No more loans with tricks & traps

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Two years ago, Elizabeth Warren proposed the creation of a “financial product safety commission.” Its mission: Review financial products “to eliminate the hidden tricks and traps that make some of them far more dangerous than others.”

Even as the mortgage meltdown morphed into an economic crisis, Warren’s idea didn’t get a lot of traction. Then, in June, the Obama administration adopted it as part of a broad reform of financial regulations, renaming Warren’s brainchild the Consumer Financial Protection Agency.

Warren is a professor at Harvard Law School and is an expert on debtor and bankruptcy law. She has written or co-written about 15 books, including “The Fragile Middle Class: Americans in Debt” and “The Two-Income Trap: Why Middle-Class Mothers and Fathers Are Going Broke.”

She is chairwoman of the Congressional Oversight Panel, which supervises Treasury’s management of the Troubled Asset Relief Program, or TARP, and reviews financial regulations. In recent weeks she has talked with legislators and sat for interviews to push for financial regulatory reform. asked Warren which parts of regulatory reform are more important, why she thinks tighter banking rules can yield greater innovation, and why shopping for a mortgage is like shopping for a car.

What parts of the Consumer Financial Protection Agency are dearest to you? If Congress enacts only part of what you suggested, what parts do you most want to keep?

Here’s the heart of it, what I think this thing does. The form of regulation we have now is a do’s and don’ts approach — a complex regulatory structure with many layers. Some of the rules apply differently depending on whether a lender is a federally chartered bank or a state-chartered thrift or a nonregulated business group.

Changes needed for the market to work again
  • All products of the same kind have the same rules.
  • Make the language of the deal easy to understand.

The point behind the CFPA is to replace the do’s and don’ts approach with two key shifts:

First, all products of the same kind shall face the same set of rules.

For example, all mortgages, regardless of who issues them, have to meet certain minimum standards. That would be true whether these are from an unlicensed institution or they’re from a nationally chartered bank. That would level the playing field. It’s important to shift regulation into a product orientation — that is, all products within a category are treated alike.

“There will be a lot of two-page credit card agreements and two-page mortgages and one-page checking account overdraft arrangements.”

The second part is to move toward leveling the playing field by making the products easy to understand. Disclosure has come to mean six more paragraphs of unreadable text back on page 91, which doesn’t change consumer behavior and doesn’t make markets competitive.

This agency will have the capacity to reach across all similar instruments and the ability to push toward revealing the key information and not hiding it in incomprehensible language or long disclosures that discourage consumers from reading them. Those changes will make big differences in how the markets function.

Ultimately, if this agency works the way it ought to, there will be a lot of two-page credit card agreements and two-page mortgages and one-page checking account overdraft arrangements. When that happens, there will be real competition and markets can work again.

That’s the heart of it for me. If that’s lost, there’s not much point.

You describe the industry’s definition of financial innovation as six new paragraphs of boilerplate to discuss something new. Where do you disagree with the industry’s definition of financial innovation and what kind of innovation would you like to see?

Innovation works for consumers only in a truly competitive market. Right now, partly because of the regulatory structure and partly because of the gaps in regulation, the business model for selling financial products to consumers has changed dramatically.

“The market became wildly profitable through innovations that were oriented toward tricks and traps.”

The old model was to sell a fairly straightforward product to people that the lender was pretty sure would they’d be able to repay. Lenders priced the product by figuring out what’s the risk of nonpayment, what’s the inflation risk, and what costs the business needs to recover.

The new pricing model shifted away from that, so that a handful of features are pushed out in front of the consumer that appear very attractive, like the monthly payment and no money down, while the cost and risks are buried in fine print that are often not well described. A lot of mortgage issuers made a lot of money over the past 10 years by selling products that many consumers barely understood or didn’t understand at all. More importantly, the capacity to compare directly from product to product fell apart.

I shopped for mortgages in the 1990s, when we were buying a house, and 45 minutes on the phone pretty much told me how that market worked. I knew I was comparing apples to apples, because I got the prices and that was it. I made a decision. That’s not how that market works anymore. The market became wildly profitable through innovations that were oriented toward tricks and traps.

Consider another regulatory example. In the 1920s, anyone who had a bathtub and a few boxes of chemicals could be a pharmaceutical company, and the company could make any claims they wanted about cures. Products sold in the 1920s, according to the manufacturers, cured cancer, hair loss and every other sort of malady. In a market like that, no one invests in research and development. No one invests in developing products that work better for consumers because they are competing with snake oil.

“We have had change in financial services, but not consumer-oriented innovation.”

When regulators started taking the most dangerous products off the market and forcing a lot more disclosure in the pharmaceutical industry, companies started investing in products that really worked for consumers. I see the same kind of thing over in the financial services market.

We have had change in financial services, but not consumer-oriented innovation. 2/28 mortgages were sold to people who did not understand that in the third year, if the market was not rising, they would lose their homes. That’s not an innovation. That’s a new business practice that doesn’t help consumers and it doesn’t help result from a competitive market.

Am I being clear?

Definitely. You’re saying it’s the kind of thing that’s an implication in a loan paperwork, but it’s not spelled out.

Exactly. It’s there, somewhere buried in here. Let’s go run a survey: How many people, a) will know if they had a prepayment penalty in their mortgage, and b) will understand the implications of it?

You and I both know that prepayment penalties are a way to fool people about pricing. They may also have other functions in limited circumstances, but the innovation in the marketplace over the last few years was to use prepayment penalties as a way to mislead people about pricing and risk. Prepayment penalties were what permitted the companies to lend to people knowing that those people could not afford to pay this mortgage in the third year.

When the industry says, “The new consumer agency is going to stifle innovation,” I think they have it exactly backwards. The agency opens the door to innovation, at least the innovation that will be helpful to consumers. It will drive out the kind of tricks-and-traps pricing that rewards the lenders who can come up with product that fools the maximum number of people.

Kind of reminds me of psyching yourself up to shop for a car. You feel like, “Oh my gosh, I’m in for manipulation and all sorts of psychological tricks.”

You put your finger on another important issue: the importance of consumer confidence. When I put money in a bank, I have a lot of confidence that I’ll be able to get it out on the other side. And look how well that has worked for us. We know that there are still a lot of shaky banks out there, and yet there has been almost no run on the banks as people try to withdraw their money from their savings accounts or checking accounts. People still write checks and those checks pass through the system. Consumers have confidence in the system. They know that it’s an honest and straight-up system, and that as long as it’s an FDIC-insured bank, they’re fine.

The analogy breaks down a little with credit. We all understand that if you’re borrowing money, you’re taking on risk. You could lose your job tomorrow, the market could fall out, the housing market could fall. Those are risks that families take on.

“Prepayment penalties are a way to fool people about pricing.”

But not so long ago, no one thought they were taking on a risk that — even if they made all their payments on time, and even if they filled out all the paperwork honestly and they continued to have their jobs — that they would wake up one day and their mortgage payments would have shot up by several hundred dollars and no longer be affordable.

Bad actors in the mortgage industry not only changed industry practices but changed consumers’ understanding of the home buying transaction. No one knows what the long-term cost of the loss of trust is going to be.

Today lenders work to hide their revenue enhancers so that there’s no direct competition in this marketplace. This marketplace is broken. It’s broken for credit cards, it’s broken for mortgages. It’s broken for all of these consumer products where the model has shifted way from making the price and the product clear up front and doing a head-to-head competition in the marketplace that benefits consumers.

We have a window of opportunity to fix this. Right now people recognize that this market didn’t work. I think that there’s a shot to try to clean things up. The question is: “How?” We can pass more laws that say you can do this kind of thing and you can’t do that kind of thing. Or we can push toward a real reform that makes the market work again.

The irony is that I want just enough regulation to get this market working again. I want this market to work the way that most of the other markets work. Regulation can work. We sometimes complain about the FDA, for example, but the problems are at the small margins. Does anyone want to go back to a world with no FDA? A world where anyone can sell any product that they can brew in a bathtub?

Do we want to go back to a world in which there’s no Consumer Product Safety Commission and anybody can put out something and call it an infant car seat, even if it collapses on impact?

Regulation pushes those kinds of products out of the marketplace so that competition works for consumers.

There are a lot of people who are alive today because of the Consumer Product Safety Commission and the FDA. And there are a lot of people who are financially dead because of a broken mortgage market.

We can do better.