July/August 2012 Too Important to Fail

Predatory lending still poses a systemic risk to the economy. Will Obama's new Consumer Financial Protection Bureau succeed in taming it, or will the agency be strangled in its crib?

By John Gravois

In a world where plenty of people still want to see bankers sent to jail, this might not sound like regulation with a full set of teeth. But simple disclosure, if it forces companies to market products on their true costs—including the stuff that has traditionally been buried on page 19 of a contract—could have a hugely powerful effect in reshaping markets and even upending business models. Companies would suddenly have to compete with each other on value to the consumer, rather than on how to most cleverly hide the ball. (For complicated contracts like a mortgage, which may not be reducible to a couple of pages, the behavioral economist Richard Thaler recommends using online “choice engines”—tools not unlike Kayak.com or Expedia, which can rank and compare products even when they involve a complicated set of variables and parameters.)

But undoubtedly, in some cases the bureau’s research will lead it to the conclusion that disclosure is not enough. For example: after the crash, mortgage brokers came under fire for taking special kickbacks called “yield-spread premiums” in return for guiding borrowers to loans with a higher interest rate but lower up-front costs—loans, in other words, that were more profitable for lenders. When the Federal Reserve performed some empirical tests to see whether the problem could be tackled with disclosure, the results were unexpectedly fascinating. When brokers were required to disclose how much money they were getting out of a yield-spread premium, the Fed found that consumers simply didn’t understand what they were being told. And in a different test, when brokers were required simply to explain in the abstract that they were working in their own interest and not the borrower’s, something strange and utterly human happened: borrowers trusted them more for being honest, still without really understanding what was going on. And so the Fed decided that disclosure was not going to work. It banned the yield-spread premium altogether. Down the road, the consumer bureau is bound to make similar calls of its own; as the financial industry surely knows, given their full-court war on the CFPB, some of their practices are not long for this world.

The other day, I was taking an early-morning walk around my neighborhood when I saw a sheaf of papers scattered across the street and a nearby yard. The cover page was lying faceup on the crosswalk. It was a notice of foreclosure. The address listed on the paper referred to a house a little way down the street, one much like mine: toys and plastic sleds in the yard, a slightly overgrown garden.

A person in today’s economy doesn’t have to look hard to see that, four years after the 2008 crisis, the American household balance sheet has made a modest recovery at best. After reaching the highest average debt-to-income ratio since 1929, families have been slowly “deleveraging” ever since. Between 2007 and 2009, the typical American household lost a fifth of its wealth. Nearly half of Americans say they would have a hard time coming up with $2,000 in thirty days if a financial emergency arose. And in some states, foreclosures are back on the rise.

Another way in which the crisis lingers is in the deep distrust many Americans still feel toward the finance industry. Last year, around the time a Los Angeles artist was making a killing on eBay selling oil paintings that depicted suburban Chase Bank outlets on fire, an online activist in Southern California was organizing a mass protest called Bank Transfer Day—encouraging people across the country to close their bank accounts en masse and switch over to nonprofit credit unions. (On the appointed date, some 40,000 people reportedly joined credit unions.) According to a recent survey by the Corporate Executive Board, only one in five North Americans has confidence that their financial institution will keep its promises and commitments. Globally, the same report finds, this lack of trust in financial institutions results in some sixty-three million unsold products every year.

The banks, for their part, seem stuck in an embattled and defensive crouch. At an annual meeting of the American Bankers Association in Washington this year, the audience gave a cool if not overtly hostile reception to a representative of the CFPB, offering applause on a five-second delay. The small bankers I spoke to there felt that they were being unfairly blamed for problems that started in unregulated pockets of the financial market; but at the same time, they simply didn’t believe that the consumer bureau would be capable of leveling the regulatory playing field. The mood was one of closed ranks; the bankers repeatedly referred to themselves as “the indispensable industry” and proffered the slogan “To denigrate one is to denigrate all”—which is, bizarrely, only a slight variation on a saying most closely associated with the Wobblies.

All this comes at a time, ironically, when Americans need financial services—the boring, help-you-plan-for-tomorrow kind—more than ever. “People need a place to safely store their money, they need a way to make payments, they need a way to save, and they need access to credit,” said Jennifer Tescher, the president and CEO of the Center for Financial Services Innovation, in a recent speech. “Financial services aren’t going to provide more income, or a job, or health care. But they provide structure and stability, and without that all those other things are hard to achieve.”

Some bankers, at least, are starting to see the upside of the CFPB. Sallie Krawcheck, the former president of Bank of America Wealth Management and the former chief financial officer at Citigroup, wrote an op-ed for Politico in April arguing that the bureau would ultimately expand and strengthen the market for financial services. Most banks, she wrote, owe far too much of their revenue to plain customer inertia. Financial products, with their umpteen-page contracts, are so opaque that consumers don’t really know what they’re getting—or what they would gain from switching to someone else’s product. And so they stick around, confused, frustrated, and dependent. The supposedly hyper-innovative financial industry is actually, when it comes to customer service, a sucking bog.

If the CFPB instituted a world of simple, one- or two-page contracts for all competitors in a market, Krawcheck writes, the immediate result would be a bunch of customer churn. This would “strip banks of the significant earnings they derive from customer inertia—including earnings from deposits on which they pay below-market interest rates,” she writes. But it would also, in the next beat, introduce a jolt of competition and innovation to the market, as providers scrambled to find more clear ways to benefit consumers. And who knows? Perhaps one day banks and thrifts could compete to use the insights of behavioral economics to get people to actually save money.

John Gravois is an editor of the Washington Monthly.


  • paul on July 09, 2012 1:30 PM:

    The other week I was reading some century-old novel from Gutenberg, in which the hero, a munitions manufacturer (!) decides that he's not going to gouge the government for a huge set of emergency war orders. Instead, he's going to take "only a banker's profit."

    That's what commodity businesses where customers know exactly what they're buying ultimately come down to: small, consistent profits. Exactly the opposite of the financial industry today.

  • kay sieverding on July 14, 2012 11:29 AM:

    I don't understand why no one is talking about modifying the 1948 McCarran Ferguson Act. It prohibits federal regulation of insurance.

    Even if the McCarran Ferguson is allowed to stand, the feds should step in when the states fail to regulate insurance.

    Look at this insurance company. It claims to be a Bermuda company and claims to sell insurance across the U.S. It's not listed on the website of the National Association of Insurance Commissioners


    Look at Colorado Intergovernmental Risksharing Agency. Here's a blog I wrote about CIRSA


    Now the State of Colorado links to the NAIC. Previously they listed TIG as active and selling health insurance. The phone number listed was a residential cell phone and the address listed was a private home.

    There are other examples. If you look at state insurance websites you will see that they list out of state insurers. But the states where they are listed as being based in won't have records of them. Often the names are changed slightly too indicating that legally they aren't the same company.

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