July 17, 2007

Professor
Elizabeth Warren

The following op-ed, You're getting burned, written by Harvard Law School Professor Elizabeth Warren, was published in the Dallas Morning News on July 16, 2007.

It is difficult 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.

Consumers can enter the market to buy physical products confident that they won't be tricked into buying exploding toasters and other unreasonably dangerous products. Consumers entering the market to buy financial products should enjoy the same protection.

Just as the Consumer Product Safety Commission protects buyers of goods and supports a competitive market, we need the same for consumers of financial products – a new regulatory body to protect consumers. The time has come to put scare-mongering to rest and to recognize that regulation can often support and advance efficient and more dynamic markets.

Do you have credit problems?

Americans are drowning in debt. One in four families say they are worried about how they will pay their credit card bills this month. Last year, 1.2 million families lost their homes in foreclosure.

Families' troubles are compounded by substantial changes in the credit market that have made debt instruments far riskier than they were a generation ago. The effective deregulation of interest rates, coupled with innovations in credit charges (e.g., teaser rates, increased use of fees, cross-default clauses and penalty interest rates), have turned ordinary credit transactions into devilishly complex financial undertakings. And consumers sign on with only a vague understanding of the terms.

Credit cards offer a glimpse at the costs imposed by a rapidly growing credit industry. In 2006, for example, Americans turned over $89 billion in fees, interest payments and other charges associated with their credit cards. Debt repayment has become a growing part of the American family budget, so much so that the typical family with credit card debt now spends only slightly less on fees and interest each year than it does on clothing, shoes, laundry and dry cleaning.

Why do people get into debt trouble in the first place? People know that credit cards are dangerous. And there can be no doubt that some portion of the credit crisis in America is the result of foolishness and profligacy. But that is not the whole story. Lenders have deliberately built tricks and traps into some credit products so they can ensnare families in a cycle of high-cost debt.

Creating safer marketplaces is not about protecting consumers from all possible bad decisions. It is about making certain the products themselves don't become the source of the trouble. This means that terms hidden in the fine print or obscured with incomprehensible language have no place in a well-functioning market.

How did financial products get so dangerous? Part of the problem is that disclosure has become a way to obfuscate rather than to inform. According to The Wall Street Journal, in the early 1980s, the typical credit card contract was a page long; by the early 2000s, that contract had grown to more than 30 pages of incomprehensible text.

For some, Shakespeare's injunction that "neither a borrower nor a lender be" seems a good policy. Just stay away from all debt and avoid the trouble. But no one takes that position with tangible goods. No one advocates that people who don't want their homes burned down should stay away from toasters.

Instead, product safety standards set the floor for all consumer products, and a competitive market revolves around the features consumers can see, such as price or convenience or, in some cases, even safety. To say that credit markets should follow a caveat emptor model is to ignore the success of the consumer goods market – and the pain inflicted by dangerous credit products.

Limits of traditional solutions

The credit industry is not without regulation; credit transactions have been regulated by statute or common law since the founding of the republic. Traditionally, states bore the primary responsibility for protecting residents against unscrupulous lenders.

While states still play some role, their primary tool – interest rate regulation – has been effectively destroyed by federal legislation. Today, any lender that gets a federal bank charter can locate its operations in a state with high usury rates (e.g., South Dakota or Delaware), then export that state's rate caps to customers all over the country.

As a result, and with no public debate, interest rates have been effectively deregulated, leaving states powerless to act.

Local laws suffer from another problem. As lenders have consolidated and credit markets have gone national, a plethora of state regulations drives up costs for lenders, forcing them to include repetitive disclosures and meaningless exceptions in order to comply with differing local laws. The resulting patchwork of regulation is neither effective nor cost-effective.

Any effort to increase or reform statutory regulation of financial products is met by a powerful industry lobby on one side that is not balanced by an equally effective consumer lobby on the other. As a result, even the most basic efforts are blocked from becoming law.

Beyond Congress, some regulation of financial products occurs through the Federal Reserve, the Office of the Comptroller of the Currency and the Office of Thrift Supervision. Each agency, for example, has some power to control certain forms of predatory lending. But their main mission is to protect the financial stability of banks and other financial institutions, not to protect consumers. As a result, they focus intently on bank profitability and far less on the financial impact on customers of many of the products the banks sell.

Time for a commission

Clearly, it is time for a new model of financial regulation, one focused primarily on consumer safety rather than corporate profitability. Financial products should be subject to the same routine safety screening that now governs the sale of every toaster, washing machine and child's car seat sold on the American market.

The model for such safety regulation is the U.S. Consumer Product Safety Commission, an independent regulatory agency founded in 1972 by the Nixon administration. The CPSC's mission is to protect the public from risks of injury and death from products used in the home, the school and recreation. The agency has the authority to develop uniform safety standards, order the recall of unsafe products and ban products that pose unreasonable risks.

In establishing the commission, Congress recognized that "the complexities of consumer products and the diverse nature and abilities of consumers using them frequently result in an inability of users to anticipate risks and to safeguard themselves adequately."

So why not create a Financial Product Safety Commission? It would be charged with responsibility to establish guidelines for consumer disclosure, collect and report data about the uses of financial products, review new products for safety and require modification of dangerous products before they can be marketed. The agency could review mortgages, credit cards and car loans.

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.

And 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. By the same reasoning, no customer should be forced to read the fine print in 30-page contracts to determine whether a credit card company can raise the interest rate by 20 points if the customer gets into a dispute with the water company.

Product safety standards will not fix every problem associated with consumer credit. It is possible to stuff a toaster with dirty socks and start a fire, and, even with safety standards, it will remain possible to get burned by credit products. Some people won't even have to try very hard.

But safety standards can make a critical difference for millions of families – and help change the industry.

Personal responsibility will always play a critical role in dealing with credit cards, just as personal responsibility remains a central feature in the safe use of any other product. But a Financial Product Safety Commission could eliminate some of the most egregious tricks and traps in the credit industry.

And for every family who avoids a trap or doesn't get caught by a trick, that's regulation that works.

Elizabeth Warren is the Leo Gottleib Professor of Law at Harvard Law School. A longer version of this article originally appeared in "Democracy: A Journal of Ideas."