By Edward Harrison

This is the third in a series of posts about ideas for financial reform generated by the “Make Markets Be Markets” conference I attended yesterday in New York City on 3 Mar 2010. You can download all of the written presentations here.

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. -Elizabeth Warren, 3 Mar 2010

After Elizabeth Warren had her chance to speak, the thought on my mind was ‘complexity is the handmaiden of deception.’ That wasn’t the only point of her presentation on consumer protection, but that was the takeaway for me. Her point was simply that contracts are the bedrock of the U.S. legal system in promoting law and order. The purpose of contracts is to support the ‘invisible hand’ by allowing both sides of the contract to walk away happy.

This purpose is thwarted when contracts are designed to promote an information asymmetry which enshrines into law the advantage of one party over the other. The expert understands but the layman does not – and the expert uses this fact to insert terms favorable to him and his associates to the layman’s disadvantage. Ultimately, the system breaks down because of widespread distrust. Opaque and asymmetric contracts diminish from the free market and undermine the invisible hand.

Warren started out by detailing the rise in complexity of credit card agreements. She showed a Bank of America agreement circa 1980. It was one-page in large print and plain English with no hidden language buried within. Today, including riders, a Bank of America credit card agreement is 30 pages of dense legalese with all manner of disclaimers and hidden surprises. She says:

Study after study shows that credit products are deliberately designed to obscure the real costs and to trick consumers. The average credit-card contract is dizzying—and 30 pages long, up from a page and a half in the early 1980s. 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.

This is deception, pure and simple. And you will notice the close relationship between deception and fraud in the definition below.

Etymology: Middle English decepcioun, from Anglo-French deception, from Late Latindeception-, deceptio, from Latin decipere to deceive Date: 15th century 1 a : the act of deceiving b : the fact or condition of being deceived 2 : something that deceives : trick <a clever deception> — de·cep·tion·al \-shə-nəl\ adjective synonyms deception, fraud, double-dealing, subterfuge, trickery mean the acts or practices of one who deliberately deceives. deception may or may not imply blameworthiness, since it may suggest cheating or merely tactical resource <magicians are masters of deception>. fraud always implies guilt and often criminality in act or practice <indicted for fraud>. double-dealing suggests treachery or at least action contrary to a professed attitude <a go-between suspected of double-dealing>.subterfuge suggests the adoption of a stratagem or the telling of a lie in order to escape guilt or to gain an end <obtained the papers by subterfuge>. trickery implies ingenious acts intended to dupe or cheat <resorted to trickery to gain their ends>. –Free Dictionary

The Credit CARD Act of 2009 was passed in part to crack down on this type of deception. But it is clear that the deception is still ongoing, even in credit cards (see here and here). The reason for the deception is clear: money. Banks increasingly rely on fees as a profit center, in part because of the rise of securitization.

But, the complexity and reliance on fees is not just about credit cards. Felix Salmon pointed out an interesting case today where a bank asked for and received authorization to post account debits largest-to-smallest, which allows them to collect overdraft fees for more transactions. Felix says:

On another post, RogerNegotiator finds an astonishing OCC letter, authorizing a bank’s request to adopt largest-to-smallest check posting, thereby maximizing overdraft revenue. (If you have $100 in your account, and put a $1 candy bar on your debit card, followed by a $15 t-shirt, both transactions will end up generating a $34 overdraft fee if a $90 check comes in later in the day: the bank will end up making over $100 in fees that day alone.) The key section in the letter is the last one, entitled “The Bank’s Consideration of the Section 7.4002(b) Factors”. That section lays out four reasons to adopt the practice, and concludes that “the Bank’s process for deciding the order of check posting is consistent with the safety and soundness considerations set forth in section 7.4002(b) and that the Bank may therefore post checks in the order it desires”. What are those four reasons for ripping off consumers so blatantly? The very first one is “projections showing that revenue is likely to increase as a result of adopting a high-to-low order of check posting”. That’s considered a reason to adopt the practice, in the eyes of the OCC. As for the rest of the reasons, they’re mostly ridiculous on their face. I love this one, for instance: The Bank concludes that it needs to adopt the high-to-low order of posting so that customers who frequently write checks against insufficient funds do not do business with the Bank primarily because the Bank’s fee for checks presented against insufficient funds is lower than its competitors’. Essentially, the bank is saying that its competitors have high overdraft fees, and that it doesn’t want to compete against its competitors, so it needs high overdraft fees too. And then there’s this beaut: The Bank states its belief that a high-to-low order of posting is consistent with the majority of its customers’ preferences. The Bank surmises that the intended order, which will result in a customer’s largest bills being paid first, will have the consequence of the customer’s most important bills (such as mortgage payments) being paid first. The Bank thus concludes that a high-to-low order is aligned with the majority of its customers’ priorities and preferences. This is accepted at face value by the OCC, instead of simply being laughed at. Of course, no one bothered to ask the customers, because they knew full well that customers would never say that they preferred this way of doing things. But so long as the bank simply says that customers prefer it, no problem.

This is predatory behavior, but it has been sanctioned by regulators.

Warren mentioned these overdraft fees specifically when she discussed complexity in financial contracts. The average overdraft in America is $17, while the average overdraft fee is $34. Don’t like it? It’s all there in the fine print – take personal responsibility!

She also mentioned the kickbacks hidden in car loan contracts that used car dealers often receive ($1000-$3800 per contract) for steering consumers to a particular lender.

As for mortgages, the same goals of opacity were in effect. A recent post on Baseline Scenario tells us:

First, lenders made loans that virtually invited default. Thus, Countrywide’s manual approved the making of loans that left consumers as little as $550 a month to live on, or $1,000 for a family of four. And lenders qualified borrowers for loans based on a temporary low teaser rate even though they knew that borrowers would not be able to make the higher payments required when the teaser rate expired. Of course, when loans became unaffordable, lenders could anticipate that borrowers would refinance, triggering a new round of fees for lenders-but they gave too little attention to the possibility that the loans could not be refinanced. Consumer protection laws failed to prevent this disaster-in-the-making. Second, the Federal Reserve’s disclosure rules made it impossible for adjustable rate mortgage borrowers-and 80% of the subprime loans were adjustable–to understand the risks they faced. Since the eighties, the Fed has mandated that the disclosures for such loans state figures for monthly payments that are simply wrong. That may have led consumers to believe their loans would be more affordable than they were. One of us recently presided over a survey of mortgage brokers that revealed that many borrowers spent little time reviewing those disclosures and never changed what they did because of them-something that ironically makes sense when the disclosures are misleading.

Again, the borrower is told to take personal responsibility. But, of course, had regulators cracked down on these deceptive practices, the loans could not have been made. Warren’s desire is for a “cop on the beat” to enforce the rules and regulations that our laws have enshrined, rather than relying on personal responsibility and industry self-regulation, even in matters of fraud, as Alan Greenspan wanted to do.

The problem, of course, is bureaucracy. Below is a picture of the present regulatory infrastructure for consumer protection.

There are multiple regulators trying to accomplish a lot of different tasks. Warren’s suggestion is that we need to streamline this, eliminating all the duplication and regulatory overlap, combining all of these mandates in one agency, the Consumer Financial Protection Agency.