In the wake of the election of Senator Brown, the Administration has signaled increased resolve to reform financial services regulation. If banks want a fight, a fight they will get.
A proposed a new agency, the Consumer Financial Protection Agency, will be at the center of the upcoming battle. Last month the House passed a financial services reform bill that includes a CFPA. Chairman Dodd is now navigating the particulars of the Senate's bill, which will include some kind of new financial-product regulator as well--perhaps as a stand-alone agency, perhaps as a division within a parent agency. President Obama has stated that the establishment of a stand-alone CFPA is "non-negotiable."
But what exactly is the proposed CFPA, and why it is such a good idea?
Start with exploding toasters. The proposed new CFPA is modeled loosely (hopefully very loosely; more to come later) on the existing Consumer Product Safety Commission. The CPSC regulates ordinary consumer products--children's toys, power tools, and the like. The premise of the CPSC is that consumers lack complete information about the risks of certain products. Lacking such information, and given that manufacturers are not always completely forthcoming about product risks, consumers buy risky products too often. The CPSC enhances the safety of consumer product markets, then, by providing information about product risks, which in turn discourages manufacturers from offering excessively risky products in the first place.
The FDA is another rough analogy. The FDA protects consumers against the risk of unsafe medical drugs and devices. Here again, consumer-patients lack adequate means to distinguish between safe and unsafe drugs. By requiring drug makers to establish their products' safety before taking them to market, the FDA protects patients from excessively risky drugs.
As the financial crisis has tragically shown, financial products can be risky too. Like other consumer products, mortgages can impose hidden dangers. And because lenders often sell off pieces of mortgages anyway, they have large incentives to lend--even where a mortgage poses a high risk of default. A new CFPA would protect consumers against such risks.
But there is a dis-analogy here too, and it is crucial. Unlike the dangerous toaster and defective medical device, a risky mortgage threatens to harm not only the consumer who buys it, but the whole neighborhood. If your neighbor signs a risky mortgage and later cannot pay, the consequences of that decision are felt down the block in the form of depreciating housing prices. If this happens on a large enough scale, the availability of consumer credit shrinks. When things get really bad, taxpayers have to support the large investors who bought sliced and diced financial instruments derived from the bad mortgages. In short, the burdens of risky financial products are felt throughout the economy. A new CFPA is important not only to protect the potential purchasers of dubious mortgage products, but to ensure the integrity of consumer finance markets more generally. Although some will object that a new CFPA would reduce the availability of consumer credit, those critics have not applied for a mortgage loan lately. Nothing reduces consumer credit like a financial crisis.
Nor is there any alternative to regulation. The only question is what form regulation will take. In the absence of genuine reform, the government will continue to clean up the consequences of exploding mortgages after the fact--by shoring up holders of bad debt and stimulating the economy to revive housing and credit markets. Better to discourage risky retail financial products in the first place. An ounce of CFPA prevention is far preferable to billion-dollar cures.