By Bill Black, the author of The Best Way to Rob a Bank is to Own One, an associate professor of economics and law at the University of Missouri-Kansas City, and co-founder of Bank Whistleblowers United. Originally published at New Economic Perspectives
Politico has just published a column with a title and analytics that drive white-collar criminologists nuts: “In a major setback for businesses, CFPB opens door to consumer class actions.” Logically, the title should have read: “In an important step forward for consumers, investors, and honest bankers and lenders, CFPB begins to restore the rule of law to banking.”
The CFPB is the acronym for the Consumer Financial Protection Bureau. The problem that led to CFPB to issue its new rule has six parts. First, it is often profitable for lenders to abuse and defraud borrowers. Second, lenders are able to do this because financial understanding is highly asymmetric. Third, even if the borrower eventually spots the fraud or abuse it is rare that the typical borrower could profitably prove the fraud and recover enough funds in a lawsuit to (net of legal expenses) recover effectively and could never recover enough to deter future misconduct. Fourth, the only potential legal remedy for the typical victim to recover and deter is the class action suit.
Fifth, lenders routinely eliminate this potential remedy by requiring in their form contracts that the borrower give up any right to bring a class action suit against the lender. Indeed, they typically forbid the victims of their frauds and abuses to bring any civil suit. They permit only arbitrations in a rigged system that ensures that the typical borrower will rarely find it cost-effective to arbitrate and deterrence is impossible. The Supreme Court, to its shame, has allowed this abusive use of form contracts.
Sixth, the environment I have just described is highly criminogenic. It creates powerful perverse incentives not simply for individual bankers to defraud and abuse their customers, but for such frauds and abuses to become dominant. Elite bankers will gain a competitive advantage by causing the firms they control to abuse and defraud the borrowers. Economists and criminologists refer to this as a “Gresham’s” dynamic. George Akerlof gave it this name in his famous 1970 article on a market for “lemons” that led to the award of the Nobel Prize in Economics in 2001. Akerlof explained that the dynamic is so perverse that it not simply the individual customer who is a victim of the fraud, but also the honest CEO who cannot compete with the cheater. Akerlof further explained that this meant that all of us would suffer as customers in such an industry as it became corrupted.
[D]ishonest dealings tend to drive honest dealings out of the market. The cost of dishonesty, therefore, lies not only in the amount by which the purchaser is cheated; the cost also must include the loss incurred from driving legitimate business out of existence.
Economists and criminologists have a common sense definition of a Gresham’s dynamic – bad ethics drives good ethics out of the markets unless the rule of law prevents it.
Kartik Athreya, an exceptionally conservative economist who is the Richmond Fed’s research director, admitted that Akerlof had demonstrated that asymmetric information could create “spectacular pathologies” and that they were most severe in the lending context. (Economists like Athreya focus almost exclusively on the hypothetical case in which the borrower has superior information compared to the lender, but that is the product of his ideological blinders). As the recent financial crisis demonstrated, it is the CEOs that control our largest and most elite lenders that create and exploit those loans that seem to the unobservant to create an informational advantage for the borrower, i.e., “liar’s” loans. It was overwhelmingly lenders and their agents that put the lies in “liar’s” loans and appraisals as I have demonstrated in many articles.
The Supreme Court and the lending industry have destroyed the rule of law in lending for the typical borrower. The result, as economics and criminology predicts, has been an orgy of fraud and abuse of borrowers. This adds to the profit of firms led by dishonest and abusive CEOs and tends to drive honest competitors out of the business. The way to block the dynamic is to take the profit out of fraud and abuse by lenders by restoring the rule of law. The four strategies that are essential to defeat a Gresham’s dynamic are (1) prosecutions of the elite fraudsters, (2) regulations banning the industry’s odious form contracts requiring borrowers to give up their legal rights to bring class action suits, (3) adopting laws and rules that encourage and protect whistleblowers to come forward and disclose the lenders’ frauds and abuses, and (4) a campaign by honest CEOs to denounce publicly their fraudulent competitors and embrace and require the highest standards of integrity in hiring senior officers and in rejecting compensation systems that create perverse incentives to cheat and abuse the customer. Steps three and four should be combined. The way for lenders to signal their adherence to the highest moral standards is to hire as leaders whistleblowers who have been through the crucible and demonstrated their exceptional integrity.
The CFPB cannot prosecute. The Trump administration has made clear that it intends to withdraw resources from the already inadequate FBI agents and prosecutors dealing with elite white=collar criminals. This makes the CFPB rule restoring the civil rule of law to borrowers all the more essential. The dishonest lenders are baying for the Republican-controlled Congress to block the CFPB’s restoration of your civil law rights. This gives each of us two invaluable opportunities. First, we can push our representatives to refuse to destroy our civil law rights. Second, we have a priceless opportunity to observe how many honest bank and credit card CEOs come forward to defend the CFPB rule to begin restoring the rule of law to lenders and breaking the Gresham’s dynamic that favors the most dishonest CEOs. I am skeptical that we will observe many honest CEOs come forward, but I would be delighted to praise in print any who do so. I make this invitation to all CEOs of lenders; please contact me with your public statement of support for the CFPB rule. I will write to praise your membership in our legion of honor. It will take courage to take on your industry trade associations, which are uniformly opposed to restoring the rule of law to finance.
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It’s not just financially important for the individuals, it is a requirement for the successful functioning of any economy, any society to have the rule of law. There plenty of reasonable arguments to be made for any of the major economic systems even those we today would consider unfair like feudalism. But there must a consistent, reliable, and counted fair system of rules, and laws, otherwise Bad Things happened. See the fall of the Western Roman Empire, or perhaps a number of Chinese dynasties. The general population losing faith in the system has often been the cause of a collapse.
I guess my lengthy posting is because this nearly mindless financial pillaging, disparagement of the political system, of science, of facts, of the rule of law, of the Constitution itself, even of cause and effect, could cause such a loss of faith. And don’t think it’s a conservative or liberal problem. The differences between them is like arsenic and lead. Both will kill you, it’s just a little faster with one.
It’s a bit scary to realize too many of our leaders are functionally suicidal. Or is it homicidal?
Except this is not the rule of law as defined by our constitution. The document which defines our governance says that laws must be passed by Congress, not by a committee of unelected bureaucrats.
Yes, these bureaucrats must define the regulations which detail the manner in which laws passed by Congress are carried out, but the CFPB was created without anything more than a name and charged with the task of creating the laws which it would then implement. This is another case, like the sole authority of declaring war, of Congress abdicating its responsibility to the executive branch of government.
Once they have turned over the entirety of their authority to the executive and have become mere window dressing, we will have the same kind of government that Syria had before it devolved into civil war.
Does anyone know the background of the Supreme Court and mandatory arbitration clauses?
I know this much: 1) the Federal Arbitration Act makes arbitration clauses generally enforceable unless there is a basis in law or equity not to enforce them; 2) a number of federal courts were using their equitable powers to reform contracts and remove arbitration clauses among other things under the doctrine of adhesion contracts, i.e. where the negotiating powers of the parties are unconscionably imbalanced; 3) Scalia and his minions do not care for equitable remedies, ostensibly because they create uncertainty in contracts, but realistically because they interfere with their strong-arming consumers and small businesses; 4) Scalia therefore spent a great deal of his time on the Court dismantling the equitable powers of the federal judiciary to keep such shenanigans from continuing.
the nonworking link “column” is here: http://www.politico.com/story/2017/07/10/consumer-class-actions-business-240375
Excellent exposition, clear and powerful. I think you might have some effect, if any is possible, if you sent sections 5 and 6 to the Supreme Court Justices with a catchy heading:
“HOW THE SUPREME COURT IS COMPLICIT IN DRIVING HONEST CEO’S OUT OF BUSINESS
[L]enders routinely eliminate [the] potential remedy [to fraud] by requiring in their form contracts that the borrower give up any right to bring a class action suit against the lender. Indeed, they typically forbid the victims of their frauds and abuses to bring any civil suit. They permit only arbitrations in a rigged system that ensures that the typical borrower will rarely find it cost-effective to arbitrate and deterrence is impossible. The Supreme Court, to its shame, has allowed this abusive use of form contracts.
[T]he environment I have just described is highly criminogenic It creates powerful perverse incentives not simply for individual bankers to defraud and abuse their customers, but for such frauds and abuses to become dominant. Elite bankers will gain a competitive advantage by causing the firms they control to abuse and defraud the borrowers. Economists and criminologists refer to this as a “Gresham’s” dynamic. George Akerlof gave it this name in his famous 1970 article on a market for “lemons” that led to the award of the Nobel Prize in Economics in 2001. Akerlof explained that the dynamic is so perverse that it not simply the individual customer who is a victim of the fraud, but also the honest CEO who cannot compete with the cheater. Akerlof further explained that this meant that all of us would suffer as customers in such an industry as it became corrupted.
[D]ishonest dealings tend to drive honest dealings out of the market. The cost of dishonesty, therefore, lies not only in the amount by which the purchaser is cheated; the cost also must include the loss incurred from driving legitimate business out of existence.
Economists and criminologists have a common sense definition of a Gresham’s dynamic – bad ethics drives good ethics out of the markets unless the rule of law prevents it.
The Supreme Court and the lending industry have destroyed the rule of law in lending for the typical borrower. The result, as economics and criminology predicts, has been an orgy of fraud and abuse of borrowers. This adds to the profit of firms led by dishonest and abusive CEOs and tends to drive honest competitors out of the business. “.
short and sweet
These are naive views around trial attorneys and their willingness to bring frivolous suits just to get a payout.
Allowing class actions may actually favor large financial corporations over mid to small where the playing field is already skewed to hamper competition with high compliance costs on the smaller players.
There is a middle ground where arbitration is funded via the gov’t and claims are based on their merit. Classes could be found in claims patterns. Regulators already have significant powers to root out abuses.
Interesting! Can you give us some examples/links?
Please ask Warren Buffet to second all the pledges you get.
“D]ishonest dealings tend to drive honest dealings out of the market. The cost of dishonesty, therefore, lies not only in the amount by which the purchaser is cheated; the cost also must include the loss incurred from driving legitimate business out of existence.”
Very true!