Is the proposed Consumer Financial Protection Agency elitist?

Why do consumers need consumer protection when choosing financial products? Because many financial products are hard to understand, and deceptive marketing that exploits that complexity can lead even smart consumers to make bad choices.

That sounds like common sense. But opponents of the proposed Consumer Financial Protection Agency (CFPA), say such protections could be "elitist" because they would effectively restrict the sale of innovative and potentially beneficial products only to the most sophisticated buyers. "Conservatives have long argued that liberalism reflects a paternalistic desire on the part of elites to control and limit others’ choices while leaving themselves unaffected," stated Peter F. Wallison of the American Enterprise Institute in his comments yesterday before a Senate subcommittee. "The [proposal] seems to validate exactly that critique. Providers will be at risk if they offer some products to ordinary consumers but could feel safe in offering the same products to those who are well educated and sophisticated."

Harvard Economist Sendhil Mullainathan, who specializes in behavioral economics–the melding of economics and psychology–has an answer to that. Sophisticated or not, educated or not, we can't all be experts in everything. And without some protections, many people make very damaging mistakes. 

In his testimony yesterday, he illustrated by comparing how we shop for paint and how we buy digital cameras and mortgages. Though Benjamin Moore has 140 types of white, the process of selecting white–or any other color–doesn't necessarily require expert skills (apologies to interior decorators). 

Buying a digital camera, however, is more complicated (no wonder it's one of our most sought-after topics on Consumer Reports Online). You have to understand what megapixels are, and why a 12-megapixel camera might be better than an 8-megapixel camera, and determine if the quality differential between the two is worth the extra cost. And purchasing a really complicated and expensive product–exotic mortgages being an extreme example–requires knowledge that not all of us have, and can't always be easily be taught, Mullainathan says. 

"Suppose one mortgage costs 1,000 dollars a month for the first two years and payment is 3 points above one month LIBOR, while another says it is 900 dollars and then the payment is 4 points about the 1 year constant Treasury bills rate," the professor says. "How do you make this choice? What is the difference between the LIBOR and the T‐Bill rate? How much do they vary?  Are 3 and 4 points about the right number? If the provider says you can refinance in 2 years, should you worry about being able to get another loan? ... Few know the answers to these questions and those who do are the kind of people you avoid at a dinner party. 

"Choices such as these are at the heart of why choosing mortgages and other financial products pose so many difficulties for customers," Mullainathan adds. "With paint, you can try different colors; you can’t really try on many mortgages. With paint, you get feedback; with mortgages feedback comes rarely and far too late—when the payments explode. With paint, a mistake is, well, easily painted over; with mortgages mistakes have lifetime consequences. And most importantly, we understand the colors we like whereas few of us understand the financial technicalities that can have large consequences.  Under such conditions, errors [in choice] abound."

And, when the products include so many complexities, bad eggs in the financial marketplace can use marketing to make their wares look good, even when they're not. Toward that end, Mullainathan recommends that the proposed CFPA regulate relatively straightforward, "plain vanilla" financial products like 30-year fixed mortgages with a very light hand, but place limitations on how more exotic products are marketed, and even what features they can provide. 

Opponents to the CFPA contend that innovation will be stifled as a result. Mullainathan picks that argument apart. "When consumers choose badly innovation–one of the greatest benefits of markets–is also perverted," he says. "What did mortgage markets innovate in the beginning of this decade? Teaser rates, negatively amortizing loans, exploding subprime interest rates, prepayment penalties and low‐ or no‐doc lending are hardly shining examples of how financial innovation helps consumers. Instead these products, while surely useful for a few customers, have been abused because they have a superficial appeal to confused customers. They likely contributed heavily to the defaults we now must deal with. In short, when borrowers choose badly innovation can be geared toward exploiting mistakes rather than producing products that help customers." 

Though I've spent more than two decades trying to explain mortgages and other products to consumers, advice like mine is not enough to keep people from making bad mistakes in such an environment. How, for example, can a consumer know whether the marketer has disclosed everything important about a really complicated product? Mullainathan cites studies showing that 50 percent of ARM borrowers think they can convert to fixed-rate mortgages, when only 9 percent of ARMs appear to be actually convertible. The complexities are too much for the average consumer, the one this proposed agency aims to protect. 

For that reason, and many others, I believe that such regulation, including more straightforward disclosure, is needed. Police the exotic stuff and lightly supervise the plain-vanilla products like 30-year fixed mortgages. The issue is not elitism, it's creating a level playing field for average folks.–Tobie Stanger

Comments

[Ann Nonymous]

"Conservatives have long argued that liberalism reflects a paternalistic desire on the part of elites to control and limit others’ choices while leaving themselves unaffected," stated Peter F. Wallison of the American Enterprise Institute in his comments yesterday before a Senate subcommittee."

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Call me a liberal, then, because the drop in my 401K over the last year tells me that I need a nanny state to oversee my money. I think of myself as a smart person that keeps up with stuff, but man, I just don't feel like I have the expertise to keep up with financial planning.

I put all my money in "high risk" stock funds in my 401K accounts because it was recommended by someone, somewhere (Today Show? Oprah?) that for my age. They said I should go with stock funds and I should ignore the "lows" of the stock market because the stock market historically gains, on average, over time. So I moved a lot of my cash out of bonds. (At a loss.) Well, I have lost a lot of my money in every 401K fund I own. Believe me, I'm trying my best to "ignore" this past historical low. But will I ever recoup the money I lost?

Also, I would like to roll-over some of my accounts from old jobs to new retirement accounts but I'm terrified I'll make the wrong choice.

Please, give me the helping hand of the "nanny state."

[eric]

Hey Ann - that's why there are people called financial planners out there. Give them a little money and you'll keep yourself from losing/wasting a lot of money on bad financial products. Of course you have to know what makes a good financial planner - but CR can help you with that.

Good balanced on the issue CR - NOT! I'm sure that Wallison had a little more to say than you reported on. What, two sentences from him, but a dissertation from the other guy? You need to read Fox's tagline and take that to heart.