Elizabeth Warren: Perfect for a Job She Created

Elizabeth Warren
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Elizabeth Warren

Can Mary and Elizabeth remake the financial world for consumers?

Mary Schapiro of the SEC has tried to help consumers.

They just might, if Elizabeth can get the job.

The women referred to are not the queens who, you may recall, did not get along too well. Their dispute ended badly for Mary.

Mary is Mary Schapiro, the chairwoman of the Securities and Exchange Commission, which this week moved to open up more price competition in the selling of mutual funds, and soon will deal with the issue of just how much responsibility a stock broker has to act in a client’s best interests.

Elizabeth is Elizabeth Warren, the Harvard law professor who dreamed up the idea for the Bureau of Consumer Financial Protection, which became law when President Obama signed the Dodd-Frank law this week.

Whether or not she is named to run the bureau may depend on how willing the president is to anger the banks yet again, and whether he is willing to risk a big confirmation battle in the Senate. There may be people less popular in bank boardrooms than Warren, but none come immediately to mind.

"If he [the president] names Warren, and she wins confirmation, she and Schapiro could become a dynamic duo in reforming Wall Street."

In making the decision, the president may want to keep in mind that those two organizations, the SEC. and the new bureau, will be largely responsible for the actions that will make the Dodd-Frank law visible to most Americans by the 2012 election.

Other provisions of the law—creation of a financial stability panel, a more transparent derivatives market, limits on bank risk-taking through proprietary trading, a new way to liquidate big banks—will be really noticed only if they fail and we get a new financial crisis. But the bureau and the commission could change the way financial products are sold and make it easier for those who are cheated to get compensation.

Molded by its First Boss

The bureau, more than most new agencies, is likely to be molded by its first boss.

While the average new agency is created by a law that gives it a bunch of duties no one had before, this agency is supposed to enforce laws long on the books that were enforced poorly, if at all, by the bank regulatory agencies. It will also establish new rules.

Never has the Biblical adage of “No man can serve two masters” been better proved than in bank regulation. The first duty of bank regulators is to protect the safety and soundness of banks, and it is easy to see why protecting consumers from hidden fees and unfair practices might seem to threaten bank profits and be contrary to the goal of healthy banks. To say the bank regulators neglected consumer protection is to be kind.

Logically, the belated discovery that financial consumer protection needs to be increased might have led to increased powers for the SEC, which was created to protect investors. But it stumbled badly in recent years, and that idea does not seem to have occurred to anyone.

Schapiro’s move this week was to do something that sounds just like what Warren would propose for banks: Bring fees out into the open, so everyone can see them.

The SEC proposed rules to change the cozy system that lets “no load” mutual funds charge sales fees, known in the business as 12b-1 fees, that are taken from an investor’s profits year after year. Under the proposal, the fees would be above board, and differing brokers selling funds could discount them if they chose to compete that way.

The commission will soon move to consider the issue of whether to require brokers to have a “fiduciary duty” to investors, meaning they would have to offer advice they believed to be in the customer’s best interest. Such consideration is required by the new law, and how far the commission goes could help to determine just how consumer-oriented it is.

The most notable enforcement case of Schapiro’s tenure can be read as an indication that she cares deeply about such issues.

"Such Sophistry Must End"

Under current law, brokers serving retail investors are held to a limited standard requiring that investments be “suitable” to the buyer. But brokers for institutional investors have not faced even that minimal rule. That freed brokers to let clients view them as trusted advisers when pitching an investment. If and when the product blows up, the broker disclaims any responsibility for the bad investment decision made by the customer. The broker was simply a “counterparty” who took the other side of a trade that the customer wanted to do.

That essentially was Goldman Sachs’s defense when the commission filed suit against it over a disastrous mortgage-backed securities deal that Goldman sold without telling customers that it had been partly created by the firm that wanted to bet it would fail. Goldman’s settlement helps to establish a precedent that such sophistry must end. The history between the banks and Warren goes back for many years. In their first epic battle, which lasted for nearly a decade, the banks scored a decisive victory. Their win, alas, was a pyrrhic one that led to hubris, bad lending practices and big losses.

In 1994, the Congress established the National Bankruptcy Review Commission, which was to suggest changes in the law. Warren, whose detailed research into why people file for bankruptcy is respected even among some of her critics, became the principal staff member for the commission, and soon ran afoul of the banks.

The banks wanted legal changes to make it harder for bankrupt people to escape credit card debt. The commission decided not to back most of what the banks wanted and to suggest a few things the banks hated.

Audits of Some Claims by Lenders

The commission suggested weaker protection for mortgage lenders who lent out more than a home was worth. To combat what it saw as abuses by both debtors and creditors, the commission proposed changes like requiring audits of some claims by lenders and limiting the ability of banks to get borrowers to voluntarily reaffirm debts.

Mary L. Shapiro
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Mary L. Shapiro

Even before the report came out in 1997, the banks had called on Congress to ignore the commission and pass a bill to crack down on consumer abuse of lenders. It took years, but in 2005, Congress passed and President George W. Bush signed the new law, called the Bankruptcy Abuse Prevention and Consumer Protection Act. The banks got pretty much what they wanted.

That act, in fact, did anything but protect consumers. Credit card lending had grown rapidly before it was passed, but it accelerated afterward. Banks thought there was new safety in lending to dubious credit risks because those borrowers could not use the bankruptcy laws to renege if they went broke.

That orgy of lending ended with the financial crisis. It is possible, even likely, that if the bankruptcy law passed in 2005 had been less friendly to the banks, they would have been less careless in their lending and lost less in the end.

Warren is one of the more intelligent people I know. She is not among the more diplomatic, which is a major reason she may not get the job. As chairwoman of the Congressional oversight panel on the bank bailouts, she has sometimes angered Treasury officials.

"Sharp Practices" that Hurt Consumers

In a law review article calling for a financial consumer protection agency, she and a colleague explained the need as follows: “Thanks to effective regulation, innovation in the market for physical products has led to greater safety and more consumer-friendly features. By comparison, innovation in financial products has produced incomprehensible terms and sharp practices that hurt consumers and reduce social welfare.”

There are more polite terms than “sharp practices” that she and her co-author could have used.

With the new law now enacted, liberal and labor groups are publicly demanding that Warren be appointed. Financial companies are doing their best to persuade the administration that she could not be confirmed.

The quandary faced by President Obama is reminiscent of one that confronted President Franklin Roosevelt after Congress created the SEC in 1934. Then the president turned aside pleas from those who had pushed for reform and named Joseph P. Kennedy, a man who knew about financial industry abuses because he had taken part in them, as the commission’s first chairman. Ferdinand Pecora, whose investigations had created the clamor for reform, was made a member, not the chairman, and he soon left the commission.

President Obama has no such ready compromise. The new office has a director, not a board, and it is hard to imagine what runner-up position could be offered to Warren.

The president could choose someone who will not ruffle too many feathers, and in the process avoid yet another Senate floor fight.

But if he names Warren, and she wins confirmation, she and Schapiro could become a dynamic duo in reforming Wall Street.