Discussion of the financial collapse routinely touches on issues of solvency, liquidity, bundled securities and the collapsing housing market. But it rarely gets at the rampant fraud that helped bring the whole thing about.
A Democratic bill introduced today aims to prevent a recurrence. On Tuesday, House and Senate Democrats, joined by Elizabeth Warren (who heads the commission overseeing the disbursement of bailout funds), announced a bill to create a Financial Product Safety Commission. The body would have oversight of mortgages and other financial instruments just as other commissions regulate the safety of toys, drugs or airplanes.
"In America, we don't say 'buyer beware' when people are buying prescription drugs or when they're concerned about lead paint in toys," said Majority Whip Dick Durbin (D-Ill.), a cosponsor of the bill.
Warren, who has been singled out for seeing the roots of the economic collapse before it happened, highlighted how the commission would work and how it could have prevented the current crisis.
She offered the example of a loan with a low "teaser rate" and an obscured prepayment penalty. "Prepayment penalties are a way to try to fool [borrowers] into thinking the price is $1100 dollars a month -- that's the teaser rate -- when in fact the real price of this product is the equivalent of $1900 dollars a month. And if you try to refinance out of the product, you'll pay a prepayment penalty. That's how the company will make its money. You'll either pay higher interest later on, or you'll pay a prepayment penalty to get out of it."
When the price rises to $1900 a month or higher, the borrower can't refinance, can't make the payment, and goes into foreclosure.
"If there had been an agency, like the Financial Product Safety Commission, that had said, 'You just don't get to fool people on pricing,' then what would have happened is," she said, "there would have been millions of families who got tangled in predatory mortgages who never would have gotten them."
Preventing the proliferation of those loans could have stopped the housing bubble from forming -- and then popping.
"It never would have been as profitable for mortgage brokers and others in the financial services industry to market these products, because they would not have been such high-profit products. If we never would have started at the front end, we never would have fed them into the financial system. So there never would have been this expansion in the housing market, this housing bubble. And more importantly, never the fodder that went in, ultimately, to the mortgage-backed securities that created the credit default swaps and so on through the system," Warren said.
Without all these toxic assets on banks' balance sheets, the institutions wouldn't be on the brink of collapse and the recession would be more manageable. "Consumer financial products were the front end of the destabilization of the American economic system," Warren said.
Sen. Charles Schumer's cosponsorship of the bill is notable because of his proximity to Wall Street. The bill's merit, the New York Democrat said, is that it regulates the actual financial product rather than the company producing it.
He argued that full disclosure -- which the banking industry claims is all that is necessary to educate a borrower -- is no longer sufficient, because banks bury crucial details in fine print scribbled in complex terminology that too many consumers don't or can't read.
"Disclosure is no longer enough," said Schumer. "Just as you wouldn't just have disclosure on drugs, you can't simply have disclosure on financial products. Consumers have been trapped in a business model that's designed to induce mistakes and jack up fees."
In the case of a dangerous drug, he said, no one would consider it sufficient to simply require companies to disclose what chemicals are in it with no oversight as to the drug's safety. "What happened with drugs in the early 1900s is happening with financial products in the beginning of the 21st century," he said.
House cosponsor Bill Delahunt (D-Mass.) referred to the fraudulent products by the mob term "vig" and called the bill "fundamentally a game changer."
Rep. Brad Miller (D-N.C.) said the bill "would allow lenders to make an honest living."
The system is so broken, he said, that the highest-risk products are consistently sold to the people least able to handle much risk. The only explanation for such an outcome, he said, is that somebody's getting conned.
He quoted the late Federal Reserve governor Ned Gramlich to make the case: "Why are the most risky products sold to the least sophisticated borrowers? The question answers itself, Gramlich said. The least sophisticated borrowers are probably duped into taking these products."
Miller had the quote almost word for word. Google turns it up in this Paul Krugman column from 2007, in which Gramlich also adds: "The predictable result was carnage."