A century ago, anyone with a bathtub and some chemicals could mix and sell drugs — and claim fantastic cures. These “innovators” raked in profits by skillfully marketing lousy products because customers were poorly equipped to tell the difference between effective and ineffective treatments. In the decades following, the Food and Drug Administration developed some basic rules about safety and disclosure, and everything changed. Companies had greater incentives to invest in research and to develop safer, more effective drugs. Eliminating bad remedies made room for creating good ones.

Nearly every product sold in America today has passed basic safety regulations well in advance of being put on store shelves.  A focused and adaptable regulatory structure for drugs, food, cars, appliances and other physical products has created a vibrant market in which cutting edge innovations are aimed toward attracting new consumers.  By contrast, credit products are regulated by a bloated, ineffective concoction of federal and state laws that have failed to adapt to changing markets. Costs have risen, and innovation has produced incomprehensible terms and sharp practices that have left families at the mercy of those who write the contracts.

While manufacturers have developed iPods and flat-screen televisions, the financial industry has perfected the art of offering mortgages, credit cards, and check-overdrafts laden with hidden terms that obscure price and risk.  Good products are mixed with dangerous products, and consumers are left on their own to try to sort out which is which.  The consequences can be disastrous.  More than half of the families that ended up with high-priced, high-risk subprime mortgages would have qualified for safer, cheaper prime loans.¹  A recent Federal Trade Commission (FTC) survey found that many consumers do not understand, or even can identify, key mortgage terms.²  After extensive study, the Federal Reserve found that homeowners with adjustable rate mortgages (ARMs) were poorly informed about the terms of their mortgages.³  Research from the Department of Housing and Urban Development (HUD) concluded that, “[t]oday, buying a home is too complicated, confusing and costly. Each year, Americans spend approximately $55 billion on closing costs they don’t fully understand.”⁴

This information gap between lender and borrower exists throughout the consumer credit market.   The so-called “innovations” in credit charges—including teaser rates, negative amortization, increased use of fees, universal default clauses, and penalty interest rates—have turned ordinary credit transactions into devilishly complex undertakings. Study after study shows that credit products are deliberately designed to obscure the real costs and to trick consumers.⁵ The average credit-card contract is dizzying—and 30 pages long, up from a page and a half in the early 1980s.⁶ Lenders advertise a single interest rate on the front of their direct-mail envelopes while burying costly details deep in the contract.

Creditors try to explain away their long contracts with the claim that they need to protect themselves from litigation. This ignores the fact that creditors have found many other effective ways to insulate themselves from liability. Arbitration clauses, for example, may look benign to the customer, but their point is often to permit the lender to escape the reach of class-action lawsuits. The result is that the lenders can break and, if the amounts at stake are small, few customers would ever sue. Legal protection is only a small part of the proliferating verbiage.

Faced with impenetrable legalese and deliberate obfuscation, consumers can’t compare offers or make clear-eyed choices about borrowing.  Creditors can hire an army of lawyers and MBAs to design their programs, but families’ time and expertise have not expanded to meet the demands of a changing credit marketplace. As a result, consumers sign on to credit products focused on only one or two features—nominal interest rates or free gifts—in the hope that the fine print will not bite them.  Real competition, the head-to-head comparison of total costs that results in the best products rising to the top, has disappeared. 
 
Regulatory Failure
The lack of meaningful rules over the consumer credit market is the direct result of a sluggish, bureaucratic regulatory system.  Today, consumer protection authority is scattered among seven federal agencies.  Each of those agencies has plenty of workers on payroll and plenty of budgeting. But not one of those agencies has real accountability for making consumer protection work, and, as a result, not one has been successful at doing so.

The seven agencies with a piece of consumer protection have failed to create effective rules for two structural reasons.  The first is that financial institutions can currently shop around for the regulator that provides the most lax oversight.  By changing from a bank charter to a thrift charter, for example, a financial institution can change from one regulator to another.  In fact, an institution may decide to evade a federal regulator altogether by housing its operations in the states and forgoing a federal charter.  Bank holding companies can shift their business from their regulated subsidiaries to those with no regulation—and no single regulator can stop them.  The problem is exacerbated by the funding structure:  regulators’ budgets come in large part from the institutions they regulate.  To maintain their size, these regulators compete to attract financial institutions, with each offering more bank-friendly regulations than the next.  The result has been a race to the bottom in consumer protection.

The second structural flaw is cultural: consumer protection staff at existing agencies is small, last to be funded, and always second fiddle to the primary mission of the agencies.  At the Federal Reserve, senior officers and staff focus on monetary policy, not protecting consumers.  At the Office of the Comptroller of the Currency and the Office of Thrift Supervision, agency heads worry about bank profitability and capital adequacy requirements.  As the current crisis demonstrates, even when they have the legal tools to protect families, existing agencies have shown little interest in meaningful consumer protection—and there has been no accountability demanding that they do so.
 
The Consumer Financial Protection Agency
The Consumer Financial Protection Agency (CFPA) is designed to fix these structural problems by consolidating the scattered authorities, reducing bureaucracy, and making sure there is an agency in Washington on the side of families.  In the process, the CFPA would develop the expertise to fix the broken consumer credit market, giving families a fighting chance against the lawyers and resources of the Wall Street banks.  This agency would have a clear mission, answering directly to Congress and the American people.

The CFPA has the opportunity to revolutionize consumer credit by promoting simple, straight-forward contracts that allow consumers to make better-informed choices.  For decades, policymakers mistakenly followed the principle that more disclosure will promote product competition.  What they missed is that more disclosure is not necessarily better disclosure.  The extra fine print has given creditors pages of opportunity to trick unsuspecting customers.  Comparison shopping has become impossible.  The CFPA would cut through the fragmented, cumbersome, and complex consumer protection laws, replacing them with a coherent set of smarter rules that will bring more competition into the market.  These rules will drive toward shorter, easier to understand agreements, like the one-page mortgage agreement promoted by the American Enterprise Institute.⁷  Shorter, clearer contracts will empower consumers to begin making real comparisons among products and to protect themselves. Better transparency will mean a better functioning market, more competition, more efficiencies, and, ultimately, lower prices for the families that use them.

In addition, the agency can reduce regulatory costs and promote a working marketplace by pre-approving templates for simple contracts designed to be read in less than three minutes—a regulatory safe harbor that would eliminate the need for companies to pay legions of lawyers to ensure compliance with the maze of laws. The lenders would still set rates, credit limits, penalties, and due dates. But consumers would be able to lay out a half-dozen contracts on the table, knowing the costs and risks right up front.  They can then choose the product that best fits their needs. Banks and other lenders could continue to offer more complicated or risky products—as long as the risks are disclosed so that customers can understand them without relying on a team of lawyers.
 
Conclusion
Nothing will ever replace the role of personal responsibility.  The FDA cannot prevent drug overdoses, and the CFPA cannot stop overspending.  Instead, creating safer marketplaces is about making certain that the products themselves don’t become the source of trouble. With consumer credit, this means that terms hidden in the fine print or obscured with incomprehensible language, reservation of all power to the seller with nothing left for the buyer, and similar tricks have no place in a well-functioning market.  A credit-card holder who goes on an unaffordable shopping spree should bear the consequences, as should someone who buys an oversize house or a budget-busting new car. But most consumers—those willing to act responsibly—would thrive in a credit marketplace that makes costs clear up front. And for the vast majority of financial institutions that would rather win business by offering better service or prices than by hiding “revenue enhancers” in fine print, the CFPA would point the way to an efficient and more competitive financial system.

Endnotes

1. Rick Brooks and Ruth Simon, Subprime Debacle Traps Even Very Credit-Worthy, Wall Street Journal (Dec. 3, 2007); Financial Services in Distressed Communities, Fannie Mae Foundation (Aug. 2001).
2. See James M. Lacko and Janis K. Pappalardo, Improving Consumer Mortgage Disclosures: An Empirical Assessment of Current and Prototype Disclosure Forms, Federal Trade Commission Bureau of Economics Staff Report (June 2007) (online at www.ftc.gov/os/2007/06/P025505MortgageDisclosureReport.pdf).  For example, 95% of respondents could not correctly identify the prepayment penalty amount, 87% could not correctly identify the total up-front charges amount, and 20% could not identify the correct APR amount.
3. See Brian Bucks and Karen Pence, Do Homeowners Know Their House Values and Mortgage Terms?, Federal Reserve Board, at 26-27 (Jan. 2006) (online at www.federalreserve.gov/pubs/feds/2006/200603/200603pap.pdf).
4. U.S. Department of Housing and Urban Development, News Release (June 27, 2005) (online at www.hud.gov/news/release.cfm?content=pr05-091.cfm).
5. For a more detailed discussion of the difficulties customers face in trying to decipher their credit agreements, see Oren Bar-Gill and Elizabeth Warren, Making Credit Safer, University of Pennsylvania Law Review (2008) (online at www.pennumbra.com/issues/article.php?aid=198).  The research from that paper is summarized here.
6. Brian Grow and Robert Berner, About that New, “Friendly” Consumer Product, BusinessWeek (Apr. 30, 2009); Mitchell Pacelle, Putting Pinch on Credit Card Users, Wall Street Journal (July 12, 2004).  For example, Citibank’s credit card agreement was about 600 words—one page of normal type.
7. Alex J. Pollock, The Basic Facts About Your Mortgage Loan (online at http://www.aei.org/docLib/20070913_20070515_PollockPrototype.pdf).

Elizabeth Warren
Professor Elizabeth Warren is the Leo Gottlieb Professor of Law at Harvard University and the Chair of the TARP Congressional Oversight Panel. She has written eight books and more than a hundred scholarly articles dealing with credit and economic stress, and she first developed the idea for a Consumer Financial Protection Agency and has been one of its leading activists.  Time named her one of the 100 Most Influential People in the World in May 2009, and the Boston Globe named her “Bostonian of the Year” in December 2009.

The views expressed in this paper are those of the author and do not necessarily reflect the positions of the Roosevelt Institute, its officers, or its directors.