An in-depth look: financial reform called for a major overhaul but did not get one

In pondering the Obama administration’s Financial Regulatory Reform: A New Foundation plan announced this week I find myself agreeing with New York Times columnist Joe Nocera, who wrote on June 18:

“… the Obama plan is little more than an attempt to stick some new regulatory fingers into a very leaky financial dam rather than rebuild the dam itself. Without question, the latter would be more difficult, more contentious and probably more expensive. But it would also have more lasting value.”

“If Mr. Obama hopes to create a regulatory environment that stands for another six decades, he is going to have to do what Roosevelt did once upon a time. He is going to have to make some bankers mad.”

So far as consumer protections are concerned I fear they will not be effective. Let’s take a look at some portions of the president’s plan related to consumer mortgage protections that I have excerpted.

I have interspersed my editorial comments below in notes in blue text with my initials as such – JH:

Financial Regulatory Reform: A New Foundation

Banking regulators at the state and federal level had a potentially conflicting mission to promote safe and sound banking practices, while other agencies had a clear mission but limited tools and jurisdiction. Most critically in the run-up to the financial crisis, mortgage companies and other firms outside of the purview of bank regulation exploited that lack of clear accountability by selling mortgages and other products that were overly complicated and unsuited to borrowers’ financial situation. – page 56

JH: This is hardly an accurate overview of what went wrong. First of all, it wasn’t just mortgage companies that were engaged in subprime lending. They were some of the biggest offenders but the banks were in there along with them pushing bad loan products on consumers. Implicit in this statement is the idea that the loan products they were being marketed had some worth, when in reality many of them never should have been allowed to be marketed in the first place.

A. Create a New Consumer Financial Protection Agency

We propose the creation of a single regulatory agency, a Consumer Financial Protection Agency (CFPA), with the authority and accountability to make sure that consumer protection regulations are written fairly and enforced vigorously. – page 56

The CFPA should give consumer protection an independent seat at the table in our financial regulatory system. – page 57

Oversight of federally supervised institutions for compliance with consumer protection, fair lending, and community reinvestment laws is fragmented among four agencies. – page 57

JH: Having apparently concluded that the Federal Reserve and the banking regulatory agencies are never going to control the egregious practices of the financial service industry in the exploitation of consumers the administration proposes to create a new agency.

I fear that this agency will prove too weak to exercise effective control over the industry however. It’s true that the existing regulators had the opportunity and arguably the authority under existing law to exercise better control over regulated financial institutions but they never effectively exercised

that authority. But these regulatory agencies have far more authority and pose far more of a threat to the industry then does some new independent consumer protection entity. It would have been better to figure out a way to get the Federal Reserve and others to adopt the culture and the mission that emphasize consumer protection as being equally important as ensuring the smooth operation of the financial services industry.

Mortgage companies not owned by banks fall into a regulatory “no man’s land” where no regulator exercises leadership and state attorneys general are left to try to fill the gap. State and federal bank supervisory agencies’ primary mission is to ensure that financial institutions act prudently, a mission that, in appearance if not always in practice, often conflicts with their consumer protection responsibilities. – page 57

JH:  There’s no arguing with the observation that mortgage companies were virtually unregulated so far as their exploitation of consumers goes. Here the administration has identified a major problem that needs to be fixed.

I don’t really get the recurrent theme in the administration’s plan that there is some inherent conflict between prudent operations of the financial services industry and consumer protection responsibilities. I also don’t agree with the implication that state bank supervisory agencies in most states are effectively engaged inappropriate regulation of the industry. Their ability to control industry excesses is certainly weak in many states including Texas.

1. We propose to create a single primary federal consumer protection supervisor to protect consumers of credit, savings, payment, and other consumer financial products and services, and to regulate providers of such products and services.

2. The CFPA should have broad jurisdiction to protect consumers in consumer financial products and services such as credit, savings, and payment products.

3. The CFPA should be an independent agency with stable and robust funding.

JH:  As I observed earlier, separating consumer protection responsibilities from banking regulation is a perilous proposition. There are also built-in conflicts of interest between the consumer protection functions of this new agency and the regulatory functions of existing agencies that the plan noted earlier. What happens when these conflicts emerge? What happens when an institution depends upon continuing to engage in activities of offering loan products that the CFPA deems are undesirable but the regulators see as essential to maintaining the safety and soundness of the institution? The conflict the administration has identified between a financial institution’s ability to make money (safety and soundness) and the institution’s responsibility not to offer products which harm the public are not solved simply by creating a separate consumer protection entity.

If the financial services industry decides the consumer protection entity is compelling the industry to do things that the industry doesn’t want to do then the financial services lobbyists will have an easy target in the consumer protection entity whereas they would be more hesitant to directly confront their regulator.

In short, the  CFPA is inherently a weak entity and easy target.

4. The CFPA should have sole rule-making authority for consumer financial protection statutes, as well as the ability to fill gaps through rule-making.

The CFPA should have sole authority to promulgate and interpret regulations under existing consumer financial services and fair lending statutes, such as the Truth in Lending Act (TILA), Home Ownership and Equity Protection Act (HOEPA), Real Estate Settlement and Procedures Act (RESPA), Community Reinvestment Act (CRA), Equal Credit Opportunity Act (ECOA), and Home Mortgage Disclosure Act (HMDA), and the Fair Debt Collection Practices Act (FDCPA).

5. The CFPA should have supervisory and enforcement authority and jurisdiction over all persons covered by the statutes that it implements, including both insured depositories and the range of other firms not previously subject to comprehensive federal supervision, and it should work with the Department of Justice to enforce the statutes under its jurisdiction in federal court.

JH:  So the CFPA is granted enforcement authority over banking institutions as well as mortgage companies.

The regulation of mortgage companies and their practices is essential so it’s a good thing that somebody is going to be regulating them and stopping them from engaging in selling really bad loans to consumers. But relying on the Department of Justice for enforcement is not going to work. One need look no further than the pitifully inadequate enforcement of federal fair housing laws by HUD to see the disastrous consequences of a bifurcation of regulation and enforcement between an executive agency and the Department of Justice.

For a regulatory agency to be effective it has to be able to make an irrevocable decision to enforce its regulations. Under this scenario the CFPA must first discover a violation, then make a decision that enforcement action is warranted, then refer the enforcement request to the Department of Justice, then convince the Department of Justice that the enforcement action is merited and finally hope that the enforcement action is of sufficient priority within the Department of Justice to be acted upon in a reasonable amount of time.

As I said, this doesn’t work based on the track record of fair housing enforcement.

6. The CFPA should pursue measures to promote effective regulation, including conducting periodic reviews of regulations, an outside advisory council, and coordination with the Council.

JH:  In other words, an advisory council containing members of the regulated institutions will be given an ability to lobby internally with the new agency to weaken consumer protection regulations.

7. The CFPA’s strong rules would serve as a floor, not a ceiling. The states should have the ability to adopt and enforce stricter laws

We propose that federally chartered institutions be subject to nondiscriminatory state consumer protection and civil rights laws to the same extent as other financial institutions.

JH:  Pardon me while I get up off the floor from my hysterical fit of laughter.

A whole lot of us in states like Texas will never see any more strict regulations than those imposed by the federal government. Implying that many states will do so is naïve.

8. The CFPA should coordinate enforcement efforts with the states.

JH:  Excuse me while I get back up off the floor a second time.

9. The CFPA should have a wide variety of tools to enable it to perform its functions effectively.

Research and Data. Empirical evidence is critical to a well designed regulatory structure. The CFPA should have authority to collect information through the supervisory process as well as through specific data collection statutes, such as the Home Mortgage Disclosure Act.

Complaints.

Financial education.

Community Affairs. The CFPA’s community affairs function should promote community development investment and fair and impartial access to credit. It should engage in a wide variety of activities to help financial institutions, community-based organizations, government entities, and the public understand and address financial services issues that affect low and middle-income people across various geographic regions.

JH:  Expansion of the data collected under the Home Mortgage Disclosure Act would be most helpful in assessing the performance of financial institutions in serving community credit needs. The administration better plan to spell out exactly what regulated institutions are going to provide in the way of additional reporting at the time this bill is passed. That may be the one opportunity we have two expand reporting requirements because the industry will ferociously resist additional reporting. Once this weak CFPA is established there is no way it will have the political power to compel additional disclosure.

As for the financial education and consumer affairs functions they could prove useful. But they will require funding.

10. To improve incentives for compliance, the CFPA should have authority to restrict or ban mandatory arbitration clauses.

JH:  Finally we arrive at a specific recommendation that will do some good for consumers. Hooray!

11. The Federal Trade Commission should be given better tools to protect consumers.

JH:  This sounds like an honest acknowledgment that the CFPA is not going to be able to do the job protecting consumers on its own.

B. Reform Consumer Protection

1. Transparency. We propose a new proactive approach to disclosure. The CFPA will be authorized to require that all disclosures and other communications with consumers be reasonable: balanced in their presentation of benefits, and clear and conspicuous in their identification of costs, penalties, and risks.

Make all mandatory disclosure forms clear, simple, and concise, and test them regularly.

Require that disclosures and other communications with consumers be reasonable.

Harness technology to make disclosures more dynamic and relevant to the individual consumer.

JH: No quarrel with this.

2. Simplicity. We propose that the regulator be authorized to define standards for “plain vanilla” products that are simpler and have straightforward pricing. The CFPA should be authorized to require all providers and intermediaries to offer these products prominently, alongside whatever other lawful products they choose to offer.

“Plain vanilla” mortgages, whether they have fixed or adjustable interest rates, should be easy for consumers to understand. They should not include prepayment penalties and should be underwritten to fully document income, collect escrow for taxes and insurance, and have predictable payments. These products are also easy to compare because they can be differentiated by a single, simple characteristic, the interest rate. We propose that the government do more to promote “plain vanilla” products. The CFPA should be authorized to define standards for such products and require firms to offer them alongside whatever other lawful products a firm chooses to offer.

JH:  Of course consumers should be offered the chance to take out a conventional loan instead of some highly exploitive, subprime product. But giving consumers options doesn’t necessarily ensure that they will make the appropriate decisions. I blogged at length yesterday about my concerns that this provision, which seems to be a centerpiece of the administration’s reform plan, will do little to dissuade credit challenged and low income borrowers from diving into a really bad subprime loan.

The financial services industry has proven to be very aggressive in creating new types of risky credit for which it can charge high fees and high interest. The premise behind the Obama plan seems to be that the financial services industry should be able to offer risky types of credit to borrowers so long as the borrowers understand the risks involved and a prime loan is also included on the list of available products. Implicit in this is a belief that all consumers will act in an informed and rational manner if they are presented with the facts. Self-restraint on the part of consumers, the plan implies, will limit the exposure of our financial system to risky lending

That’s not a safe assumption about many low income borrowers.

We have so overhyped homeownership in this country that most people believe homeownership is an indication of their worth as an individual. They will risk anything to achieve it. They are told by the real estate And financial services industries that homeownership is the “American Dream.” For a significant number of lower income borrowers, and for borrowers as a whole for that matter, who are not able to qualify for a “plain vanilla loan,” no amount of government warnings or loan disclosure documents will dissuade them from taking out any loan, no matter how onerous the terms, to fulfill that dream.

3. Fairness. Where efforts to improve transparency and simplicity prove inadequate to prevent unfair treatment and abuse, we propose that the CFPA be authorized to place tailored restrictions on product terms and provider practices, if the benefits outweigh the costs. Moreover, we propose to authorize the CFPA to impose appropriate duties of care on financial intermediaries.

Give the CFPA authority to regulate unfair, deceptive, or abusive acts or practices.

Give the CFPA authority to impose empirically justified and appropriately tailored duties of care on financial intermediaries.

The CFPA should apply consistent regulation to similar products.

JH: This is definitely what is needed. But, once again, can a weak agency like CFPA effectively exercise this authority? How will it deal with conflicts with safety and soundness regulators when the CFPA proposes to outlaw a financial product other regulators and the industry itself deem important to the safety and soundness of the institution?

4. Access. The Agency should enforce fair lending laws and the Community Reinvestment Act and otherwise seek to ensure that underserved consumers and communities have access to prudent financial services, lending, and investment.

Some have attempted to blame the subprime meltdown and financial crisis on the CRA and have argued that the CRA must be weakened in order to restore financial stability. These claims and arguments are without any logical or evidentiary basis. It is not tenable that the CRA could suddenly have caused an explosion in bad subprime loans more than 25 years after its enactment. In fact, enforcement of CRA was weakened during the boom and the worst abuses were made by firms not covered by CRA. Moreover, the Federal Reserve has reported that only six percent of all the higher-priced loans were extended by the CRA-covered lenders to lower income borrowers or neighborhoods in the local areas that are the focus of CRA evaluations.

JH:  First, let me say that I agree wholeheartedly with the aside regarding the fact that the Community Reinvestment Act (CRA) had virtually nothing to do with the subprime meltdown in financial crisis.

I doubt that the CFPA will be an effective administrator of the Community Reinvestment Act however. The hammer, or enforcement authority of the CRA is the ability to block regulated financial institutions from taking actions like opening new branches, etc. These are actions that are so closely tied to the functions of the traditional regulatory agencies that it’s hard to see how the CFPA is going to be able to use them as an enforcement tool.