Warren: Reform Would Even Field for Small Banks

The banking crisis involved Repo 105 accounting, synthetic-synthetic collateralized debt obligations and special purpose entities, but Elizabeth Warren will tell you the real problem wasn't that complicated.

According to her scorecard, banks turned predatory, misled their borrowers and then used their returns to make ever riskier bets. Restoring the system to health, therefore, is less about tinkering with financial architecture than beating the banking industry back into shape from the retail level on up, in her view.

It is not a message that the industry likes to hear, but Warren — a Harvard contract law professor on leave to head the Congressional Oversight Panel for the Troubled Asset Relief Program — has been successful at presenting it. The Oklahoma-raised Warren has compared mortgages with defective toasters, credit cards with snakes and effective regulation with good prairie fencing. She told the Huffington Post that the next best thing to a strong, independent consumer protection entity would be "plenty of blood and teeth on the floor."

Asked to discuss the future of banking and reform, Warren agreed to do so on the condition the interview be conducted via e-mail. She laced into banks for acting so contrary to consumers' interests, but she displayed sympathy for community banks and gave thoughtful answers on the interplay of valuations, homeownership and the broader economy.

Her replies to our questions were lightly edited for space.

Many small banks have claimed that regulators have shown too much deference to big banks while overzealously failing community banks. Do the small banks have a point, and would it be worthwhile looking for ways to give some of them more time?

ELIZABETH WARREN: Of course they have a point. Big banks were largely responsible for creating the risks that brought down the economy, both directly and also indirectly by funding nonbanks that were able to avoid federal rules and engage in particularly reckless behavior. The [proposed] new consumer agency is designed to focus its attention and resources on big banks and, for the first time, on nonbanks. These changes will help level the playing field and take enormous pressure off the small banks.

You've frequently said that Americans know they're being snookered by behemoth financial institutions. If that's the case, why don't the big banks' customers switch to credit unions or small banks?

WARREN: It is simply too hard to sort out the good products from the bad. Citigroup learned that the hard way in 2007, when it decided to clean up its credit card [business] just a little bit by eliminating universal default. Ultimately, Citi's action resulted in lower revenues and no new customers, and so it reversed itself. Citi explained that credit cards were now so complicated that customers couldn't tell when a company offered something a little better, so it went back to something a little worse. In this kind of market, small banks have a tough time showing that their products are better, particularly when they are up against multimillion-dollar advertising campaigns that draw customers to dirtier products.

Banks' reluctance to take writedowns on their own portfolios has been blamed for the underwhelming performance of the Home Affordable Modification Program. But modifications done by servicers without portfolios of their own are performing no better. Is there a reason the Hamp program hasn't worked out, and why are redefaults so high if mods really are being offered too rarely?

WARREN: Redefaults do not mean there are too many modifications. Today's mods are mostly about interest rate reductions, while loan balances remain high or go up, increasing the likelihood of redefaults.

Reducing redefaults will require [the] Treasury [Department] to re-examine its view of affordability. Taxpayer money should not be spent on modifications that are ultimately unsustainable. Sustainability can be improved if lenders will take writedowns. If a modification leaves a homeowner $40,000 underwater, then a family facing other economic stress — a cutback in work hours, a medical problem, a child going off to college — may decide that struggling to pay on that home makes no sense. …Any real solution to the redefault problem must deal head on with negative equity. Otherwise, foreclosures will remain elevated and will exert downward pressure on housing prices for years to come.

You've cited the expansion of credit card terms from 1 page to 30 as evidence of how far the industry has gone off track. Some banks would probably place much of the blame on class actions that hinge on the sort of nitpicky fine print that is in those agreements. Would going back to a one-page version be equivalent to unilateral disarmament for the companies?

WARREN: I have followed class-action litigation, and I can't find the connection you suggest. So far as I can tell, there were no class-action lawsuits that forced credit card companies to protect themselves with double-cycle billing, universal default or $39 penalties for a payment that arrived one hour late. I would be interested in any studies that isolate the amount of "nitpicky fine print" that is the direct result of class-action suits, but so far I haven't found them.

There's been some discussion as to whether a Consumer Financial Protection Agency should be subject to an override from the proposed systemic-risk council, with regulators like John Dugan suggesting that, in some cases, a CFPA might force banks to do things that would increase risk. Is this a concern?

WARREN: It is astonishing to me that Mr. Dugan or anyone else would suggest with a straight face that the new agency could undermine the safety and soundness of banks when it was the lack of rules in the consumer credit market that permitted banks to take on extreme risks, ultimately leading to the near collapse of the entire banking system. Consultation among regulators is critical, but the veto has no precedent and is justified only by the make-believe threat that consumer rules would pose by not letting banks sell deceptive products.

Borrowers facing foreclosure are popularly portrayed as struggling to retain the "American Dream" of homeownership. Is there too much emphasis on keeping people in their homes?

WARREN: In the wake of this crisis, many people — lenders, borrowers, policymakers, academics — are reconsidering the balance between homeownership and renting, and that is a good thing. But it is important to remember that we are also in a sharp economic reversal. With 200,000 homes lost to foreclosure every month and 6 million 60-day or longer defaults, it would be irresponsible to simply say, "Let's cut the number of homeowners" and do no more. Foreclosures depress the prices of other homes, creating a cycle or more foreclosures. So long as the housing market stays depressed, the construction industry and the ancillary home industries, such as furniture and retail home centers, will remain depressed and will keep unemployment high. It is important that the housing market return to prices that are driven by supply and demand, but the current downward cycle could press below that point and impair economic recovery.

Not every homeowner should stay in his home, and many should be moved out to more affordable housing as quickly and cheaply as possible. But it would be hard to fault the current foreclosure programs as "keeping too many people in their homes." In fact, for every one family that Hamp helped into a so-called permanent modification, 10 other home foreclosures went forward. The data are so poor that it isn't possible to know the number of families who, with some reasonable modification, could continue regular payments on their homes, but it is clear that everyone — homeowners, lenders, neighbors and workers — benefits from getting the housing market stabilized.

For reprint and licensing requests for this article, click here.
MORE FROM AMERICAN BANKER