What are the common sense reforms we need?

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We support reforms to the financial marketplace that protect consumers from unscrupulous banks and lenders.

By Consumers Union on Thursday, March 26th, 2009

This week, our own Gail Hillebrand testified before Senate Banking–along with a host of bankers and government officials.

It’s hard to remember sometimes, in the chatter about CDOs and SWAPs and leverage, that real American families got loans that were structured to fail, and fail they did. Why would lenders trick their customers into taking money the customers couldn’t repay? If you can answer that question, you can probably figure out how to write common sense laws to prevent that behavior in the future. That’s what Gail attempted to do. Here’s her written testimony.

First, the incentives are all wrong these days. The guy that sells the loan gets a fee, whether or not the loan can be repaid. The bank that makes the loan sells it to someone else and gets a fee, whether or not it can be repaid. That means we have to change the incentives. Gail says:

Consumers Union believes that accountability must include making every entity receiving a fee in connection with a financial instrument responsible for future problems with that instrument. This would help to end the “keep the fee, pass the risk” phenomenon which helped to fuel poor underwriting of nonprime mortgages. Moreover, everyone who sells a financial product to an individual should have an enforceable legal obligation to ensure that the product is suitable. Likewise, everyone who advises individuals about financial products should have an enforceable fiduciary duty to those individuals.

Laws aren’t much good if they can’t be enforced. So Gail also insisted that when federal lawmakers lay out their own version of new consumer protections, they shouldn’t sweep away the protections we may already have in our own states, where government agencies are closer to the people they are trying to protect.

Christopher Whalen, blogger and Senior Vice President and Managing Director of Institutional Risk Analytics, gave Gail some support for that idea. Said Whalen:

While there is no doubt that the federal government should set consistent regulations for all banks, there is no reason why federal and state agencies cannot cooperate to achieve these ends. The notion that consumer regulation must be an either or proposition is wrong. As this Congress looks to reform the larger regulatory framework, a way must be found to allow for cooperation between state and federal agencies tasked with financial regulation and in all areas, including consumer and enforcement. There is no federal tort law, after all, so if consumers are to have effective redress of grievance for bad acts such as fraud or predatory lending, then the agencies and courts of the various states must be part of the solution.

Hooray for common sense!

But why should we believe that regulators will do anything at all, even if we put good laws on the books. Should we just leave it to the courts to sort out? Well, Gail told the Senators that regulators need a big change in attitude, and the fiasco that we’re now fixing may have already changed a few minds.

Consumers Union believes that federal banking regulators have placed too much confidence in the private choices of bank management and too much unquestioning faith in the benefits of financial innovation. Too often, the perceived value of financial innovation has not been weighed against the value of preventing harm to individuals. The Option ARM, as sold to a broad swathe of ordinary homeowners, has shown that the harm from some types and uses of financial services innovation can far outweigh the benefits.

Yes, the “Option ARM”–before you run to Google to look it up, here’s a pretty good description of this and other exotic adjustable mortgages. The Option ARM mortgages that set people up to pay less than their monthly interest, so their loans actually increased over time, might have been among the worst of those dangerous “exploding toaster” loans that President Obama mentioned last week on Leno. The problem was so serious, and people knew about it so long ago, that these guys named their blog after it, Option ARMaggedon, a history lesson since 2007. And this toaster is of the “exploding” type, but hasn’t finished exploding yet. Watch this 60 Minutes segment, with some additional data added by New York real estate blogger Thomas McGiveron.

With more fallout to come, as the Option ARMs hit their “reset” dates and more borrowers face bigger loans and higher payments, Congress must address the regulatory problems as quickly as possible, and reform must include all kinds of lenders and the “shadow” financial sector. We will be tracking this every step of the way, urging changes that are meaningful to you and good for the economy.

What do you think the Senate Banking committee needs to consider?

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