An FDA for financial products

Proposed agency should be a lasting benefit of the Great Recession.

Mark Zandi

is chief economist at Moody's Economy.com

One of the more contentious debates in Washington today concerns a plan to regulate consumer financial services.

The proposed Consumer Financial Protection Agency would be the most important effort to protect consumers since the formation of the Food and Drug Administration more than a century ago. As the FDA has ensured the safety of our food supply, the proposed agency would ensure the safety of financial products. If anything rises from the ashes of the recent financial crisis and Great Recession, such an agency should be it.

The need for the agency was made clear when the existing financial-regulatory structure failed to prevent millions of consumers from signing up for loans they would almost certainly not be able to afford. The only basis for making these loans was a clearly unreasonable belief that unemployment would stay low and housing prices would keep rising, nirvanalike, almost forever. Now reality has bitten: Unemployment is above 10 percent and home prices have fallen more than 30 percent in just under four years.

Not all the blame falls on regulators for the bad loans and resulting financial mess, but a good portion does, because our alphabet soup of boards and agencies failed to stop the egregious lending that inflated the housing bubble.

The OCC, OTS, FDIC, CUNA, Federal Reserve Board, and 50 state regulators each have some authority over lenders, and thus some responsibility for seeing they do right by consumers. Yet with so many agencies, each protecting its own turf, lenders are able to shop for the most lenient regulator or even find ways to avoid regulation.

Under the current system, moreover, no regulator's mission statement puts consumer protection at the top of the list.

The current agencies' first priority is typically to make sure lenders are financially sound, with sufficient capital cushions to survive if loans go bad. There is no inherent conflict between this task and watching out for consumers, but with safety and soundness their first priority, regulators do not typically think much about the consumer's perspective. Indeed, the financial crisis showed a tendency among regulators to forget consumers' needs entirely.

Some would argue that consumers don't need protection. I disagree. We Americans aren't nearly as smart about money as we should be. Yes, many people knowingly stretched to buy an expensive house with a risky subprime loan, figuring they could either sell quickly at a profit or refinance before the mortgage payment ballooned. But many more barely understood what they were getting into.

According to Federal Reserve surveys done before the financial panic, almost half of all lower-income buyers (most of them subprime borrowers) couldn't describe basic features of their mortgages, such as how their interest rates were determined or whether they were capped. Many trusted mortgage brokers to arrange an affordable loan, believing it was the broker's responsibility to look after their financial interests.

The nation's general financial illiteracy contributes to a wide range of poor decisions on borrowing, saving, and investment. This may have been less dangerous 10 or 25 years ago when there were fewer financial products to choose from and thus fewer opportunities to make a financially catastrophic mistake. But ignorance of the basics is certainly perilous today. Some mortgage options presented to buyers during the housing boom were mind-numbingly complex; even an economist adept at manipulating spreadsheets would have trouble calculating future payments on an interest-only or "option" ARM loan.

It is bizarre and tragic that American high schools today are more likely to offer classes in cooking than in personal finance. When I graduated from Upper Merion High School about 30 years ago, my home economics course taught me how to make a pretty good omelet. It did not prepare me to understand a mortgage loan or invest for retirement.

But even if such subjects were required in high schools, they wouldn't be enough. Borrowing and investing today are extraordinarily complex, so consumers need a regulator looking out for their interests.

The financial-services industry is largely opposed to the proposed agency. Lenders and brokers are skeptical that another regulator looking over their shoulder will benefit them or consumers. Lenders also worry that after any change, states will impose inconsistent rules to outdo federal regulators.

These worries are legitimate, but they are trumped by the benefits that would flow from a new regulatory agency making sure that financial products are safe and that consumers get all the information they need to make good financial decisions.

E-mail Mark Zandi at help@economy.com.