Protecting Consumers against Another Failure of Government

The House Financial Services Committee today held a hearing on consumer protection as part of a financial regulatory overhaul. In particular, the committee explored the creation of a dedicated agency called the Consumer Financial Protection Agency.

But before Congress creates a new entity that adds to the alphabet soup of regulatory bodies in Washington, it should take a good, long look in the mirror. Federal government policy and regulation played a sizable role in the generation of the housing bubble, and the subsequent bust that sent financial markets into a tailspin. Congress can best protect consumers by undoing many of the harmful policies that fueled the crisis in the first place.

For Congress to do that, it must rethink its steadfast promotion of homeownership, which has long been a bipartisan goal. The Democratic chairman of the committee, Barney Frank, has championed homeownership throughout his career. A keystone of President Bush's "ownership society" was the promotion of homeownership, and, indeed, the Bush administration touted rising homeownership rates during its terms as an economic and social success story.

The government needs to bury forever the government-sponsored enterprises that helped fuel the boom.

But in putting its meaty thumb on the scale in promoting homeownership, the federal government helped fuel the bubble and is partly responsible for the problems the nation now confronts.

So what will help?

Here are a few ideas.

For starters, Congress should support counter-cyclical loan-to-value ratios--that is, more stringent loan requirements during boom times and relaxed requirements in down times. This will be difficult for Congress because it means making the purchase of a home more difficult at times. There is ample evidence that during the housing boom, as asset prices rose, the federal government pushed lenders to ease standards so those Americans being priced out of the market could "afford" a home. This led to lower down payments, the explosion of ARMs and riskier lending practices. But during a housing boom, it is helpful if loan-to-value requirements become more stringent to keep a bubble in check--even if that means some Americans are priced out of the market.

Several witnesses at the hearing mentioned the role that the credit ratings agencies played in the boom. The agencies gave their seal of approval to risky mortgage-backed securities. Ed Mierzwinski of U.S. PIRG, a consumer advocacy group, said "much more regulation of credit rating agencies" was required. But the witnesses and committee members seem largely oblivious to the fact that the failures of the credit rating agencies were another example of regulatory failure.

The three major ratings agencies amount to a government-sponsored cartel. And therein lies the problem: Large institutional investors who are forced by law to rely on the agencies are harmed when there is no competition.

As my colleague John Makin put it in a recent paper:

[T]he designers of derivative securities effectively collaborated with the rating agencies, such as Standard & Poor's and Moody's, that were relied upon (often through government mandate) by pension funds and other gigantic repositories of wealth with identifying the securities safe enough to invest in. A situation in which creators of derivatives provide the monetary compensation for the very agencies that are tasked with determining the riskiness of their securities hardly constitutes a competitive market. Indeed, it constitutes dangerous collusive behavior.

But these ratings agencies were the only game in town--large institutional investors could not rely on securities analysis from competitor agencies to make their decisions. Imagine a competitor to Moody's or others blowing the whistle on the risks in these securities. It might have happened had the market been less regulated. If Congress wants to help consumers, it should open up the market for ratings.

Last, the government needs to bury forever the government-sponsored enterprises that helped fuel the boom. In the run-up to the bust, Congress enjoyed having considerable influence over Fannie Mae and Freddie Mac because they could be manipulated to serve political ends. But their public-private structure turned out to be another instance of regulatory failure. No entity can, over the long run, successfully serve the whims of Congress on the one hand and the interests of private shareholders on the other. To best help consumers, Congress should learn from this mistake by de-politicizing the housing market, starting with Fannie and Freddie.

This just scratches the surface, but it gives some sense of the steps Congress can take to help consumers. And it doesn't require the creation of a new regulatory entity.

Nick Schulz is the DeWitt Wallace Fellow at AEI and the editor-in-chief of

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