It isn’t often that I read an article about the political battles being fought over financial regulation and get reminded of an old girlfriend, but that is exactly what happened yesterday when I read James Suroweicki’s piece in The New Yorker about how banks are flexing their political muscle to derail the creation of the Consumer Financial Protection Bureau. The CFPB is charged with bringing more transparency to consumer financial markets so that people looking to borrow money -- whether by accepting a credit card, taking out a home loan or otherwise -- have a very clear understanding of what the real cost of that new debt will be.
In his article, Suroweicki points out that the creation of the CFPB actually will benefit the banking industry, and argues that the banks are therefore acting counter to their own interests by opposing the creation of this agency.
Unfortunately, I think Suroweicki is missing something important here. I am sure that the banks fighting so ferociously against the CFPB understand quite well that its creation really will benefit the banking industry, but they also are profoundly aware that it will do so at the expense of the banks themselves. These two interests are not identical, and Suroweicki misses part of the story by assuming that they are.
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The old girlfriend I was reminded of is named Juliet, and she called me some years ago when she was in the process of refinancing her home. At the insistence of her then (but, when she called me, ex-) husband, she had purchased her home with a loan that started out at a fixed interest rate but eventually turned into an adjustable rate mortgage – and now the adjustable rate term of the loan was about to kick in. Interest rates were fairly low at the time, and she didn’t want to take the risk that they might suddenly shoot back up.
Juliet already had contacted a number of different banks and had obtained three different loan proposals, but they all required different closing costs be paid up front, they all had different interest rates, and they all involved slightly different loan amounts. Juliet couldn’t determine which loan proposal was actually the cheapest, but she knew that I had some experience with mortgages and she asked me if I would look the proposals over. Of course, I was only too happy to help.
Comparing them was fairly simple, if you already knew how to do it. Essentially, you have to calculate the Annual Percentage Rate on each loan, taking into account both the interest rate and the up-front costs. Once you have the APR for each loan you can determine the present value cost being charged by each bank. Although two of the proposals Juliet sent me were fairly close to each other, I found that the third would actually end up costing Juliet about $8,000 less over the life of the loan. When I told her the news, and explained how I had figured it out, she was very happy to be saving this much money.
But about a week later Juliet called me up again. “I called the other two banks to let them know that I was going with the bank you recommended,” she told me, “but one of the loan officers I spoke to said something that got me thinking. He pointed out that his bank had been around a long time and is really big, so that I knew I could always count on them being there. Do you think this is something I should worry about?”
That kind of cracked me up. “Juliet, think about it for a moment. The only thing you need any of these banks to do for you is to give you the money to refinance your home right now. They aren’t going to be managing an investment account for you. After you get the money all of the work is going to be on your side: you’ll have to make sure you make your payments every month. Does it really matter to you if the bigger bank is more efficient at taking your money?
“And nothing will affect you if the small bank goes out of business. You’ll still owe the money to somebody, and will have to make payments anyway. That other guy was just trying to con you into paying $8,000 more than you have to for your loan. Save that money for yourself and go with the smaller, better bank.”
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Juliet's experience perfectly illustrates America's need for an agency like the Consumer Fraud Protection Bureau. Despite her best efforts to shop around to find the best loan she could, Juliet was stymied by her inability to obtain competing loan proposals in a form that allowed for a straightforward side-by-side comparison; and then, even after she had spoken with someone who could help her, she was still almost persuaded to buy a much more expensive loan by a salesman who knew that most people's inexperience with the banking industry (and their natural cautiousness when taking out huge loans) means that they can often be flim-flammed with a little sales talk.
Of course, Juliet’s difficulty navigating the world of home mortgages arose directly from the fact that – as it is now designed -- that world is fairly opaque to consumers. But if the CFPB can get itself set up it could, for example, establish a uniform format for the presentation of loan proposals. That would make it fairly easy for people like Juliet to compare those proposals and determine for themselves which one is the better deal.
As Suroweicki points out in his article, the kind of market transparency the CFPB is charged with bringing to the consumer financial markets is a sine qua non of free market capitalism, because transparency fosters “vigorous competition and efficient markets.” But, curiously, the banks and their agents in Congress don’t seem to really like the idea of greater market transparency. For all of their reflexive blather about “the power of the free market” and how all the solutions to our problems can be realized if only we “allow the market to work its will unimpeded,” they have no interest in making something as basic as shopping for a home loan an easier process for consumers to understand.
Instead, they are working overtime to – in Elizabeth Warren’s words – "delay, defund and de-fang or even kill outright" the CFPB, all the while claiming that the agency and Warren are "enemies of a free market and obtacles to economic growth.” (emphasis added) To date, most of the political media has attempted to turn this legislative battle into a dispute over Elizabeth Warren herself and whether she could survive the nomination process to become the agency’s first Director. However, the banking industry’s Congressional catspaws have made it clear that it is not Warren to which they object, it is the creation of the agency itself. Mitch McConnell’s office spelled this out in plain language yesterday: “It’s not sexist. It’s not Elizabeth Warren-specific. It’s any nominee.”
Quite simply, the Republican minority in the Senate intends to hamstring the CFPB by blocking the appointment of any nominee to head the new agency unless that agency is effectively “de-fanged” by, among other things, having its funding placed under congressional control. You know, the same Congress that right now wants to prevent the agency from being set up in the first place. According to the Republicans, they will not allow the appointment of any Bureau Director unless the agency is severely weakened. Of course, without the appointment of a Director the CFPB “will have limited ability to write new rules or supervise certain financial firms that are not banks, such as payday lenders.”
So this latest act of hostage-taking can be a win-win for Republicans. Unless the CFPB is rendered toothless, they won’t allow the appointment of a Director. Without the appointment of a Director, the CFPB is rendered toothless.
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But why would the banking industry – that bastion of "free market freedom" – be so against the creation of an agency that will help unleash the magic power of the free market? The answer is simple: despite their rhetoric, our Galtian Overlords have no actual interest in free markets because free markets are extremely efficient and public efficiency is the enemy of private profit.
As I've mentioned before, the phrase "free market" does not mean something so simple as a market without any government regulation. Instead, a "free market” is one characterized by (i) a multitude of sellers, so that no single supplier can dominate the market (which would be a Monopoly), (ii) a multitude of buyers, so that no single consumer can dominate the market (which would be a Monopsony), and (iii) transparency of information, so that the party with superior knowledge of the product cannot cheat the other (which would be fraud):
Only if all three factors are present are market participants truly free to make rational decisions in pursuit of their own self-interests. But – very often – one or more of these factors is missing. When that happens, and in direct furtherance of free market principles, the government needs to step in and correct the system so that the benefits of free market capitalism can flow once again to society.
In properly constituted free markets stiff competition between actors on both sides of many, many individual and transparent transactions functions as a bottom-up organizing principle that minimizes overall economic “waste” -- that is, sellers don’t get to pocket outsized profits and buyers don’t get to pocket outsized savings. From society’s point of view, maximizing the public efficiency of its markets is the proper goal of economic regulation.
However, no particular actor really wants to experience perfect market efficiency because a perfectly efficient market always minimizes the profit that any particular seller can make and always minimizes the savings any particular buyer can realize.
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For example, consider the “Efficient Market Hypothesis” as applied to the stock market. While there are a couple of variants on this hypothesis, in essence it states that the stock market accurately reflects all publicly available information about the stocks traded on that market. As a result, it is impossible for any stockbroker to outperform the market over an extended period of time, unless that broker has private information that the market has not yet had an opportunity to absorb.
It was partly the growing acceptance of the Efficient Market Hypothesis that gave rise to stock index funds. The essential idea is that (i) if it is impossible for your broker to outperform the stock market, but (ii) your broker is charging you a fee every time he buys or sells stock in a futile effort to do so, then (ii) it makes much more sense to simply purchase a bundle of stocks tied to a market index – say, the S&P 500 -- and avoid all those transaction fees. Then the return on your investment will mirror the return on the market itself, which cannot be outperformed.
The degree to which the EMH is true or not with respect to the stock market is the subject of some debate, but that isn’t really the point here. The point here is simply that it nicely illustrates the fact that traders in a perfectly efficient market can expect to make some profit (in the case of the stock market substitute “return on investment” for the word “profit”) but the profit that can be realized by any individual trader is always going to be the minimum profit at which that trade will still take place.
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But, of course, market participants don’t want to realize the minimum profit possible, they want to maximize their profit. The only way to do that is to find some inefficiency in the market and exploit it -- or, even better, create an inefficiency. And an easy way to create inefficiency in the market is to reduce its transparency. The less your customer knows about what you are selling, the greater the premium you can persuade your customer to pay.
Ultimately, this is the point that I think that Suroweicki misses. While it is true that “businesses offering better products . . . have an incentive to make sure that potential customers [are] able to distinguish between ripoffs and good deals,” it is also true that creating an actual “better product” is hard work and sometimes cannot be accomplished. Indeed, in the world of consumer finance a “better product” for the consumer pretty much just means a loan that is less lucrative for the creditor.
So while it is nice to pretend that banks are interested in competing with each other to offer the American public the cheapest loans possible, it is also naive. If the government can force banks to truly compete against each other in the consumer finance industry, then that competition can only reduce the profit all those banks now make lending to private individuals.
Contrary to Suroweicki’s conclusion, this is -- from the banks’ perspective – surely something they think worth fighting to prevent.