The financial crisis revealed many sins in the financial system, but reform without effective regulation of consumer lending is a crisis gone to waste.
Lending practices that the industry celebrated as a triumph of "innovation" have cheated borrowers, bankrupted lenders and plunged the nation into the worst recession since the Great Depression.
An undeniable lesson is that trapping borrowers in debt they cannot repay will eventually become a problem for the lender.
For years, the industry's justification for every consumer credit practice was the same: "innovative" credit terms that might appear predatory to the unsophisticated made it possible to extend needed credit to consumers who were excluded from traditional lending.
A generation ago, there was ample need for innovation in lending practices. Bankers followed the advice to "know your customer" by joining the country club and literally drew red lines on city maps around neighborhoods in which banks would not lend.
Lenders developed more objective measures of creditworthiness than a borrower's social standing, and more flexible credit practices extended credit to underserved groups, all useful innovations.
But the financial crisis has diminished the appeal of financial innovation.
Subprime mortgages, credit-default swaps and structured investment vehicles helped inflate the housing bubble, dodged regulations and created risks that were dimly understood by regulators, investors or even by the directors and CEOs of the companies that created them.
"One could be forgiven for concluding that the assumed benefits of financial innovation are not all they were cracked up to be," Fed Chairman Ben Bernanke said recently.
Differentiating between beneficial innovation and harmful products, deciding where the bath water ends and the baby begins, should be routine for a regulator, but none of the 10 existing federal financial regulators have that as their primary assignment and all 10 have done an abysmal job of it.
President Obama has joined the call for a new financial product regulator modeled on consumer product safety.
Elizabeth Warren, a Harvard law professor, argues that the Consumer Product Safety Commission would prohibit the sale of a toaster that had a one in five chance of bursting into flames, but financial regulators, until very recently, allowed subprime loans that had similar odds of going to foreclosure.
Just as the Consumer Product Safety Commission would not be persuaded that the manufacturer was bringing the dream of toaster ownership within reach by saving money on the toaster's wiring, neither would the commission expect consumers to examine the toaster's wiring themselves.
The toaster example drives home an obvious point: the dense legal language in a mortgage is as incomprehensible to most consumers as a toaster's wiring, but financial regulators left consumers to fend for themselves.
The Consumer Product Safety Administration can require manufacturers to withdraw unsafe products from the market, but other industries must win their regulator's approval before selling new products in the first place. Before the FDA approves a new drug, manufacturers conduct extensive clinical trials to show that the product is safe and effective.
Whatever the failings of the drug industry, we cannot blame them for failure to innovate.
Requiring public disclosure about new retail financial products would cure other ills. Subprime lending exploded in an almost entirely unregulated corner of the financial industry. The worst subprime mortgage lenders were generally not banks or thrifts subject to federal regulation, but unsupervised independent lenders that immediately sold the mortgages to unsupervised investment banks. Financial regulators did not learn how pervasive predatory mortgage lending practices had become until the damage was already done. We cannot let ourselves be blindsided again.
To that end, Rep. Bill Delahunt, D-Mass., and I have introduced the Consumer Financial Product Safety Commission Act, which would establish an independent federal regulator to protect consumers against abusive retail credit and debit products. And the new regulator would be much less likely to get too cozy with the financial industry if the regulator's work is all done in broad daylight.