldn't be able to see what the effects of credit card debt are. But of course banks don't want you to know that; otherwise, you might not use your credit cards so much.

Similarly, a 2007 Federal Trade Commission staff report by economists James Lacko and Janis Pappalardo documented the convoluted nature of current mortgage disclosure rules (which fail to convey key costs) and presented prototype disclosures that significantly improved key mortgage cost disclosures. Yet such common-sense proposals remain buried in the bureaucracy.

Maybe a brand new agency, which is not owned by the banks, could actually do something with these worthwhile proposals. Maybe a consumer financial protection agency?

What's needed is simplified and streamlined regulation, not another agency.

And you think you're going to get this from the Treasury or the Fed? Please.

Policies based on a misdiagnosis of the true nature of the problem might actually lay the seeds for the next crisis. For example, Ms. Warren rails in her op-ed about "tricks and traps" such as "universal default" provisions in credit-card contracts, where a failure to pay one credit-card bill can trigger a default on another one. Yet it is obvious that a consumer's failure to pay some of his bills provides valuable information about the likelihood of default on his credit-card bill (universal default provisions are common in commercial loans for this reason).

Really? The banks are being given trillions of dollars to inflate the next bubble, and they pretty much own the government. But you think that banning banks from hiding universal default provisions in credit card statement which no one can read is going to sow the seeds for the next crisis?

Thus a lender's elimination of universal default will have to be offset by higher interest rates or fees. To the extent that a CFPA makes access to credit cards less available, excluded borrowers will inevitably shift to more expensive alternatives such as payday lending or pawn shops. If the CFPA were to impose bans on efficient risk-based pricing by lenders in the name of vague claims about "fairness," the likely result will be to increase overall risk and make the next financial crisis more likely.

Yes, a consumer financial protection agency is going to make credit cards less available. And it should! Consumers debt is at an all time high. People should use their credit cards less. And at least if you go to a pawn shop, you are aware of what it's going to cost you.

The financial crisis resulted primarily from the rational behavior of borrowers and lenders responding to misaligned incentives, not fraud or borrower stupidity. Policies that fail to appreciate the difference will not protect, and may hurt, the very consumers they are intended to protect.

This is so wrong, I don't know where to begin, and would need another post to fully explain how wrong this is. But suffice it to say that the crisis was a result of big banks being allowed to do whatever the hell they wanted, and part of what they wanted to do was take advantage of borrowers who were absolutely did not have any idea about how our complex financial system worked. And since they don't know, we need an agency to take their side against the banks. A consumer financial protection agency.

On top of all of this is the fact that the need for consumer financial protection is not just limited to mortgages, but to credit cards, insurance, and any number of financial interactions in which the consumer is operating at a huge disadvantage to corporate interests that do nothing but sit around and try to figure out ways to deceive consumers.

And Todd Zywiki apparently thinks this is the way the market should work.