One of the great successes of financial regulation in the US is the Truth in Lending Act, passed in 1968, which protects borrowers from predatory lending. In the new financial architecture that will emerge following the current crisis, it is now obvious that we also need truth in borrowing legislation to protect banks and other financial institutions (if we still have any) from predatory borrowing by consumers.
As we have seen, most bankers and investment bankers are expert salesmen and managers but know next to nothing about investing and valuation, putting them at a serious disadvantage in transactions with consumers. This lack of understanding is deeply ingrained in financial institutions. Financial firms hire some of the most brilliant minds in the world to work with sophisticated financial engineering models. These people are very easily deluded into thinking that high returns are due to their own skill instead of luck. They are able to completely block out obvious facts like that a publicly-traded asset that earns a higher return does so because it is more risky. And, they think, how could their high returns be luck if they are paid so handsomely for it? In the past few years, investment bankers made lots of money buying up mortgages for themselves and selling them to their investors, so how could these poor people possibly be expected to know that what they were buying was worth less than they were paying? Clearly, bankers need protection.
Like truth-in-lending laws, the main feature of truth in borrowing legislation should be the provision of information. First, anytime a consumer takes out a mortgage, they should be required to inform the lender that a) a recession might occur during the term of the loan, and b) it is possible that their house will lose value or that they will lose their jobs. This should be written in terms the CEO can understand, such as “The valuation of the collateralized asset may be subject to revision in response to market developments and borrower’s past income is no guarantee of future ability to pay.”
Second, regulators should explain to financial institutions the implications of complex financial engineering. For example, many banks would not be under duress right now if regulators had not passively accepted banks’ confused use of “off balance sheet” entities. Banks should have been told in clear, easy to understand terms that massive losses on these entities would lead to massive losses at the bank. More generally, firms need to understand that complex investments are complex to value and potentially hard to sell because few others are able to value them.
Some argue that we need regulation to keep banks safe. But banks are unfortunately adept at co-opting regulation. For example, just prior to the crisis, the FDIC reduced insurance premia because the banks convinced the Administration regulators that the insurance fund was already large enough. I have tried a similar thing with my homeowner insurance, but my insurance company protected me by explaining to me that if I do not pay, I would not be insured. Our financial sector deserves similar protection.
Originally published at Everything Finance – Kellogg School’s Finance Department Blog and reproduced here with the author’s permission.