AEI And Consumer Financial Protection

So Peter Wallison of the AEI has an opinion piece, Elitist Protection Consumers Don’t Need, in the Washington Post, arguing against the Consumer Financial Protection Agency (h/t Nick Schulz). Mark Thoma and Richard Green give it a critical look; I’ll add my thoughts here.

I want to take Wallison’s argument apart piece by piece.

A Strong Tradition

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.

Traditionally how? Since 1983? All the stuff we associate with subprime loans and irresponsibly risky loans – prepayment penalties, interest-only loans, option-ARMs, adjustable rates – were illegal until Congress passed the “Alternative Mortgage Transaction Parity Act of 1982″ (AMTPA). You also had an interest rate ceiling on mortgages until the “Depository Institutions Deregulation and Monetary Control Act of 1980″ (DIDMCA).

This wave of deregulation was a series of experiments, and it in is the nature of experiments to sometimes fail. This one has failed. Note that the Consumer Financial Protection Agency won’t take us back to 1981; it will just set our default option to the choices in that year. If you asked me if we should revoke AMTPA, I’d say it’s not a terrible idea. However I see where the Obama administration wants to go with this, trying to save the baby in the bathwater. There are some very smart people, like Richard Serlin, who thinks we should set the clock to 1979 and cut DIDMCA – that bill just allows us to have a pointless bidding war for access to good school districts. I am not sure how I feel about that bill in terms of a tradeoff; it is important to acknowledge that Obama is trying to find a middle ground to preserve the so-called “innovations” of subprime loans, and groups like AEI should be applauding that, no?

Elites

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….

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.

Wallison seems fixated on this issue of elites versus regular Americans. In his telling of this story, he fears an America where average people get vanilla prime loans, while transnational elites get to take out subprime loans featuring option-arms, balloon payments, prepayment penalties, interest rate spikes, etc. Is this how he has read the past decade of housing – that the poor and uninformed really wanted in on the subprime bandwagon, but petty elites didn’t want them to join their exclusive party?

Do you need me to gather data on this? Fine, just a bit. Here’s your national elite, hoarding the subprime bonaza for themselves and not sharing it with regular Americans:

Feeling Humiliated; Externalities

How would a provider be expected to determine whether a product that involves more risk or complexity than the plain-vanilla version is suitable for a consumer? The white paper offers this: “The CFPA…require providers to have applicants fill out financial experience questionnaires.”…

one can only imagine the humiliation of the consumer who must fill out a questionnaire to establish his capacity to purchase anything more than the plain-vanilla product….

In this way, and for the first time in our history, the government will force a major sector of the U.S. economy to deny products and services to a large proportion of the population — not because the products or services are inherently dangerous, like drugs or explosives…

I’m kind of new to the policy thing, being from finance, but is AEI the type of organization that emphasizes feelings over responsibility? (Do they also argue that difficult tests in schools should be thrown out because they humiliate some kids?) He’s completely wrong on that not dangerous part. A ballpark estimate of the losses to neighbors from the ongoing foreclosures is $200 billion dollars. Another AIG! Spread out among people who could afford their mortgages! Mortgages have externalities with them if they go bad; real value is lost in bankruptcy, and foreclosures directly effects the options that can be exercised by their neighbors over their lives and their property. Can they follow a job to a new city? Upgrade to a new home? They can do that a little bit less if there is a foreclosure sign down the block, and not at all if their neighborhood is littered with them. Options have value, and hurting options harms people’s lives. Homeownership is a responsibility.

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16 Responses to AEI And Consumer Financial Protection

  1. pebird says:

    First of all, what if I am a sophisticated, “elite” consumer and I decide I want the plain vanilla product? Maybe I want to teach my children how to understand debt before I get them diving into the family hedge fund.

    The elitism drips from the Wallison himself – HE makes the assumption that only the “less sophisticated” will want plain vanilla. HE makes the assumption that the “less sophisticated” still won’t purchase high risk. Why wouldn’t they? Because the financial institutions can’t explain their products sufficient to close the sale when there is a plain vanilla alternative – albeit with lower return/risk.

    He implies that somehow the government is going to require some kind of financial sophistication “test” before a financial institution can sell a non-vanilla product to a consumer: “who will be able to buy the more complex products that are tailored to a consumer’s specific needs?”. How about … anyone? Since these complex products will offer so much more obvious value to consumers, who would want the plain vanilla anyway?

    I guess the only way they would not be purchased would be if the consumer didn’t understand the obvious higher value of these sophisticated instruments. So, what we have is a market-driven mechanism – consumers who understand (based on their own internal definitions, not the government’s) the sophisticated vehicles will of course buy them, because they understand the superior value. Those that do not, will purchase the “plain vanilla”.

    Shorter Wallison: “we can’t convince unsophisticated investors that our product is superior to a plain vanilla product – so lets blame the government for our inability to compete”.

  2. pebird says:

    With regard to a questionnaire to be filled out – I’ve filled out many financial questionnaires for brokerage account so they could determine my “risk profile” and recommend the “most appropriate investment vehicles”. It was SOOOO humiliating.

  3. racerx says:

    Has this guy ever completed a mortage application? Can this questionnaire really be more intrusive than a standard 1003?

    https://www.efanniemae.com/sf/formsdocs/forms/pdf/sellingtrans/1003.pdf

    Would anyone really care what type of loan they got as long as they were approved?

  4. Chris says:

    If bad mortgages have externalities, should we impose a Pigouvian tax on them? Any mortgage can go bad, but some are more likely to than others, so the higher the risk, the higher the tax? If the mortgage originator has to pay the tax up front (i.e. before he unloads the mortgage on the secondary market), could this actually make a difference in mortgage practices? (It seemed like a joke when the idea first occurred to me, but the more I think about it, the more I think it might deserve to be taken seriously. Are there even broader ways of defining externalizable risks and imposing Pigouvian taxes on them?)

    Also, IANAL, but those maps have disparate impact written all over them. I wonder if there is anything actionable there. (And who’s in that cluster of nonblack subprime borrowers?)

  5. Mike says:

    Chris – cars have externalities in this sense. That’s why we require driver’s licenses. There’s no need for taxes. Do we have a better word for this? Something from the legal dictionary?

    racerx – I started to read that but felt humiliated.

    pebird – The argument isn’t that strong; particularly if you believe in efficient markets (which wipe value out of these extra options) or rational agents (at which point they’ll ignore the vanilla and pay the minor transaction costs). I assume they had to take the opposite stance.

  6. racerx says:

    …one can only imagine the humiliation of the consumer who must fill out a questionnaire to establish his capacity to purchase anything more than the plain-vanilla product….

    It’s almost as bad as the humiliation of the consumer who must fill out an application to establish his capacity to purchase a home. Oh wait, we need to get rid of the mortgage application with it’s elitist asset and income requirements.

  7. financeguy says:

    Wallison’s just reading off the conservative cue cards. “Elitist” has become the new pejorative for anything Democratic that restricts unfettered choice, even if that choice involves embracing a hand grenade disguised as a baby (“You want to stop poor people from investing in Ponzi schemes? Then only the rich people will get to invest in Ponzi schemes! Why that’s elitist!”) The thing is, we restrict choice all the time, for everything from buying firearms to morphine to investing in hedge funds. Also you’re right about the externalities but you didn’t go far enough: you’re looking at neighborhoods; the cumulative effect of enough neighborhoods collapsing, simultaneously, can be really nasty. Like a subprime housing crisis.

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  9. Chris says:

    Cars are an interesting analogy – was there an elitism argument against seatbelts? If people want to buy a car without seatbelts, does government have any business telling them they can’t?

    But having no seatbelts mainly injures the driver and passengers. In light of the neighborhood foreclosure blight effect, maybe some of these products are more analogous to a car without headlights, or even brakes. Again, who is government to tell me I can’t buy one? Isn’t it humiliating to be told what kind of car is safe for me, as if I couldn’t make that decision myself?

    I think these arguments prove too much, and in so doing, reduce themselves to absurdity. Some people no doubt feel humiliated by the suggestion that they can’t drive competently when drunk, too.

    Licensing and safety standards notwithstanding, some localities also dol have car taxes – they pay a small fraction of the costs of publicly-maintained infrastructure that benefits car users. What public infrastructure benefits loan users, and should they be expected to pay for it? (IIRC, while real estate itself is taxed, home *loans* are actually tax-break subsidized to a substantial degree.)

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  11. q says:

    are there details yet about what a financial consumer protection agency would be charged with doing and what its authority would be? it’s fine to go kick some conservative AEI strawman’s tuchus (he totally deserves it by the way) but, and i ask this to preserve your effort for when it is needed, is there an actual proposal or substantial leak under debate now?

  12. John McGowan says:

    There is a large and rapidly growing literature from conservative, libertarian, and business sources blaming the financial crisis on … you guessed it… the government. Peter Wallison has been a major promoter of this view:

    Peter J. Wallison , “Cause and Effect :Government Policies and the
    Financial Crisis”, Posted: Wednesday, December 3, 2008, FINANCIAL
    SERVICES OUTLOOK, (American Enterprise Institute) AEI Online,,
    Publication Date: November 25, 2008

    Peter J. Wallison, “The True Origins of This Financial Crisis”, The
    American Spectator, February 2009

    In almost every financial crisis following putative deregulation conservative, libertarian, and business sources have aggressively blamed the government. It seems essential to comprehensively challenge and rebut these claims in the current financial crisis for there to be any hope of real progress.

    Sincerely,

    John

  13. q says:

    @JMG — you can find an argument that government is at least partially at fault for pretty much everything, because government is pretty much everywhere.

  14. Chris says:

    And even if the government didn’t do anything, you can usually argue that it should have done something, and is responsible by inaction.

    If someone sets a building on fire, and the fire department doesn’t put it out before it spreads to several other buildings, is the fire department to blame for the fire? Or is it the arsonist? Or both?

    In this case, the private sector started the fire, but it’s also true that more governmental action sooner might have put it out when it was smaller. And ironic that the same sources blaming the government now were hindering it then.

  15. NB says:

    Here in the Netherlands (and I expect in the rest of the EU too), investment banking customers have for years been required by law to fill out all sorts of questionnaires so their banks can determine their risk profiles.

    It’s mostly embarrassing for the banker, who (extrapolating from my case) has to make a lot of personal phone calls to nudge the customer into sitting down and filling out all those damn forms.

    For the US situation it sounds like a good idea in retrospect, though. “You lent this person with this clear risk profile how much money?!” – the amount of CYA needed would have been a lot higher and it may have stopped a lot of people from stepping into the housing bubble carousel. Then again, I’m sure US banks would have managed to make the paperwork so convoluted that in the end it would have been a “Sign this, sign this, oh and sign here too” exercise with nobody reading what they signed up for as usual…

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