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Why Obama's Bank Shakeup Won't Save Consumers

If President Obama gets his way, there will soon be a new government agency designed to protect you from risky financial products, the same way the Consumer Products Safety Commission keeps you safe from exploding toasters and toys that choke toddlers.

As part of his planned overhaul of the entire financial regulatory system, Obama has proposed creating an entirely new agency, the Consumer Financial Protection Agency (CFPA), to oversee consumer loans and investment products. While the new agency’s powers have yet to be fully defined, references to the need for “transparency, fairness, and appropriateness” for financial products hint at some kind of FDA-like testing process that all mortgages and investment products would have to undergo before they could be sold to the general public. The proposal also mentions the idea of requiring the vendors of those products to adhere to “higher standards” of conduct.

While financial services companies are likely to protest this initiative vigorously, the creation of such an agency seems fairly likely to win approval from Congress. But while the CFPA might make you feel more confident that you aren’t being ripped off by your lenders and investment managers, the reality is that no agency, however powerful, can save you from yourself if you don’t know what you’re doing.

First, some background: One of the CFPA’s biggest advocates is Harvard law professor Elizabeth Warren, who heads the Congressional Oversight Panel overseeing the U.S. banking bailout and who is widely expected to become the CFPA’s first head should Congress follow through on its creation. In an article in Harper’s she co-wrote last November, Warren wrote that while baby strollers are rigorously safety-tested, consumers are left unprotected as they try to navigate “the complex and constantly evolving” financial markets. “It’s time we created an agency whose purpose would be to protect homebuyers and investors from finance’s most dangerous offerings,” she proclaimed.

In Warren’s vision, such an agency could scrutinize new products in search of hidden fees, bait-and-switch sales tactics, or signs that a product contains more risk than its vendors advertise. If regulators spotted a problem, they could give that vendor a period of time to clean up its act and would only intervene if the bank or mortgage lender didn’t follow through.

But while Warren frets about the sale of financial instruments “designed to create a false sense of safety,” a consumer protection agency like the CFPA wouldn’t necessarily be a panacea for those woes. At worst, it could deflect attention from real problems that fall outside its scope, or even create new ones. Here are some of the potential challenges it faces:

1. Additional regulation is not always the best solution

There are already plenty of agencies regulating the financial services industry and while they don’t have the words “consumer protection” in their names, that’s the essential reason for their existence. Of course, they haven’t done their jobs very well of late. The SEC could have paid attention to the whistleblower who repeatedly tried to alert them to Bernie Madoff’s Ponzi scheme, for example. And the Office of Thrift Supervision (OTS) could have done more than just stand by, watching benignly, as Washington Mutual and IndyMac sold high-fee, high-risk mortgages to consumers and ramped up their leverage to boost profits.

Both the Federal Reserve and the OTS have had the power to curtail “unfair and deceptive” lending since the 1970s, points out Oliver Ireland, a Washington-based partner at law firm Morrison & Foerster; that would have covered some of the problematic mortgages. “They chose not to act,” Ireland says, noting that the Fed has had the power to pass rules on high-cost home loans for some time, but only got around to doing so last summer.

Adding yet another regulator to the mix wouldn’t necessarily fix things and could make them more muddled. A better strategy might to give new leadership, a new mandate, and more resources to existing entities.

2. The risk of unintended consequences

Every law or regulation has its unintended consequences. When Alan Greenspan kept interest rates artificially low for so long earlier this decade, for example, he didn’t intend — or even expect — the result to be such a massive asset bubble. Now the Obama administration promises that the CFPA will help promote transparent financial markets through more complete disclosure. In the wake of a financial markets crisis spawned in part by speculation involving complex and opaque derivative securities, that sounds wonderful. But there’s also a risk that Washington could go too far in the other direction.

Harold Evensky, a veteran financial adviser, loves the concept of more candid disclosure from companies selling financial products. But he’s worried that the CFPA’s simultaneous emphasis on simplified disclosure might mean that he will get less information than he needs to reach a decision about a new financial product. “They could end up eliminating what they see as unnecessary detail in the name of simplicity, but that detail is what I need to have,” he says.

Similarly, the possibility of outlawing overly complex products or strategies worries Evensky, whose wealthy clients rely on them. “Properly used, they can help manage complex risks,” Evenksy says. “Financial products aren’t always simple, but that doesn’t mean they are ‘bad’ or unnecessary.”

3. You can’t be protected from everything

Fear and greed shape your decisions about the financial products you consume as much as those of the Wall Street institutions that pitch them. And while a new consumer protection agency might prevent the financial industry from trying to sell high-risk products, it can’t stop you from making decisions that aren’t in your best financial interests. In the long run, then, a big push for greater financial literacy may be more helpful than an agency like the CFPA. After all, representatives from the agency aren’t going to be on call whenever you need them to help you decide what mutual funds to buy in your 401(k) plan this year, or whether a particular mortgage structure is right for you.

In her essay proposing the creation of a CFPA-style entity, Warren noted that 60 percent of consumers that were sold a sub-prime mortgage could have qualified for a conventional mortgage. If a new agency can teach consumers to be more informed and skeptical of mortgages and investment products, then perhaps there will naturally be fewer toxic mortgages and exploding savings products sold.

In the end, consumer protection can only go so far; after that, it’s up to you to watch out for yourself. “I have all my fingers and toes crossed that [the CFPA] works,” says Evensky. “But investors also have a responsibility to look out for themselves; no agency can protect everyone against everything.”

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