Wednesday, July 29, 2009

Consumer Financial Protection, Understandable Disclosure and Financial Education

Congress has developed a 10-member commission to determine the causes of the financial crisis. The commission will be chaired by former California State Treasurer Phil Angelides and former Ways and Means Committee Chairman Bill Thomas will serve as vice chairman. As we await the findings of the report, there are certain observations that we can make. Firstly a “pricing correction” can occur when investors least expect it, in any sector—real estate, insurance, and, of course, banking. Secondly, the federal government will provide an infusion of necessary capital when certain companies that are viewed as “too big to fail” are on the precipice of a financial meltdown. Thirdly, despite federal disclosure laws, investors are not always given “understandable disclosure” that allow investors to adequately comprehend investment options and to make reasonable investment decisions. For example, whether lenders adequately explain the intricacies between a fixed rate 30-year mortgage vis-à-vis a 3-5-or-7-year adjustable rate mortgage to potential homeowners is never clear. Presuming that lenders do provide adequate explanation of loan terms, a fundamental question remains– does the average investor “sufficiently understand” the loan terms to make a “reasonable” decision as to what is best for him or her?

It is this disconnect between disclosure, understandability and reasonable decision-making, which challenged Professor Elizabeth Warren to propose the creation of the Consumer Financial Protection Agency Act of 2009 (“CFP”). Congress has been listening to Professor Warren and it appears as if the proposed Consumer Financial Protection Agency Act of 2009 will likely be adopted. CFP will have regulatory authority over retail financial products including mortgages and credit cards. CFP’s principal directive is to ensure that consumers “have, understand, and can use the information they need to make responsible decisions.” CFP will accomplish its goal by doing more than simply providing information to the public; it will develop “standard” consumer financial products that consumers can compare to financial products offered by the private sector. More importantly, CFP can prohibit the private sector from offering to sell financial products in the marketplace that create “substantial injury to consumers” which is “not reasonably avoidable by consumers” such as the rapid loss of home values, in part due to, underwriters’ over-valuation of homes.

As part of CFP’s consumer protection mandate, it will design standard plain vanilla financial products that should be offered to potential borrowers along with the more exotic financial products offered by private sector lenders. More importantly, CFP has the authority to require that private lenders modify the terms of their financial products that would create “substantial injury to consumers” which is “not reasonably avoidable by consumers. Some commentators have argued that consumers will more than likely select the CFP financial product in lieu of the private sector financial products. However, private lenders that sell CFP designed standard vanilla financial products will be insulated from lawsuits, that is, to say they will be to a large extent, litigation-proof. Protection from litigation is a major advantage for the private lenders, because it shifts the investment risks including interest rate fluctuation, corporate wrongdoing, and poor financial product design, to the consumer. This is not the case for private lenders that sell their financial products despite modifications that CFP may have required the lenders to make to their financial product terms. They are not protected from litigation. Consumers are free to sue such private lenders for any wrongdoing in which a lender may have engaged. We seem to have gone from one extreme to another. I am not certain as to what the correct answer should be. However, a more balanced alternative should at least be considered.

Additionally financial education has been pushed to the forefront of the consumer financial protection debate; the Treasury Department recently issued a white paper that concluded consumer finance can be based on actual data “about how people make financial decisions.” The findings of the research indicated that a majority of consumers do not make reasonable decisions because they cannot understand financial product terms. This should not be a surprising discovery to any one involved with the financial and securities industries. The Financial Regulatory Administration Investor Education Foundation has been providing and sponsoring investor education and research programs for years. [link]Several years ago, I was appointed as the inaugural director of the St. John’s University School of Law Securities Arbitration Clinic (“Clinic”). In addition, to representing small investors in securities disputes with their financial advisors, the Clinic provided financial literacy seminars to the public. The Clinic captured a great deal of empirical data from investor questionnaires, interviews, and intake sheets that reflected a dearth of basic understanding of investment terminology. Nevertheless, these investors were usually categorized by their financial advisors as having an aggressive investment profile with a high risk tolerance. It was always a mystery to me as to how these small investors could be so grossly mis-categorized as to their risk tolerance. Oftentimes, it was simply a matter of an investor misunderstanding what the investment term actually meant. For example, “aggressive profile” does not relate to a personality trait. It relates to whether an investor can withstand the financial and emotional upswings and unpredictable downswings of their investment. It seems almost laughable but many, many investors do not understand the meaning of such basic investment terminology. More importantly, a misunderstanding of this magnitude usually resulted in an investment loss because the investor is inappropriately invested based on his risk profile. Therefore, if consumer financial protection is to be effective, financial education must be an integral part of consumer financial protection.

Financial education should not be left to federal agencies and business schools to provide. Consumer financial protection overlaps commercial, investment and legal issues. Law schools can play a pivotal role in providing financial education programs to the communities within which they are located. I have encouraged law students at St. Thomas University to provide financial education seminars to under-served communities in South Florida with the cooperation of the Federal Reserve Bank of Georgia and War on Poverty FL-Inc. In a time when many law schools are incorporating practicum components to their law school curriculum, financial education programs appear to be the proverbial win-win because the program benefits law students by providing them with a better understanding of the financial world in which they will be practicing attorneys, and the program unquestionably benefits the consuming public.


  1. Professor Pierre-Louis raises an interesting perspective regarding disclosure, understandability and consumer education. The real estate crash would not have been as extensive, if howeowners understood the mortgage terms. But education alone is not the answer. Legislation and regulation with real penalties is going to be the key.

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  3. Mortgage brokers in Florida are not trained to provide the best services for their clients, they are trained to maximize commissions. Having completed the 24-hour licensing requirement to become a certified mortgage broker we are taught where to include extra points that are straight commissions carved out by the legislator. There is no financial background requirement to become a licensed mortgage broker just a 24 hour class. The training doesn't even include all the products that are available to their clients. So you are left with people who know little more than the clients themselves pushing mortgages.

    Why would a mortgage broker tell a client it's better to get a fixed interest rate when 1) you will come back to us to refinance when it adjust too high; and 2) if you refinance within a certain number of years there is a $15,000 prepayment penalty that goes to the broker not the bank. It would be different if they followed torts duty to disclose. Even realtors have a fiduciary duty I have yet to see one single form from a mortgage broker disclosing a duty.