The standard account of regulation focuses on problems of market failure. One form of market failure stems from information scarcity or informational asymmetries. Regulations can deal with this kind of market failure by requiring information disclosure using standard metrics, often in a form that is assessable to relatively unsophisticated actors. This form of regulation can be quite useful in promoting mutually beneficial exchanges between consenting adults. Example: the Federal Trade Commission’s Used Car Rule requires dealers to post a buyers guide on used cars that inform the customer of basic information (e.g., is it being sold “as is” or is there a warranty). Presumably, this reduces informational asymmetries and facilitates exchanges. Regulation by information can also reduce more intrusive expressions of government power. For example, the Securities and Exchange Commission requires firms to disclose their financials so that potential investors can make informed decisions. It does not, however, bar firms with a higher probability of bankruptcy from entering capital markets. Regulations facilitate exchanges and regulation by information does so with minimal state intrusion.
Paul Krugman has a piece today in the NYT (“Friends of Fraud”) decrying the GOP threats to block the confirmation of Richard Cordray as head of the Consumer Financial Protection Bureau created under Dodd-Frank. Having lost the battle over Dodd-Frank, they want to strip the new bureau of its independence and are using the appointment to leverage the changes in question. Krugman’s take:
What Republicans are demanding, basically, is that the protection bureau lose its independence. They want its actions subjected to a veto by other, bank-centered financial regulators, ensuring that consumers will once again be neglected, and they also want to take away its guaranteed funding, opening it to interest-group pressure. These changes would make the agency more or less worthless — but that, of course, is the point.
How can the G.O.P. be so determined to make America safe for financial fraud, with the 2008 crisis still so fresh in our memory? In part it’s because Republicans are deep in denial about what actually happened to our financial system and economy. On the right, it’s now complete orthodoxy that do-gooder liberals, especially former Representative Barney Frank, somehow caused the financial disaster by forcing helpless bankers to lend to Those People.
Elizabeth Warren (the policy entrepreneur who fought for a new consumer protection agency) was an expert in bankruptcy (before winning the Senate race) and she documented the large percentage of prime borrowers who were directed into subprime vehicles (I don’t recall the exact figure, but I believe it was around 25 percent). Others signed on to mortgages they didn’t understand, in part, because the terms of the agreement and the consequences were sufficiently obscured by the issuers. The problems of information asymmetry were significant, particularly for the less sophisticated borrower.
A few points of clarification: I think Dodd-Frank was bad legislation for a host of reasons that are beyond the scope of this posting. I do not think that the evil mortgage broker exploiting the hapless rube was the source of the financial crisis. Nor would I agree with Krugman’s portrayal of the crisis. There was so much more going on in this tale of crony capitalism, transfer-seeking, and failed regulation. But there is good evidence that many (not all) borrowers were exploited in ways that cost them dearly. I am at a loss to understand why the regulation of the kinds of mortgage instruments that are sold and the information provided to borrowers is so objectionable, particularly when (as noted above) it can facilitate functioning markets.
Quick question to the skeptics: when is the last time you read the information that was provided before you clicked “accept” and upgraded to the newest version of iTunes or installed the newest fix to whatever problem was discovered in your word processing or spread sheet program? Do you know what you agreed to? Now imagine a relatively unsophisticated borrower signing off on a 20-page document, having concluded that the mortgage broker told them all they needed to know about the agreement.
Bottom line: even those who support market governance can make a compelling case for regulation, particularly when it involves the provision of information that facilitates voluntary exchanges.
Question: is there a credible argument to be made against the Consumer Financial Protection Bureau? Note: the claim that all regulation is bad is not a credible argument.
What a great post. As a former mortgage broker and later on as an underwriter, I can tell you that the lending standards in place during the bubble years were akin to the Wild West. The emphasis was always on volume of deals and and not quality of deals. When you have an industry like the mortgage lending industry, which essentially had no barriers to entry for new brokers, a complete lack of oversight and compensation based purely on performance with no base salary, it’s obvious what the end game is. Incentives matter in markets. When you design them poorly then you get poor results.
It’s also funny how you mention information assymetry as a problem. The pure opacity of the mortgage CDO market is directly what led to the shadow bank run that triggerred government intervention. Nobody knew who had what or how much it was even worth and the market just froze up. The opacity, and advantage during the boom years, became the very thing that undid the system.
Thank you for this post. A few questions.
“But there is good evidence that many (not all) borrowers were exploited in ways that cost them dearly.”
How can a borrower be exploited in ways that cost them dearly? Say you are a high-risk borrower, the kind that could get a crazy subprime mortgage during the heyday of the bubble. You get your home, you get your house, the economy tanks, you lose your job, you can’t pay your mortgage so you…give the house back. What are you out? If you happened to lose a lot of your wealth in the bust (let’s say you put your life savings into buying that home at the peak of home prices) then obviously you got hurt, but is this a case of exploitation?
As to the question you posed:
My argument is one based on implicit trust and the way that affects market relations. I recently installed iTunes, and I assure you I did not read a single line of the user agreement. Apple *could* have had me sign away my soul in the fine print. Do I need a Consumer Electronic Protection Agency to look over the contracts that Apple is offering to police them? It is certainly *possible* that doing so would promote more effective communication and lower transaction costs and info asymmetry in the tech market. Yet we don’t see these asymmetries or destructive problems in the software and I think that part of it is that if Apple tried even *one* instance of bad business practices, you’d see huge repercussions. Companies take customer trust seriously.
What confuses me is why we didn’t see similar behavior in the financial markets. Ratings agencies are supposed to sell *trustworthy* ratings. Whatever your business is you want to earn trust. If I’m an investor and I’m being offered a bundle of subprime mortgages I would do my homework or pay a reputable firm to do the homework for me. If they defrauded me I’d sue them and at the very least never do business with them again. Fraud and dishonesty should be *severely* punished in the marketplace, and I don’t see why finance should be any different in this regard.
All of this is to say: when I see markets that intuitively have no good reason to be failing, I suspect that there is an underlying regulatory/structural/incentives problem. An example of this: we bemoan the lack of middle-income housing in big cities, decrying the almost universal luxury developments, and we appoint state regulators to control rent and dictate development mixes and zone our problems away. On closer examination, we observe that the *reason* we don’t have a diverse mix of housing construction is the entrenchment of high-cost construction trade unions and zoning laws that mandates costly parking and historical preservation concerns (channeling The Gated City here). In that regulatory/business environment, the only thing you can profitably build is a luxury condo high-rise. So that’s the only thing developers can bring to the table.
To bring it back to finance/housing: the “fraudulent mortgage” is as strange to me as the “ubiquitous luxury high rise development.” The market should be more diverse, more dynamic, and more functional than it is. I’m inclined to dig deeper rather than lay a bureaucratic band-aid over it.
“Ratings agencies are supposed to sell *trustworthy* ratings. Whatever your business is you want to earn trust. If I’m an investor and I’m being offered a bundle of subprime mortgages I would do my homework or pay a reputable firm to do the homework for me.”
You can’t be serious. The issuers pay for the ratings, not the investors. Needless to say, this creates a severe agency problem. You could end this by intervention, but I doubt that’s something you would support. You could set it up where raters are randomly assigned by lottery to issuers. That could end the conflict, but the current structure where an issuer can bully the rater by refusing business if not given the right rating is clearly broken.
On all the other points you make, I mostly agree.
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