Mortgages, Neckties and Toasters. What Will They Think of Next?

Serious economists are now arguing that we should not reflexively celebrate “innovation” in the financial sector as we do innovation in the real economy. I was ahead of my time. I said the same thing almost two years ago, and people laughed at me.

Okay, that may have had something to do with how I said it.

When the House debated predatory mortgage lending legislation on November 15, 2007, I responded in an extemporaneous floor speech to Republican arguments that the legislation would throttle innovation in the financial sector, using an example of innovation in the real economy that was within my reach:

Now, several speakers have said that they think the consumers should make choices, there should be a variety of choices available to consumers. Sometimes they say that this bill will shut down market innovation. Americans are for innovation, Mr. Speaker, just as they are for reform. Americans are fundamentally reformers. So politicians have figured out to call everything they do a reform. However obviously contrary to the public interest it is. And now American business has learned to call everything they do an innovation, regardless of how bad it hurts consumers. I can think of many wonderful innovations. When we think of an innovation we think of a scientist in a lab coat coming up with new products...Mr. Speaker, this necktie is an innovation. Ten years ago you could not buy a silk necktie that was stain resistant. And for those folks like me who tended to miss their mouth from time to time, the cost in new neckties in any given year was hundreds of dollars. But this tie has a nanotechnology process that causes liquids to bead up and roll off rather than soak in and stain. Mr. Speaker, this necktie is an important innovation to me.

But what on earth do we mean when we say that a mortgage is innovative? It means, simply, Mr. Speaker, that there is no end to the variety of terms, there is a proliferation of indecipherable terms that are not designed to help consumers.

Alan Greenspan called them “exotic loans.” Others have called them “toxic loans.” The innovation is not really about allowing consumers to tailor narrowly the loan they get to their specific circumstances. The late Ned Gramlich, a well regarded former Federal Reserve Board Governor asked why was it that the riskiest loans were being sold to the least sophisticated consumers? It was a rhetorical question, Mr. Speaker. He knew the answer. He knew those loans were being sold to people to take advantage of them, to separate from middle class homeowners more and more in equity in their home, to trap them in a cycle of having to borrow and borrow again, every time they borrowed losing more of the equity in their homes.

My floor remarks attracted some press attention, but the tone was not so much that I had made a telling, insightful argument, but that my comparison of neckties to mortgages was...well... kind of goofy. Roll Call, a Washington political trade rag, ran this snide item in their gossipy “Heard on the Hill” column:

Spotless Speech. Rep. Brad Miller has an innovative metaphor for innovation. Not content to fall back on dusty old metaphors like putting a man on the moon or curing polio, the North Carolina Democrat on Thursday praised that most crucial emblem of man’s progress: the stain-resistant necktie. In trying to knock down the idea that risky mortgages are “innovative” financial products during the House debate over home-lending legislation, Miller sought to put a finer point on what exactly progress means.

“Mr. Chairman, this necktie is an innovation,” Miller announced on the House floor, motioning to his own tie. “Ten years ago, you could not buy a silk necktie that was stain-resistant. And for those folks like me who tend to miss their mouth from time to time, the cost in new neckties in any given year was hundreds of dollars. But this tie has a nanotechnology process that causes liquids to bead up and roll off rather than soak in and stain. This necktie is an important innovation to me.”

Wow, non-technology that allows messy guys to keep their ties spotless. And still, no run-free pantyhose? Now that’s what HOH would call innovation.

But Paul Krugman, a Nobel laureate in economics, recently made almost exactly the same point, that innovation in consumer financial products is way overrated:

There’s no longer any reason to believe that the wizards of Wall Street actually contribute anything positive to society, let alone enough to justify those humongous paychecks.

Remember that the gilded Wall Street of 2007 was a fairly new phenomenon. From the 1930s until around 1980 banking was a staid, rather boring business that paid no better, on average, than other industries, yet kept the economy’s wheels turning.

So why did some bankers suddenly begin making vast fortunes? It was, we were told, a reward for their creativity — for financial innovation. At this point, however, it’s hard to think of any major recent financial innovations that actually aided society, as opposed to being new, improved ways to blow bubbles, evade regulations and implement de facto Ponzi schemes.

Consider a recent speech by Ben Bernanke, the Federal Reserve chairman, in which he tried to defend financial innovation. His examples of “good” financial innovations were (1) credit cards — not exactly a new idea; (2) overdraft protection; and (3) subprime mortgages. (I am not making this up.) These were the things for which bankers got paid the big bucks?

And James Kwak, another serious economist, argued at The Baseline Scenario that innovation in the financial sector is fundamentally different from innovation in the real economy:

Ordinarily, if an industry innovates, a few people make a lot of money, and then most of the benefits flow to that industry’s customers. Let’s take one of the greatest examples of recent history: Microsoft and Intel together probably created a handful of billionaires and a few thousand multi-millionaires out of their employees; but for at least the last ten years, no one going there has gotten anything more than a decent salary and a good resume credential. As computers get smaller, cheaper, and faster, the benefits flow overwhelmingly to their customers – to us. And those are near-monopolies. The general pattern in the technology industry is that a few entrepreneurs make a lot of money, and the vast majority of people make a decent salary; even the highly-educated, highly-trained, hard-working software developers, most of whom could have been “financial” engineers, are making less than a banker one year out of business school.

That’s the way innovation is supposed to work. You invent something great, you make a lot of money, then your competitors copy you, prices go down, and the long-term benefits go to the customers. And you and your competitors all get more efficient, meaning that you can do the same amount of stuff at a lower cost than before. If you want to make another killing, you have to invent something new, or at least invent a better way of doing something you already do.

Kwak said that “by contrast, the historical pattern of the financial sector...[was] rising revenues, rising profits, and rising individual compensation.” “Sure, prices fell on some financial products,” Kwak said, “but financial institutions encouraged substitution away from them into new, more expensive products, with the net effect of increasing profitability (and compensation).”

Congress will soon begin considering new “systemic risk” regulation of the financial sector to protect the financial industry from itself. But we have to do more than just keep “the wizards on Wall Street” from running with scissors again. We need to make sure that their “innovations” actually benefit society, not just increase profits and compensation in the financial industry.

Elizabeth Warren, a Harvard law professor, has famously urged that Congress create a new Financial Products Safety Commission, patterned after the Consumer Products Safety Commission. Warren compares a toaster that is likely to catch fire and cause the consumer’s house to burn down, which the Consumer Product Safety Commission would view with grave disfavor, to a subprime mortgage that is equally likely to result in the home’s foreclosure, which appears to be of no particular concern to any existing regulatory agency. A toaster manufacturer could puff up and argue that by using wires without insulation inside the toaster, they can make the dream of toaster ownership possible for millions of Americans who were denied that dream in the past. The Consumer Products Safety Commission would probably not be impressed, even without examining whether the savings on the wires actually reduced the cost of the toaster to consumers or just increased the profit for the manufacturer. Bill Delahunt and I have introduced legislation in the House to create such a commission, and Dick Durbin, Chuck Schumer and Edward Kennedy have introduced identical legislation in the Senate.

So why did my comparison of a mortgage and a necktie provoke snickering, and Elizabeth Warren’s comparison of a mortgage and a toaster was seen as serious, scholarly insight?

There are some details to work out. The toaster analogy is a persuasive argument for the need to regulate consumer financial products, but the regulation of consumer product safety is not the only model for a regulatory regime. Daniel Carpenter, a government professor at Harvard, argues that consumer financial products should be subject to a prior approval requirement like the approval required from the Food and Drug Administration for a new pharmaceutical, complete with consumer testing of financial products comparable to clinical trials of new drugs. I have argued that the better model might be approval of insurance policy forms and premium rates under state insurance laws, and state law requirements that insurance companies periodically report their sales of different policies, premium revenues, claims experience and consumer complaints.

The Obama Administration will reportedly include a consumer protection agency for financial products as part of their proposed systemic risk regulation for the financial industry. The Huffington Post said that the idea had moved swiftly from a wonky policy proposal to “near-law.” That’s wildly optimistic. The industry is adamantly opposed, and still has remarkable clout in Congress.

It will be a fierce battle, even with the full support of the Obama Administration. “All of the signature economic reforms the President has promoted...are under siege,” The Nation reports. “Without a grassroots uprising that challenges business as usual in Washington, we aren’t likely to get the change we were promised, much less the change we need.”

We’ve won some battles. A couple of weeks ago the President signed into law the credit card reform bill that Carolyn Maloney introduced. A few weeks ago the House passed a solid bill—not perfect, but solid—to reform mortgage lending that I introduced along with Mel Watt and Barney Frank.
But we can’t possibly anticipate and prohibit every new predatory financial product that the industry claims is “innovation.” Requiring the industry to show that innovative new financial products are a positive contribution to society—and get approval before selling the products to consumers—fundamentally changes an industry desperately in need of fundamental change.

That is the kind of change that we cannot achieve without a “grassroots uprising that challenges business as usual in Washington.”


Thank you, sir.

Consider us uprising.

PS I've worked in around financial services for three decades. Innovation has generally had one of two purposes: (1) operational cost reduction or (2) products designed to hook customers so it's harder for them to leave. And from all I've seen lately, nothing's changed.

I know what your problem was

You oversimplified. See, all these people in Washington are waaaay too intellectually sophisticated for a story about a necktie - especially the reporters.

Vote Democratic, the ass you save may be your own.

I just wonder why banks aren't satisfied with being banks

why do they have to be "innovating" at all. Aren't they supposed to be careful, studied, risk averse? It's other people's money they are handling after all.

Wasn't that what The Glass-Steagall Act that served us so well for 66 years was all about?

Progressives are the true conservatives.

here'a an additional idea...

...require banks and other financial players to disclose, in their 10-q filings, exactly what the status of their derivitive holdings might be.

as it stands today, not only were financial players failing to disclose the extent of those holdings, some of them appear to have been unaware of exactly what they were holding.

"...i feel that if a person can't communicate, the very least he can do is to shut up." --tom lehrer, january 1965