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Can We Make Financial Products as Safe as Toasters?

My colleagues Zachary Goldfarb, Binyamin Appelbaum and David Cho had a nice scoop last night. Apparently, Larry Summers, Tim Geithner, Barack Obama, and a variety of other "senior policymakers" met last night to discuss the creation of a new regulator who would have broad authority over consumer financial products.

This idea, put simply, is Elizabeth Warren's. The key document to understand the proposal is her article in Democracy calling for just such a commission. An excerpt:

It is impossible to buy a toaster that has a one-in-five chance of bursting into flames and burning down your house. But it is possible to refinance an existing home with a mortgage that has the same one-in-five chance of putting the family out on the street–and the mortgage won’t even carry a disclosure of that fact to the homeowner. Similarly, it’s impossible to change the price on a toaster once it has been purchased. But long after the papers have been signed, it is possible to triple the price of the credit used to finance the purchase of that appliance, even if the customer meets all the credit terms, in full and on time. Why are consumers safe when they purchase tangible consumer products with cash, but when they sign up for routine financial products like mortgages and credit cards they are left at the mercy of their creditors?

The difference between the two markets is regulation. Although considered an epithet in Washington since Ronald Reagan swept into the White House, the "R-word" supports a booming market in tangible consumer goods. Nearly every product sold in America has passed basic safety regulations well in advance of reaching store shelves. Credit products, by comparison, are regulated by a tattered patchwork of federal and state laws that have failed to adapt to changing markets. Moreover, thanks to effective regulation, innovation in the market for physical products has led to more safety and cutting-edge features. By comparison, innovation in financial products has produced incomprehensible terms and sharp practices that have left families at the mercy of those who write the contracts.[...]

this agency would be charged with responsibility to establish guidelines for consumer disclosure, collect and report data about the uses of different financial products, review new financial products for safety, and require modification of dangerous products before they can be marketed to the public. The agency could review mortgages, credit cards, car loans, and a number of other financial products, such as life insurance and annuity contracts. In effect, the FPSC would evaluate these products to eliminate the hidden tricks and traps that make some of them far more dangerous than others.

An FPSC would promote the benefits of free markets by assuring that consumers can enter credit markets with confidence that the products they purchase meet minimum safety standards. No one expects every customer to become an engineer to buy a toaster that doesn’t burst into flames, or analyze complex diagrams to buy an infant car seat that doesn’t collapse on impact. By the same reasoning, no customer should be forced to read the fine print in 30-plus-page credit card contracts to determine whether the company claims it can seize property paid for with the credit card or raise the interest rate by more than 20 points if the customer gets into a dispute with the water company.

Instead, an FPSC would develop precisely such expertise in consumer financial products. A commission would be able to collect data about which financial products are least understood, what kinds of disclosures are most effective, and which products are most likely to result in consumer default. Free of legislative micromanaging, it could develop nuanced regulatory responses; some terms might be banned altogether, while others might be permitted only with clearer disclosure. A Commission might promote uniform disclosures that make it easier to compare products from one issuer to another, and to discern conflicts of interest on the part of a mortgage broker or seller of a currently loosely regulated financial product. In the area of credit card regulation, for example, an FPSC might want to review the following terms that appear in some–but not all–credit card agreements: universal clauses; unlimited and unexplained fees; interest rate increases that exceed 10 percentage points; and an issuer’s claim that it can change the terms of cards after money has been borrowed. It would also promote such market-enhancing practices as a simple, easy-to-read paragraph that explains all interest charges; clear explanations of when fees will be imposed; a requirement that the terms of a credit card remain the same until the card expires; no marketing targeted at college students or people under age 21; and a statement showing how long it will take to pay off the balance, as well as how much interest will be paid if the customer makes the minimum monthly payments on the outstanding balance on a credit card.

The problem, in part, is that there are lot of regulators charged with protecting the overall health of the financial markets. There are very few charged with protecting the consumers of financial products. This would begin to redress that imbalance.

By Ezra Klein  |  May 20, 2009; 1:48 PM ET
Categories:  Financial Crisis , Solutions  
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This part I don't understand:

"Similarly, it’s impossible to change the price on a toaster once it has been purchased. But long after the papers have been signed, it is possible to triple the price of the credit used to finance the purchase of that appliance, even if the customer meets all the credit terms, in full and on time."

Is she referring to loan agreements whereby the borrower agrees to go, for example, from an interest-only loan in the first 5 or 10 years, to a principal-and-interest loan thereafter? I'm all for the reform, but I don't think the term modifications set forth in loan agreements are the problem. Credit worthiness and full disclosure, maybe. But contracts are contracts.

Posted by: jogoldbe | May 20, 2009 2:25 PM | Report abuse

I've said this before when commenting in other blogs, but it fits well here: Think "Underwriters Laboratories." In particular, consider their use of standards, their certification process, and their funding model.

Also note that the ratings agencies were supposedly providing the equivalent of the UL seal for financial products, but that turned out not to be the case. I see that as a breakdown of all three of the above, and especially of the funding model.

Posted by: kcc3 | May 20, 2009 2:33 PM | Report abuse

A couple of points.

First, credit card companies cannot actually force you to change the terms of their lending long after you've made the purchase you're still paying off. Every time the terms of your contract change, you have the option of terminating the contract. If you do, under the law (and the policies of every credit card I've ever had), you can't charge any more on that card, but you continue to pay off your old debt at the previously agreed rate. So the company is not unilaterally changing the terms. You are agreeing to the change of terms in return for the company continuing to allow you credit for future purchases.

If consumers don't like that, they can take out individual consumer loans from their bank or credit union for particular purchases, or finance them through the vendor.

This is just another "we must protect the people from their own stupidity" legislation. It's amazing the contempt some folks have for the people they claim to be trying to help.

There is more information available to the consumer about credit cards than just about any other product on the market. Many websites exist to help the consumer identify their needs and find the card that's right for them, providing every piece of data about the contract terms that one could possibly need. This bill is about limiting the choice of consumers, not "protecting" them.

Posted by: StubbornFacts | May 20, 2009 3:10 PM | Report abuse

As Gov.Spitzer has pointed out,it all comes down to who the regulator is and how much power he/she wields.

Posted by: par4 | May 20, 2009 3:31 PM | Report abuse

@ StubbornFacts

There's lots of information on the internet about how to wire my house, do my own plumbing, and change my head gasket. But still, I pay professionals to wire my house, fix my plumbing, and change my head gasket. Just because information is out there-- and yo, have you considered the factors that make information more available and useful to some than others, say education level, time to access it, internet access availability-- doesn't mean we can reasonably expect people to make good use of it. I only use licensed plumbers, and I don't see why we shouldn't have the chance to have licensure mean something when considering a choice with even more expensive potential ramifications than hiring a lousy plumber.

Posted by: Hana1 | May 20, 2009 7:55 PM | Report abuse

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